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Tips for Last-Minute IRA Contributions

Rushing in a 2022 contribution before the April 18 deadline? Tax and IRA expert Ed Slott shares what you need to know.

Christine Benz: Hi, I’m Christine Benz from Morningstar. The tax filing deadline for your 2022 tax return is April 18 this year, and many investors rush in their last-minute IRA contributions before that deadline. Joining me to discuss what you need to know if you’re making a last-minute IRA contribution is tax and retirement planning specialist Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be back with you, Christine. Thanks.

Benz: It’s great to have you here. Now I want to talk about IRA contributions. For people who did not make an IRA contribution in 2022, they have until April 18 to get that contribution in to have it count for the 2022 tax year. People in that situation hit a fork in the road, if you’re making an IRA contribution, should you do traditional or should you do Roth? Can you walk through what people should bear in mind if they’re in that situation?

Slott: Well, first, it’s one of the rare planning opportunities you have to change something or enhance something that you didn’t do by the end of 2022. For most other tax items, once the book closes on 2022, that’s your income, that’s your deductions, except for an IRA contribution you have till April 15 or now, say, April 18 to make that contribution. So, maybe you want to decide whether to do an IRA or a Roth IRA. I’m totally biased to the Roth IRA because I like putting in money, contributing money, that I won’t owe back. If you take a deduction, according to me—this is the way I look at deductions—a deduction, when you make a contribution, a deductible IRA, say traditional IRA contribution, and you want to take a deduction, that deduction doesn’t hold long. It’s really a loan you’re getting from the government that will be paid back somewhere in the future. But if you think it will help you now, then go ahead and do it, but you’ll pay for it later on in retirement when all the accrued earnings on that deduction you got may end up being taxed at a much higher rate in retirement. That’s why I like the Roth IRA because you don’t get a deduction, but you’ll never pay tax when the funds are needed if you hold the Roth funds for the required five years, and until you’re 59.5 years old. So, I’m a big Roth fan because I like to grow money tax-free, and I believe rates will be higher in the future. So, I think that’s a good bet.

But everybody has a different idea. If they really need a deduction that badly to maybe save a few dollars. I still think that’s kind of shortsighted. Yes, you will save something in tax. And remember, when you talk about IRAs, the amount, the most you could deduct, or the maximum contribution that you’re making now, in ‘23 for ‘22, is based on $6,000 to an IRA or Roth, can’t do both. The overall limit is $6,000, plus $1,000 if you’re age 50 or over—catchup contribution. So, the highest deduction you could get if you did a deductible traditional IRA, if you even qualify, that’s another story. Not everybody qualifies for a deductible IRA, say, if you’re working and you make too much money and you have a plan, say, a 401(k) you’re involved with or a spouse is involved with. But even if you qualify for the deduction, the most is a $7,000 deduction. To me, that’s not enough. Yes, it could save you a couple of thousand in tax, based on your bracket now, but I believe you will pay for it at some point down the road.

Benz: You’ve long been a big believer in the Roth IRA, but many people will be shut out of being able to make that direct Roth IRA contribution because there are earnings limits, income limits on who can contribute. So, one thing we’ve been hearing about for people in that situation is this whole “backdoor Roth IRA” idea. Can you talk about that? Who it’s appropriate for and whether anything has changed there? I know it was a little bit imperiled a few years ago. We thought it might go away. It seems to be alive and well. But talk about that.

Slott: Yeah, for some reason, Congress and, actually, IRS didn’t like the idea. And an IRS spokesperson a couple of years ago said in a public conference—he said why they didn’t like, and he said we just didn’t like the name. “Backdoor” sounded something like that’s a workaround. Like, what is this? If we called it anything different, they said it would have been fine. And later on, they came out and said we’re fine with that. Even Congress said they’re fine. But then, as you said, Congress was thinking about: Is this some nefarious workaround or whatever? It’s totally available now. And if it isn’t, you’ll hear about it. But right now, it’s totally available. And that’s the ability to have the funds that you would have liked to contribute to a Roth end up there even though you’re over the income limit to qualify for Roth contributions.

So, the workaround, known as a “backdoor Roth,” you can make a nondeductible, traditional IRA contribution—there’s no income limits on that—a nondeductible traditional IRA contribution and then convert that to a Roth. So, the only difference is that the funds go in as a conversion rather than a contribution. But the same money can go into the Roth. Now, there could be some tax on that conversion. If you have other IRAs, say, in your total IRA balance, you have to take a proportion and there could be a small tax on that. But that’s a workaround if your income is over the limit to contribute to a Roth, but you would have liked to. So, you can have the same money, get into the Roth through a backdoor conversion, going in as a conversion.

Benz: If someone wants to take advantage of this opportunity to do that, backdoor Roth conversions, what kind of documentation do they need to hold on to and make sure that they save and provide to the IRS?

Slott: Remember, the process starts with making a nondeductible contribution to a traditional IRA, and that’s recorded everywhere in the brokerage, fund statements, whatever you get, and then you’ll make another transaction where you take a distribution, which is reported on your tax return, and you convert it to a Roth, and all that’s reported. So, you can use those brokerage statements, the 1099-R, you get the Form 5498. These are all copies that the IRS gets. You don’t have to file the 1099-R or the 5498 with your return. You just have to report it correctly that you made a contribution, a nondeductible contribution, to your IRA. You report that on Form 8606 on your tax return and then you show the conversion. And part of that, as I said, might be taxable.

Benz: That documentation is important for when you eventually pull the money out. If you are contributing nondeductible funds, you want to make sure that those contributions aren’t taxed again. Is that the point?

Slott: Right. Well, it gets a little tricky because nondeductible contributions, for example, let’s say, you want to do $6,000 or $7,000, whatever the number is, you want to do, say $6,000. And you want to do a nondeductible IRA contribution. So, you do the $6,000 you contribute. And then, you take a distribution and convert it. You can do it online. I’d be careful doing it. I would do it with some guidance and convert to a Roth. And it’s really pretty simple. It’s a simple transaction. But the nondeductible part—let’s say, all the $6,000 was nondeductible, which it is—you can’t just convert the nondeductible amounts and pay no tax on the Roth conversion unless you have no other IRA balance. If you have, say, $100,000, including that IRA balance, then only 6%, 6% of the $100,000 is tax-free. You have to do a proportion.

Benz: And how about the timing between these two steps, between making that nondeductible traditional IRA contribution and doing the conversion? How long should people wait?

Slott: That’s a gray area, and there’s been debate on that for years. Nobody really knows because some tax experts, not me, said, oh that’s a step transaction. You know, you did something the tax law didn’t allow you to do by doing this workaround. I don’t have a problem with that. But I would never do it as one transaction. What I would do—and again, my own advice, just to have clarity here in the documentation I think that would make it very clear—is to make the IRA, nondeductible traditional IRA contribution, then wait at least a month till it shows up that for a moment in time—again, this is not required, my own practical tip—till it shows up on a statement in the traditional IRA. And then, once you have that documentation showing it’s there, then at any time after that you can convert it to a Roth. So, at least for a moment in time, it wasn’t a simultaneous transaction. You can show that it was housed in the traditional IRA, at least for that one statement period.

Benz: Ed, always great to get your insights. Thank you so much for being here.

Slott: Thanks, Christine.

Benz: Thanks for watching. I’m Christine Benz for Morningstar.