With April 15 approaching (April 18 this year), many folks are searching for ways to reduce their tax liability for 2015 or identifying strategies that may lead to lower tax liabilities in the future.
One popular strategy that some higher income taxpayers may find attractive involves making non-deductible contributions to a Traditional IRA account. In other words, funding the IRA with after-tax dollars. The primary advantages of this strategy are tax-deferred growth of earnings on the contributions and the possibility that some taxpayers may be in a lower tax bracket in the future when withdrawals are made.
Perhaps one of the biggest misconceptions about funding a Traditional IRA with after-tax dollars is that future withdrawals are available on a tax-free basis. In fact, the IRS treats distributions as partially tax-free and partially taxable. To figure out how much comes from which part, you have to track how much of your total IRA balance came from non-deductible contributions and how much came from growth in the account.
And to add one more wrinkle, you must apply the IRS’s aggregation rules to Traditional and Rollover IRAs. In simplest terms, the rules state that when a withdrawal is taken from an IRA that includes non-deductible contributions, the calculation to determine how much will be tax-free must be prorated against the total of all balances the individual holds in all Traditional and Rollover IRA accounts.
Here’s an example:
Mary had an existing $50,000 IRA that was all pre-tax funds and had very recently made a $5,000 non-deductible contribution to a brand new second IRA. Now Mary has decided she needs to use some of the money and wants to withdraw the $5,000 non-deductible IRA, hoping to recover the funds tax-free.
Because of the aggregation rules, even if Mary withdraws just $5,000 from IRA #2 that contained only after-tax funds, she must apply the pro-rata rule across both accounts: $5,000/$55,000 = 9.09% is a return of after-tax funds. Therefore, Mary must report $4,545.45 of her withdrawal as taxable.
The aggregation rules have surprised many an individual since provisions apply to the balances in all Traditional/Rollover IRA accounts rather than being limited to a single account only. And the subsequent higher tax bill likely only aggravated the issue further.
Keep in mind also that the portion deemed as taxable withdrawn from such accounts prior to the individual attaining age 59 ½ is subject to an early withdrawal penalty. In addition, several other factors may reduce the perceived advantages for making non-deductible contributions to these accounts, including the possibility that overall income levels or tax rates may be higher in future years and the more time-consuming recordkeeping requirements associated with making non-deductible contributions.
What other effective strategies for growing assets on a tax-deferred basis are available, given the income limits that prevent higher income earners from making direct contributions to a ROTH account?
One effective strategy may rely upon converting portions of balances held in a Traditional/Rollover IRA account to a ROTH account during working years, using the monies earmarked for the non-deductible contribution instead to pay the tax due on the converted amount. ROTH conversions don’t have the income limits that direct ROTH contributions do and, since distributions are generally tax-free, ROTHs relieve the taxpayer of the tracking required in non-deductible Traditional IRAs.
A well-planned strategy for converting amounts to a ROTH account can be very effective in reducing overall tax liabilities paid, while striving to limit the amount of additional current tax liabilities triggered to smaller, more manageable levels. This strategy’s immediate goal is “filling up the bracket” for the individual’s current tax bracket by converting smaller amounts during working years, with the overall goal of shifting a large portion from the Traditional/Rollover IRA accounts to ROTHs by the time of retirement. Such an approach could lead to a significantly lower tax bill during retirement years. While other retirement income sources (e.g., pension, social security benefits) will be subject to ordinary income tax treatment, distributions from ROTHs will not.
Of course, ROTH accounts present several other advantages, including tax deferred growth of earnings, greater flexibility in accessing balances with no potential tax impact, no required future withdrawals for original account owners and the ability to pass along these ROTH assets on a tax-free basis to beneficiaries. A word of caution about taking withdrawals: the ROTH account must have been established a minimum of 5 years or the account owner must have reached at least age 59 ½ prior to taking any withdrawals, whichever occurs later, in order for the withdrawals to be available on a tax-free basis. (If you’d like to read more on what to think about when considering a ROTH conversion, please read our previous blog post.)
These strategies may sound similar but caution is in order as the various complexities may trip up the most well-intentioned individual. Consult with your tax professional or with us to properly evaluate your own circumstances and identify the best strategies prior to implementing any of the strategies discussed here.
Yes, tax details do matter. Still confused? Or have other financial goals which you are considering? Give us a call. We’re here to help in planning your future.
image credit: Dean Hochman