Many taxpayers choose to contribute to Roth IRA accounts because they provide for tax-free distributions in the future. However, not all people are eligible to contribute to a Roth IRA due to earned income and contribution limits. If your filing status is married filing jointly, your 2019 modified adjusted gross income (MAGI) must be less than $193,000 to get a full contribution of $6,000 (and a phase out applies up to $203,000).
If your filing status is single, your 2019 MAGI must be less than $122,000 (and a phase out applies up to $137,000). If earned income is less than your eligible contribution amount, your maximum contribution equals your earned income. If you have $3,000 in earned income, the most you can contribute to the Roth IRA is $3,000.
If your income is too high, you may want to consider making nondeductible contributions to a traditional IRA. There are several reasons to choose making nondeductible amounts to an IRA:
- You or your spouse has a retirement plan at work and your income exceeds the threshold, reducing or eliminating your IRA deductions;
- Your income is too high to qualify for a Roth IRA contribution; and
- You still wish to make the maximum contribution ($6,000 per year, $7,000 if you are 50 or older) to take advantage of tax-free growth.
Justify your strategy
For this strategy to make sense, you need to ensure that you are not paying tax on future IRA distributions of nondeductible (previously taxed) contributions. This will require you to calculate the portion of each distribution attributable to deductible and nondeductible contributions and file Form 8606 to track contributions with your federal income tax return.
Do the math
To illustrate the calculation, assume that Nick has $500,000 in his traditional IRA as of December 31, 2018. Of that balance, $125,000 is attributable to deductible contributions, $200,000 to nondeductible contributions and $175,000 to investment earnings within the traditional IRA account. Nick takes a $50,000 distribution from the IRA and reports the entire amount as taxable income on his 2019 return. By doing so, he erroneously pays tax a second time on the portion of $50,000 attributable to nondeductible contributions, which were already taxed when he made those contributions.
To avoid double taxation, Nick must determine the portion of his distribution that is attributable to nondeductible contributions. Suppose the IRA’s balance is $475,000 on December 31, 2019—$500,000 less the $50,000 distribution, plus additional earnings up to December 31, 2019. To determine the nontaxable portion of the distribution, Nick adds the $50,000 distribution to his IRA’s year-end balance (for a total of $525,000) and divides nondeductible contributions ($200,000) by that amount. He multiplies the resulting percentage (38%) by the $50,000 distribution to determine the nontaxable portion ($19,000). Because $19,000 of Nick’s IRA distribution came from nondeductible contributions, the $200,000 nondeductible distributions are reduced by $19,000 (to $181,000) for purposes of future nontaxable IRA distributions.
Handle with care
You cannot avoid taxes altogether by making nondeductible contributions to a separate account and then taking all of your traditional IRA distributions from that account.
For tax purposes, the IRS treats all traditional IRA accounts as a single IRA. So, your IRA distributions will consist of a combination of taxable and nontaxable amounts, regardless of which account they come from. The key message is to remember to compute the portion of IRA distributions that are allowed as a return of your nondeductible contributions and to track them accordingly. Both you and the IRS should have this information to avoid tax issues in the future.
For more information about the use of IRA accounts for your contributions and distributions, contact Thomas Kosinski at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.