Roth vs. Traditional: Help needed

[TBH]

Hi, folks.

A friend asked me for advice about whether she and her husband should open Roth IRAs or Traditional IRAs. Or rather, I lectured her about saving for retirement until she finally admitted that she hasn't started because she doesn't know what kind of account to open. They have quite a bit of liquid savings because they're saving for a house downpayment, and are willing to divert money from that account to fully fund IRAs for both of them for 2006 and 2007.

For 2006, their income is just barely low enough that they qualify for Roths. However, they're not sure whether their income will be too high in 2007 to qualify or not. Within the next couple of years (say, in 2008 or 2009) they're planning to start a family, at which point she will stay home and his income alone will allow them to qualify for Roths again at least for a few years. He's in a highly paid field, so probably eventually he'll make too much money on his own for them to qualify, even if she's not working. He contributes to a 401k at work but she has no retirement savings in her name whatsoever.

Should they:
1. Open a traditional IRA for each of them so they will have only one account each and so they'll be able contribute regardless of their income?

2. Open a Roth and contribute for 2006 only, and then wait and see if they qualify for 2007. If they don't, open a Trad IRA for 2007.

3. Open a Roth and contribute for 2006 and 2007. What will happen if they contribute for 2007 and their income ends up being too high?

Thanks for any help you can provide.

[jIM_Ohio]

I would use the Roths to the extent eligible. I doubt someone could be NOT eligible for a Roth (based on income) and get the deduction from a traditional IRA... so Roth is my "conventional wisdom" pick. Unless they are not covered by a work retirement plan.

Is either spouse covered by an employers retirement plan?

doing something is better than nothing...

[MonkeyMama]

As long as they qualify for Roths they should do it. Like Jim said, they would most likely not qualify for Traditional IRAs in that case.

There is an interesting tax loophole here though which might fit them perfectly.

For one tell them not to make the contribution until they do their taxes each year, so they don't accidentally over-contribute. Then if they find they can not take the max one year there is a tax loophole where you can convert all your traditional IRAs to Roths in 2010, no matter what your income is (currently the income limitation is $100k for conversions). We have a lot of clients making too much money to contribute to ROTHs or traditional IRAs so we are having them do non-deductible IRA contributions (contributions to traditional IRAs, but you don't get the deduction now). The hope is in 2010 they can roll it all to ROTHs.

This is interesting for your friend since they might make too much in the next couple of years but may possibly drop to a lower bracket in 2010. When they rollover they will pay tax on the earnings, but not the principal, since they will not get a deduction for it in the first place (already taxed).

The law could change and so who knows if this 2010 thing will hold until 2010, but regardless, when you make too much money, non-deductible IRAs are a good deal. The earnings grow tax-free in the mean-time. When you withdraw you don't pay tax on the principal you put in that was not tax-deductible. It's like a ROTH/traditional hybrid in a sense, the principal is withdrawn tax-free in retirement, but not the earnings and growth. But if you do this you must keep your tax returns forever and keep good records.

It gets REALLY complicated. In their case they may want to seek some tax advice from a professional. Might save them money in the long run.

They can contribute to both ROTHs and Traditional IRAs as long as the total of all IRAs meets each of their allowable maxes. So definitely tell them ROTH first and for whatever is left over consider non-deductible traditional IRA contribution. When they do that they have to file a for 8606 with their tax return, and keep it forever so they don't end up paying tax on the amount twice.

But just to re-iterate - I would not make a contribution for 2007 in this case until after they do their 2007 taxes. IT gets really involved when you over-contribute. This is why the IRS lets you do your taxes first before you decide how much you can contribute, for people who just will not know until the end of the year what they can contribute.

[jIM_Ohio]

As long as they qualify for Roths they should do it. Like Jim said, they would most likely not qualify for Traditional IRAs in that case.

There is an interesting tax loophole here though which might fit them perfectly.

For one tell them not to make the contribution until they do their taxes each year, so they don't accidentally over-contribute. Then if they find they can not take the max one year there is a tax loophole where you can convert all your traditional IRAs to Roths in 2010, no matter what your income is (currently the income limitation is $100k for conversions). We have a lot of clients making too much money to contribute to ROTHs or traditional IRAs so we are having them do non-deductible IRA contributions (contributions to traditional IRAs, but you don't get the deduction now). The hope is in 2010 they can roll it all to ROTHs.

This is interesting for your friend since they might make too much in the next couple of years but may possibly drop to a lower bracket in 2010. When they rollover they will pay tax on the earnings, but not the principal, since they will not get a deduction for it in the first place (already taxed).

The law could change and so who knows if this 2010 thing will hold until 2010, but regardless, when you make too much money, non-deductible IRAs are a good deal. The earnings grow tax-free in the mean-time. When you withdraw you don't pay tax on the principal you put in that was not tax-deductible. It's like a ROTH/traditional hybrid in a sense, the principal is withdrawn tax-free in retirement, but not the earnings and growth. But if you do this you must keep your tax returns forever and keep good records.

It gets REALLY complicated. In their case they may want to seek some tax advice from a professional. Might save them money in the long run.

They can contribute to both ROTHs and Traditional IRAs as long as the total of all IRAs meets each of their allowable maxes. So definitely tell them ROTH first and for whatever is left over consider non-deductible traditional IRA contribution. When they do that they have to file a for 8606 with their tax return, and keep it forever so they don't end up paying tax on the amount twice.

they could contribute 4k to Roth in 2007. if they find out in Feb/Mar of 2008 they "over contributed" in 2007, software like Turbo tax will tell you, and this can be fixed quickly.

I (Turbo Tax) found a mistake on my (over)contribution this year and had problem fixed within 5 days at T Rowe Price at cost of one stamp to me. One form, easy to fill out. DONE. I would not delay contribution when it can be fixed later. Just fix it BEFORE you file your taxes for fewest headaches. It can be fixed after you file, but then you'll also need to amend your return.

There is a standard form to "recharactorize contribution" which is one page and easy to fill out. If contributions are to one fund, this will be simple. A couple lines and that's it on the recharactorization form.

If Roth went 1k to 4 different funds, you need to fill in 4 lines on recharactorization form, then tell it where those 4 lines go in traditional account (4 more lines?), so keep it simple going in and it won't be an issue.

If someone has at least 4k of earned income, they are eligible to contribute a max of 4k to an IRA. The Roth has income limits, a traditional does not. Soa 4k Roth contribution could be recharactorized to a 4k traditional contribution at cost of one stamp to account owner. Fill out form and done.

[Scanner]

Agree with my esteemed savings colleagues here - get the money invested and have an accountant clean it up later (or Turbo Tax) if needed.

If worse comes to worst, they could stick a large chunk in their state muni bond fund and let it collect interest tax free, given it sounds like their total income as a family is substantially high until they decide what to do with it.

It's a little better than having it sit around in a savings account.

If their income is going to drop and their lifestyle is going to increase (home ownership), having that money in a muni-bond fund would be a nice liquid cushion for them, rather than earmarking the entire kit n' kaboodle for retirement.

That is, in case they get overextended, they may want to get their hot little hands on it.

BTW, a muni-bond fund really makes sense for people like this, who are high earners. Their tax bracket would raise a yield of 5% to something like 7.5%. You can't beat that for as conservative of investment as it is.

[MonkeyMama]

Actually, no I would not recommend this in this case.

If you recharacterize the entire $4k in 2007 yes this in the case.

But what if they can contribute $3k to a ROTH and have to re-characterize $1k to a traditional IRA. There are tax ramifications and complications here. IT gets really messy and you have to pay tax on the earnings you made during the year, etc. From a professional standpoint I Recommend waiting.

It is true if you recharacterize your ENTIRE contribution you get a free pass and avoid the taxes on the earnings. But in this case it seems likely some will be disallowed, some not, we don't know.

[jIM_Ohio]

Actually, no I would not recommend this in this case.

If you convert the entire $4k in 2007 yes this in the case.

But what if they can contribute $3k to a ROTH and have to re-characterize $1k to a traditional IRA. There are tax ramifications and complications here. IT gets really messy and you have to pay tax on the earnings you made during the year, etc. From a professional standpoint I Recommend waiting.

It is true if you recharacterize your ENTIRE contribution you get a free pass and avoid the taxes on the earnings. But in this case it seems likely some will be disallowed, some not, we don't know.

The 3k Roth was tax advantaged and the 1k traditional was tax advantaged... what penalty are you referring to? The penalty would only be if 1k was withdrawn in cash, correct?

[MonkeyMama]

There is no penalty here - just talking about taxes.

I would have to stop and think on this but when you recharacterize a portion there are tax ramifications on the earnings made on the contribution. Going from a ROTH to a non-deductible IRA, hmmmm, I am not exactly sure. I would really have to think about it.

Like I said, it is complicated, I would avoid it! The investment companies and Turbo tax do not necessarily know the rules even. I Was just getting into an argument with Schwab because they insisted my client would have to pay a 10% penalty for withdrawing money out of a SEP (over-contribution) before April 15th.

As long as you do it before the tax filing deadline you avoid penalty. Jim brings up a good point. But Schwab does not even know that apparently. Good luck since your custodian does the number crunching and tax reporting on these. I would avoid all this headache like the plague and just wait myself. But if they really want to invest the money now it is doable. We tell our clients to wait because we spend so much time and energy figuring this stuff out and arguing with their custodians - it just gets ugly. SO that is my bias.

ETA: Maybe I am confused. There may be no taxes in this case but the custodian does indeed have to figure how much loss or earnings is related to this and move it as well. I have seen situations where it is taxed so may be getting confused, but this may not be one (doesn't seem logiccal - but taxes aren't always logical either). But just know it is not as simple with a partial recharacterization as moving the original $4k over. You have to move the earnings that goes with it. IT just complicates things is all. IT is a totally different thing from just recharacterizing a full contribution. & when you are talking about tracking your basis in a non-deductible IRA, this just complicates things more.

[MonkeyMama]

Sorry TBH for the sidetrack - not the simplest tax situation.

[jIM_Ohio]

I won't argue with an acountant, but going traditional to Roth should be easier than this thread is making it out to be.

[jIM_Ohio]

reading IRS web site, here are some excerpts

Publication 590 (2006), Individual Retirement Arrangements (IRAs)

You may be able to treat a contribution made to one type of IRA as having been made to a different type of IRA. This is called recharacterizing the contribution. See Recharacterizations in this chapter for more information.

Recharacterizations
You may be able to treat a contribution made to one type of IRA as having been made to a different type of IRA. This is called recharacterizing the contribution.

To recharacterize a contribution, you generally must have the contribution transferred from the first IRA (the one to which it was made) to the second IRA in a trustee-to-trustee transfer. If the transfer is made by the due date (including extensions) for your tax return for the year during which the contribution was made, you can elect to treat the contribution as having been originally made to the second IRA instead of to the first IRA. If you recharacterize your contribution, you must do all three of the following.

Include in the transfer any net income allocable to the contribution. If there was a loss, the net income you must transfer may be a negative amount.

Report the recharacterization on your tax return for the year during which the contribution was made.

Treat the contribution as having been made to the second IRA on the date that it was actually made to the first IRA.

[MonkeyMama]

Oh you can argue with me all you want, I Don't have the tax code memorized, you all keep me on my toes.

[Scanner]

Oh you can argue with me all you want, I Don't have the tax code memorized, you all keep me on my toes.

And we don't help matters by just saying, "Oh your accoutant can clean it up at the end of the year", do we?

Typical businessowner, aren't I?

[TBH]

Thanks, y'all, for your help with this.

I sort of stopped following the thread because the "friend" in question made her own decision before I was able to come back with an answer for her. This is a person who is kinda spacey with money and as far as I know she still hasn't filed her taxes for 2004 or 2005. She got married last summer, and her husband is more on the ball, so I think he'll figure out the best thing to do here.

They've had some issues because he was using a financial planner before they got married and she doesn't like the financial planner's fee schedule. But he says her financial planner is inexperienced, so they need to find a new one they can both agree on. That was part of the holdup at tax time.

But they are doing some things right. They are saving her entire income (minus a small monthly allowance for her hair and nails and shoes) so that when she stops working to have a family they'll be used to living on just his income.

Did I mention this "friend" is my younger sister? Can you tell I'm both amused and driven crazy by the whole thing?

[bigsaver]

Silly question about a trad IRA. Is there an income limit to contribute to it? Actually, what are the rules?