Sunday, April 9, 2017

Help Me Out: Traditional or Roth IRA

retirement planning, traditional IRA, Roth IRA, 2016 taxes

We've just about wrapped up our 2016 taxes.  Finally.  The past few years we've been fortunate enough to be above the MAGI threshold to contribute to a Roth IRA.  Good problem to have, right?

Well, with 2016's taxes just about completed I was expecting us to be able to contribute to Traditional IRAs in order to lower our taxable income.  Apparently, that's not the case.  My understanding of the tax law is that we can only contribute a paltry amount, about $800 per IRA, because I had access to a 401k last year.  Nevermind the fact that I was laid off in April so I only had access to it for about 1/3 of the year.


Since we are also somehow above the income limit for contributing to a Traditional IRA, since I had access to the 401k, that limits the amount of tax deductible contributions we can make to IRAs.  

I was hoping to source the wisdom of the community to see what y'all think we should do.

Scenario 1:  Contribute the max allowed, ~$800 per account, to Traditional IRAs and the remainder to Roth IRAs.  

This changes our taxes from approximately $40 that we owe to about a $140 refund.  However, it complicates our investments since we'll have such small amounts in the Traditional IRAs.  Adding 2 accounts with only $800 each seems like it's not worth it to me and would just be more hassle than it's worth.

Scenario 2:  Contribute the max allowed, ~$5,500 per account, to Roth IRAs only.

This would diversify our tax situation better and allow us to have a better mix of taxable, tax deferred and tax free accounts.  However, as I mentioned earlier it comes with changing our tax status from around a $140 refund to owing around $40.  

Scenario 3:  Forego IRA contributions for the 2016 tax year entirely and use the cash that would have funded the accounts to pay down debt or buffer the emergency fund to allow more aggressive debt pay down in the coming months.

By choosing this we would end up owing approximately $40 in taxes which I'm fine with.  However, we wouldn't get the account diversification by adding to either tax deferred or tax free accounts.  We would then use that extra cash for debt reduction or just keep it in the emergency fund.

As of now for the 2017 tax year I don't have a 401k at work so we should be able to max out two Traditional IRAs for the current tax year.  That would give us approximately $11k that is tax deferred in self-directed IRAs as well as reducing our taxable income for this year.  

I'm currently leaning more towards Scenario 2 or 3.  Frankly I like things to be simple and adding 2 additional accounts to keep track of that are only funded with ~$800 isn't that attractive to me, although for 2017 those accounts should be able to get a $5,500 boost each.  Especially since it doesn't really move the needle in terms of our taxes: owing $40 vs getting a $140 refund. 

*Update*

I have everything completed now and as it stands we can make $900 in contributions to 2 Traditional IRA accounts and $4,600 to 2 Roth IRA account.  However, it swings us from paying $2 to the IRS to  a $548 refund.  Looks like the Traditional IRA's are getting funded.

**Final Update**

Everything is complete now.  Here's where we stand we can contribute $990 each to 2 Traditional IRAs.  That leaves $4,510 x2 that we can contribute to Roth IRAs depending on what cash we can scrounge up in the next week.  By contributing the $990 x2 for the Traditional IRAs it moves our refund from $111 to $699.

**Final Final Update**

Nothing has changed regarding the IRA contributions that we can make.  I know what brokerage I'll be going to for the 2 Roth IRA accounts as well as my Traditional IRA contribution.  However, for the Traditional IRA contribution for my wife I'm needing to find the best place to brokerage to park that money.  I need something that has low commissions, since we might only have $990 to invest in that account for the foreseeable future as well as free dividend reinvestment and no account fees.  

For that account I'm considering Fidelity since they check all those boxes as well as provide several commission free ETFs including dividend focused funds.  Vanguard would be another option with their suite of funds/ETFs and low fees.  However, their dividend focused fund has an expense ratio that is double what Fidelity's is.

So my question to all of you is what would you do in this situation.  Is it worth it to get as much tax benefit as possible?  Is a Roth IRA better in this situation?  Or would we be best served by using the cash for debt reduction or emergency fund buffering?

Please let me know in the comments below!

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8 comments:

  1. PIP -

    You're going to hate me for saying it - BUT - if you plan on doing Traditional this year - then why not get a kick start and fund the $800 per account for 2016? Saving $180 is huge!! (40 negative swing to 140 positive). Further - you can use that refund money to pay down debt OR throw that right back into the traditional IRA for 2017. I go for scenario 1, especially if you plan on doing those accounts anyways!

    -Lanny

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    1. Lanny,

      That's what I would do if I knew for sure I could then contribute to a Traditional IRA again for the 2017 tax year. However, there's a greater than 50% chance I could go back to being an employee with a 401k and likely be over the income limit to contribute to a Traditional IRA, although I'd still be able to contribute to a Roth most likely. From a purely tax perspective I would do the Traditional in a heartbeat, but I'm also trying to look ahead and for simplicity sake is it worth it to have 2 additional accounts with only ~$800 each in them. To me the answer is no despite it being the better move tax wise. I still have a bit of time decide, but man do I wish we had some more clarity with our taxes. There's been a pretty big change each year for the last 5 or 6 years now which always throws things off a bit.

      All the best.

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    2. PiP -

      I can see the simplicity standpoint. Wish we all knew what the forward looking tax situation looked like : ) I know mine was a whirl-fricking-wind in 2016, more specifically in the fall - where I maxed every tax advantaged account as much as I could. One thought - would you do pre-tax 401k with your potential of going back to being an employee and maxing that out to reduce your MAGI? In the end - have to do what makes you happy and helps you sleep, right? Do that!!

      -Lanny

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    3. Lanny,

      Typically simplicity wins out in my book. If I go back to being an employee it'll be pre-tax 401k contributions which would reduce our MAGI. We likely wouldn't be able to get deductible contributions to a Traditional IRA, but I would guess we'd be under the MAGI threshold to make Roth IRA contributions. That would be a waiting game to see how things shake out come tax time next year.

      I've been finishing up some things, namely entering all of the information regarding my ESPP share sales as well as another credit that I forgot we could get. Our max traditional IRA contribution is $830 per account. So the most up to date information is that if we make no IRA contributions of any kind we owe $2. If we make the max allowable Traditional IRA contribution of $830 per account it swings us to a ~$400ish refund. Then we could put the rest into a Roth IRA and have it be tax free forever. Now that the swing is a big bigger I think the Traditional IRA contribution is worth it and I'll see if we have enough free cash to max out the Roth IRA parts.

      I wish that we could just do $830 x 2 into 1 account as opposed to $830 each in 2 accounts. That makes no sense to me at all because it's the same thing but makes everything so much easier. If we could do that it would have been a no brainer decision.

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  2. Passive IncomePursuit,

    I know you've got it figured out already, but I'm a little confused. I don't think having a 401k has anything to do with being able to contribute the maximum to an IRA. It is only if you have an employer (401k or 403b) plan AND have a MAGI above a certain amount that your ability to contribute to a *tax-deductible* traditional IRA gets phased out. You could still contribute the maximum into a non-deductible traditional IRA. The phase out income range is very similar to the range that limits a direct contribution to a Roth IRA.

    Is the $990 amount what is left from the phase out that you can still contribute to a tax deductible? Even with a 401k, you'd still have the choice of contributing the maximum to a non-deductible traditional IRA or doing a backdoor Roth (doing a non-deductible traditional IRA followed by a rollover into a Roth).

    Given that you are likely at or above the MAGI limit for a Roth contribution as well, I don't think that you'd be able to contribute directly to a Roth. You'd have to contribute it first as a non-deductible traditional IRA and then do the rollover.

    Am I reading your post wrong?

    I am becoming eligible for my employer's 401k this July and will begin contributing the maximum into that. I will continue to fund my Roth through contributions of post-tax money into a non-deductible traditional IRA followed by a rollover into a Roth. This way that money will be only taxed once. If I had just left it in a traditional IRA I would not have gotten the up-front tax benefit AND would have had to pay taxes when it is withdrawn in retirement. Plus, a Roth does not have a required minimum distribution.

    Thanks for posting an interesting topic!

    Scott

    Sources:
    http://www.savingtoinvest.com/401k-ira-and-roth-ira-contribution-and-income-limits/
    https://www.kitces.com/blog/how-to-do-a-backdoor-roth-ira-contribution-while-avoiding-the-ira-aggregation-rule-and-the-step-transaction-doctrine/#disqus_thread
    https://thefinancebuff.com/the-backdoor-roth-ira-a-complete-how-to.html

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  3. Scott,

    My phone won't let me reply to the comment so here's the quick answer.

    The way I understand it there's a MAGI limit to fully contribute to a Traditional IRA and a separate MAGI threshold to be able to contribute to a Roth IRA.

    For 2016 we're below the Roth IRA MAGI limit so we could max out 2 Roths. Our MAGI is in the phase out limit to make tax deductible Tradional IRA contributions. So if we max out the Traditional IRAIRAs only $990 would be tax deductible and then there'd be $4510 non-deductible. The way I see it there's no advantage to having the non-deductible so we might as well only put the max tax deductible $990 per Traditional IRA given our situation and the rest would best be served going towards Roth's since we've already paid taxes and can't get the deduction. Essentially I don't see the need to overly complicate the Traditional IRA's by mixing tax deductible and non-deductible contributions.

    I'll check out the links you provided tomorrow when I'm on the computer. But that's the way I understand it to work and it's what TurboTax is saying we can do.

    Here's a link to TurboTax that says there's a MAGI limit on tax deductible IRA contributions if you have access to a 401k.


    https://turbotax.intuit.com/tax-tools/tax-tips/Investments-and-Taxes/Deductions-Allowed-for-Contributions-to-a-Traditional-IRA/INF14777.html

    Also here's the link to the IRS website that says if you have a 401k there's a phase out range for tax deductible contributions.

    https://www.irs.gov/retirement-plans/plan-participant-employee/2016-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work

    If MFJ and MAGI is <$98k then you CAN max out with full tax deductible contributions. If MAGI is > $118k then you CAN'T make tax deductible contributions. Our MAGI is between those hence the $990 per Traditional IRA that we can do tax deductible. However there's a separate MAGI limit for Roth contributions I think it's around $180k which we're well under.

    Hope that helps.

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  4. Yep, that makes sense. Thanks for explaining that. I thought the deductions phased out for the tax deductible IRA closer to the income contribution limits for contributing directly into a Roth. As you agree, it doesn't make sense to contribute more into a traditional IRA than you would get for the tax benefit.

    Sounds like the option you chose is the best, provided that you do want some of it to be tax deductible now.

    Scott

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    Replies
    1. Scott,

      No problem. I think if you don't have access to a 401k the MAGI phaseout for a Tradtional IRA might be about the same, but I didn't look into it.

      If anything this all goes to show how we need tax reform because it shouldn't be anywhere near this complicated.

      All the best.

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