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IRA Tips for 2016

Know what you're eligible for, take advantage of workarounds and recharacterization, and--above all--don't wait until the last minute, says retirement expert Ed Slott.

Note: This video is part of Morningstar's February 2016 Tax Relief Week special report.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. April 18 is your tax-filing deadline for the 2015 tax year, and it's also your IRA contribution deadline for 2015. Joining me to share some tips on those contributions is retirement expert Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be here in Chicago.

Benz: Thank you for being here in studio. Let's talk about April 18. It's the tax-filing deadline this year, and it's also your deadline for making an IRA contribution. One key piece of advice you have on that front is don't wait till the very last minute.

Slott: It probably doesn't matter that I tell people that. People are going to do it anyway. They like the rush of being at the post office or at the bank at the last minute. But the IRA contribution is different from filing your taxes. [April 18 is] the last day to get an IRA or Roth IRA contribution for the previous year--for 2015--and there is no extension. So, even if your regular return is on extension, there is no extension for making a 2015 contribution--or a prior-year contribution--past the normal April 15, which is now April 18 this year because of a holiday. But don't wait till then. Try to do it at least a week before; you can get the same rush.

Benz: So, it's a little bit confusing for people attempting to sort through the various income limitations that apply to a traditional deductible IRA and Roth IRA. But you say it's really important that people make sure that they are eligible to make the type of contribution that they are trying make.

Slott: Yes, things change. You have to know the eligibility rules and, unfortunately, the tax code made it more complicated. For the most part, IRAs and Roth IRAs fall under IRAs, but the rules for eligibility are almost opposite. For example, with IRAs, there are no income limits. With Roth IRAs--and we're talking contributions only--there are income limits. They are very high, but there are income limits. For Roth IRAs, there are no age limits, but for traditional IRAs, you can't fund one for the year you turn 70 1/2 or for later years.

So, you have to make sure you're eligible. And of course, to do either, you have to have earned income. People in retirement think, "Maybe I can just keep contributing." No, you have to have earned income. That's W-2 wages, self-employment income. The only exception to having earned income is for something known as spousal IRAs. If you have a spouse who's not working, who doesn't have wages or self-employment, that spouse can use the working spouse's income to qualify; but the spouse still has to qualify on their own. For example, if one spouse is working and that spouse is in his or her 60s but the other spouse who is not working is 75, the nonworking spouse can use that spouse's wages, but she doesn't qualify anyway because she is over 70 1/2. But she could qualify for a Roth, where there is no age limitation.

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Benz: One thing I wanted to ask, though, is if I inadvertently fund the wrong IRA type--for instance, I open a Roth IRA and I wasn't eligible to make a contribution there--what's the workaround? What do I have to do?

Slott: It gets a little complicated. First, make sure you're eligible because it gets a little messy. There's something called recharacterization where you can undo it. Say you did exactly what you said: You did a Roth, but your income was too high and now you can't have a Roth. You could recharacterize it as a traditional IRA--as long as you would've qualified for a traditional IRA anyway. For example, let's say the reason you didn't qualify for a Roth is because you had too much in earnings, but what if you're 75? You can't recharacterize to a traditional IRA because of the age limitation; you wouldn't qualify. Then, it has to come out, plus any income on that. Otherwise, you have a 6% excess-contribution penalty. It's got to be removed by Oct. 15 of the year after the contribution was made. So it gets a little messy. Make sure you qualify, you're eligible, and you contribute to the right account--whether it's IRA or Roth IRA.

Benz: You've mentioned these income limitations that apply to direct Roth IRA contributions a couple of times. A lot of people in recent years have been talking about this workaround; it's sometimes called the backdoor Roth IRA. Let's talk about that. You say it's a little bit of a misnomer because, really, it's kind of a two-step process.

Slott: I wouldn't call it a backdoor Roth. People call it that because it's a way to get money into a Roth even though you are over the income limit for a Roth. [You can use the traditional IRA as a workaround] because there are no income limits. So, it's two separate transactions. You really want a Roth, but you have to start out by contributing to a traditional IRA. It might be nondeductible if you are active in a plan; if not, it could be deductible. But you don't really care about that because your real intention is, at some point, getting it into a Roth.

Now you qualify for a traditional IRA contribution, where you didn't qualify for a Roth because your income was too high. You made your, say, $5,500--or if you are 50 or over, $6,500--into a traditional IRA (maybe a nondeductible traditional IRA); now, at any time, if you want, you could convert that to a Roth IRA because there are no income restrictions. There were years ago, but there aren't anymore. So, you could convert that at any time to a Roth IRA. Now, you have what you really wanted all along. That's why people call it a workaround in the Roth IRA; you have that same money because you converted it--but it's different. It's not a Roth IRA contribution; the money went in as a conversion, which makes a difference if you are under 59 1/2. If you just did a straight Roth contribution, money you contribute to a Roth can always be withdrawn at any time for any reason, tax- and penalty-free even before age 59 1/2. That's not true with converted funds. So, you could have a penalty if you withdraw converted funds too early; but if you are thinking of keeping it long term past 59 1/2 and you have five years, then it shouldn't matter.

Benz: Another question: If I've opened this traditional nondeductible IRA and I want to do the conversion to get myself a Roth IRA, how long do I have to wait?

Slott: Nobody knows. Nobody knows.

Benz: Why is that?

Slott: I would wait maybe a month or so. But I saw a tax service where a very smart tax guy said the same thing. Someone asked what the time limit was, and he said nobody knows. He said, "I think it's the same time you have to wait to remarry after a spouse has died," [which is a way of saying] it's when you feel comfortable.

Benz: That may be a good long time! But let's talk about some caveats that come along with a backdoor IRA. There are some inadvertent tax issues that you can trigger by doing this conversion. Let's talk about that.

Slott: Well, not to be too technical, but you have something called a pro rata rule. People think if they do a nondeductible IRA and convert it, that will be a tax-free conversion. Not always. Not if you have other IRA balances and that includes SEP and SIMPLE IRAs. You have to do a proportionate amount. So, it could be if you have a lot of other IRA money, most of that money you're converting will be taxable. But that's OK, too, if the whole idea is to get it into a Roth. But in most cases, unless you have no other IRAs, that conversion is going to be either all taxable or partly taxable.

Benz: Last question on this backdoor Roth IRA, even though you don't like the term--

Slott: Two separate transactions!

Benz: Last question, though: A lot of people have looked at this maneuver and have been happy that they have been able to get this money over into the Roth column; but people are concerned that Congress could close this loophole.

Slott: They've had so many chances to do it. If that ever happened, I think they have bigger fish to fry in Congress than letting people put money into a Roth. Remember, the only money that goes into a Roth is already-taxed money. I think if Congress opened that door, they'd miss out on the gravy train of all that money they're getting from people putting money in Roth IRAs. Then, people will think, "Maybe I shouldn't convert--maybe if they are going to do this, they'll go to the next step and the next step." I think you're OK. In the worst-case scenario, I think if they ever did something that outrageous--which I think would be outrageous because so many people have Roth IRAs and who knows how the money got in, whether it was this backdoor or contributions or conversions--people would stop putting money in a Roth, and the government would lose all that tax money they are actually counting on in their budgets.

I think if worst comes to worst, [any change Congress makes] would grandfather people who were already in it. But I don't think that's something to worry about. I get that question at almost every consumer seminar I do, and the question goes something like, "Can I trust the government to keep its word that Roths will always be tax-free?" [My answer is that it] brings in too much money. Our legislators have been looking for this kind of provision for over 200 years; it's something that brings in money and people like it. It's never happened before. I don't think they are going to kill the golden goose.

Benz: Ed, thank you so much for being here. Lots of valuable tips for IRA contribution season.

Slott: Sure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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