Where Investors Can Go Wrong With IRAs

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors have until April 17 to make an IRA contribution for the 2017 tax year. Joining me via Skype to discuss some IRA contribution mistakes to avoid is the IRA expert himself, Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be here.

Benz: We are hurtling toward this April 17 deadline for IRA contributions for the 2017 tax year. I want to tackle with you, Ed, some contribution mistakes to avoid as the deadline draws close. Let's start with the one that's at the top of the list. This April 17 deadline, it's coming up upon us. What do extensions have to do with this deadline, if anything?

Slott: That's the big mistake. Absolutely nothing. It's one of the few areas in the tax code that an extension won't help you. If you have an extension for your regular tax return, there is no extension on the April 17 this year, a due date for making an IRA or Roth IRA contribution for the prior year, being 2017. This April 17, whether you are on extension or not, is the drop-dead due date for making an IRA or Roth contribution for 2017.

Benz: Time's a wasting on that one. Another thing you say that people sometimes get confused about is needing to have earned income in order to make an IRA contribution. Let's talk about that one.

Slott: People think you can just put anything in a Roth IRA or an IRA. There are qualifying factors. One of them is you need earned income. Now, earned income can be wages or self-employment. Some people don't know this, but it could also alimony. Believe it or not, taxable alimony counts as earned income, and the old joke is, who said I didn't earn it.

Benz: Let's talk about the fork in the road that a lot of investors hit where they can make either a traditional IRA contribution or a Roth IRA contribution. Making the wrong contribution type can also be a stumbling block for some investors looking to fund an IRA. Can you offer any tips there, talk about how people can go wrong when they are making contributions to an IRA?

Slott: Each one, it's odd, because the two different IRAs have almost totally opposite rules. For example, for a traditional IRA, there's an age limit. After you are 70 1/2 you can no longer contribute, even if you have the earned income, you can no longer contribute to a traditional IRA for the year you turned age 70 1/2 and future years. For Roth, there is no age limit. You can contribute to a Roth as long as you have the income forever, if you are 90 years old.

Now, there's earned income and then there's income test. An IRA, a traditional IRA, has no income tests. You could make $1 billion and still contribute to a traditional IRA. With a Roth, there are income limits. Now, they are pretty high. Most people, most workers aren't able to do it, but that's another difference. You have differences in qualifications and differences in what's best for you.

By the way, back on that other one, I know some people will pick up, I said there is no income limits for making a contribution to a traditional IRA, they they might say, but yes there are. Only if you want to deduct it and you are active in a company plan, then there are income limits. But to do a nondeductible traditional IRA, there are no income limits.

Then there's the decision, should I do a traditional or a Roth. And generally, I am a big Roth IRA fan, because I don't think the deduction is worth all that much unless you are in a very high tax bracket. But even so, you might get a deduction at a high tax bracket this year even using the 2017 higher rates. Then all the earnings will be taxable forever. At one point when you pull it out, as opposed to a Roth, you forgo, you give up the tax deduction, but all the earnings accrue tax-free forever. That's a choice. I kind of like having tax-free income in retirement. I like the Roth IRA. But some people can't do a Roth IRA because they are over those high income limits that I talked about. That leads us to probably the next point.

Benz: Well, yeah, and in any case, investors need to mind those income limits and spend a little bit of time thinking about what is the right IRA type for them. Ed, for people who are shut out of deductible, traditional IRA contributions or Roth IRA contributions, one strategy that has become really popular is this backdoor Roth IRA. Let's talk about that and talk about how investors can stub their toe a little bit, especially if they have other IRA assets that might be sitting around. How can they inadvertently get themselves into a little bit of a tax pickle?

Slott: We are only talking about Roth IRAs because that's the IRA that has the income limits, those high income limits. We are talking only about, when we say Roth, you've got to be clear, we are talking about contributions, not conversions. Conversions, there are no income limits. We are talking about the $5,500 a year, or if you are 50 or over, the $6,500 and that's another point--some people forget about the catch-up contribution, that extra $1,000.

Let's say, you are over the income limit. You are around $200,000 of income and you are over the income limit, so you can't qualify for the $5,500 or $6,500 Roth IRA contribution. There's something that's been so-called the backdoor Roth IRA. What that is, as I told you earlier, there are no income limits like that on a traditional IRA. You could make a nondeductible traditional IRA as long as, again, you have the earnings, and convert it to a Roth IRA. On in prior years, people questioned, was that a legal strategy. Nobody really knew the answer, but now, we do know the answer because in the conference committee report or the new tax law, the Tax Cuts and Jobs Act, Congress actually said in four places that that is an allowable strategy. There's no problem there.

What you have to do, you still have four different cautions. The idea is, you make a nondeductible contribution to a traditional IRA. That's where it starts and then you convert to a Roth IRA. There's four cautions, I call them. First, the age. Remember I said traditional IRA contributions have an age test. If you are over 70 1/2, this strategy won't work with you because the whole strategy starts with making a contribution to a traditional IRA. If you are 75, you can't do that. So, that won't work.

You have to have the income. Even though you are making a traditional IRA nondeductible contribution, you still have to qualify as having earned income to be able to do that. But there is a loophole. Even if you don't have earned income, if you file a joint return with a spouse who does have earned income, you can qualify on his or her as a spousal IRA. So, you are OK there, but you have to have earned income.

The rule you are talking about is if you have other IRA--so people tell you sometimes you make this contribution to a nondeductible IRA and then you convert it tax-free to a Roth IRA. Well, if you have other IRAs, traditional IRAs, pre-tax money, you have to figure that into the mix. It's a so-called pro rata rule, a proportionate rule. It means if you have a lot of other IRAs, chances are maybe 90% of the conversion to the Roth could be taxable. It may not be tax-free if you have other IRAs. Just be aware of that. I don't think it's a bit deal because you are only talking about the tax on maybe part of the $5,500 or $6,500.

The last caution is, it goes in as a conversion, not a Roth contribution. We call it a backdoor Roth contribution. But really, the way the money gets to the Roth is through a conversion, not a contribution. Now, that makes no difference if you've had a Roth for five years and you are over 59 1/2, then whatever you pull out is tax-free. But if you ever need to get to your Roth money early, the fact that it goes in as a conversion, you have to hold that money for five years and 59 1/2, as opposed to a contribution--if it was a straight Roth contribution--Roth contributions can be withdrawn at any time, for any reason, tax- and penalty-free. But this is not going in as a contribution. It's going in as a conversion. The best advice, if you are doing a Roth, you are doing it for the long term. You shouldn't be looking at taking it out early. The power of the Roth is the decades of tax-free compounding. That's where you really make your money. The point is to hold it for the five years and you are 59 1/2. That's why you will do better and then that's not an issue.

Benz: Some important things to know if people are considering embarking upon this backdoor Roth IRA maneuver. One other point you make is, and a place where people can sometimes drop the ball, is that they do need to file an additional piece of paperwork if they are doing this backdoor Roth IRA contribution and conversion. This is a Form 8606. Tell us what we need to know about that one.

Slott: It's a separate form that's attached to your tax return. You have to file it anytime you do a Roth conversion. That's a Roth conversion. That has to be filed, and that's the form that figures and you don't have to figure it. It does that pro rata calculation automatically, through the computer, as most people do it. So, it will tell you how much of that $5,500 or $6,500 will be taxable. The form goes through that calculation. That will help you there to make sure you are showing the right amount as taxable.

Benz: Ed, as IRA contribution season winds down, thank you so much for being with us to share these tips.

Slott: Great to be with you again, Christine. Thank you very much.

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