Rules for contributing to multiple retirement accounts.
Money Girl
302 MG Should You Contribute to a Non-Deductible IRA?
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[MUSIC] >> Hi, friends. Thanks for downloading the MoneyGirl podcast. >> [NOISE] >> I'm Laura Adams, the author of an award-winning book called MoneyGirl Smart Moves to Grow Rich. You'll find the paperback or e-book at your favorite bookseller. I recently received a couple of related questions about making contributions to multiple retirement accounts. Marta says, "I max out my 401k at work each year and still have more to invest. If I contribute to a traditional IRA, I understand that I don't get a tax deduction, but I can't contribute to a Roth IRA because I earn too much. What should I do?" Arthur asks, "I max out my 401k for 2012 and want to know if I can also max out an IRA. If so, would my IRA contributions also be tax deductible?" Both of these questions beg for an explanation of the rules, and whether using a non-deductible IRA is right for you. Okay, let's dig into retirement accounts. Before we get too far, I want to make sure you understand the terms deductible and non-deductible. Certain expenses, like mortgage interest, charitable donations, and qualified retirement contributions, allow you to legally reduce your taxes, because in general, they can be deducted from your taxable income. It's always smart to reduce your taxable income, because that cuts the amount of tax you have to pay, so you get to keep more of your hard-earned money. So a tax deductible expense is one that has the potential to reduce your taxable income and save money, but a non-deductible expense does not. This distinction between deductible and non-deductible is important when it comes to retirement accounts. Here's what you need to know. With a traditional retirement account, you make contributions on a pre-tax basis, meaning before taxes are taken out, or you can claim a deduction on your tax return, which essentially gives you a refund for any taxes you previously paid on contributions during the year. The rule is that you don't have to pay any tax on contributions or earnings in a traditional retirement account until you make withdrawals at some time in the future. However, whether you qualify for a deductible IRA depends on whether you or a spouse participate in a retirement plan at work, your tax filing status and your income. If you don't qualify for a deductible IRA, you can contribute to a non-deductible traditional IRA, and I'll give you more details about that in a moment. Now, with a Roth retirement account, your contributions are always non-deductible, because you must fund it on an after-tax basis. In other words, you have to pay tax up front on Roth contributions and never get to claim them as a deduction on your tax return. But unlike a traditional retirement account, withdrawals you make from a Roth IRA during retirement are completely tax free. You get to skip paying tax on potentially decades of growth in the account, which can add up to massive savings. But the rub with Roth IRAs is that high earners are excluded from making contributions, which is what Marta mentioned is her situation. For 2013, if you're married in file taxes jointly, you can't make Roth IRA contributions if you're modified, adjusted, gross income, or what accountants call Magi, tops $188,000. If you don't file jointly, you're excluded from making Roth IRA contributions when your Magi is over 127,000. Both Marta and Arthur are in enviable positions because they're maxing out their 401ks. That means they contributed $17,000 in 2012, or are on pace to put in an increased amount of $17,500 for 2013. And that's an addition to any amounts their employers contribute. Plus, if you're over 50, you can sock away an additional $5,500 each year. September is a great month for planning. We start thinking about the rest of the year, whether it's back to school, big year-end work projects, holiday plans or travel. Planning ahead is crucial in life, especially when it comes to what happens when you're gone. Getting life insurance may sound daunting, but Policy Genius makes the process a breeze. With Policy Genius, you can find insurance policies that start at just $292 a year for a million dollars of coverage. Some options offer same day approval and avoid unnecessary medical exams. Policy Genius's technology lets you compare quotes from America's top insurers in just a few clicks to find your lowest price. It's the country's leading online insurance marketplace. 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Get IXcel now and money girl listeners can get an exclusive 20% off IXcel membership when they sign up today at IXcel.com/moneygirl. Visit IXcel.com/moneygirl to get the most effective learning program out there at the best price. But what happens when you max out a retirement plan at work and still have more to invest? The good news is that you can also max out an IRA. However, the contribution limits for IRAs are much lower than for workplace plans. For 2012, you can put $5,000 in either a traditional IRA, a Roth IRA or a combination of both. For 2013, the limit is bumped up to $5,500. And if you're 50 or older, you can contribute an additional $500 to an IRA each year on top of the limits. So I'd recommend that Arthur max out a Roth IRA if he's eligible. As I mentioned, Roth IRA contributions are not tax deductible, which means there's never a conflict with participating in a retirement plan at work and a Roth IRA in the same year. To learn more, be sure to listen to a previous podcast called Your Guide to the Roth IRA, part one. But let's say you participate in a retirement plan at work and make too much for the Roth IRA, like Marta. She can still max out a traditional IRA. However, some or all of her contributions may not be tax deductible. I want to repeat that because this trips up a lot of people. You can still max out a workplace plan and a traditional IRA, even if some or all of your contributions are not tax deductible. Here's the deal. You don't get the full deduction if you file taxes jointly and have Magi over $95,000, or if you don't file jointly, your Magi generally can't exceed $59,000. Additionally, if you make contributions to a traditional IRA that are not tax deductible, you're required to file IRS form 8606. Now, if this all sounds really complicated, it's because it is. It's your responsibility as the tax payer to keep up with the amount of deductible versus non-deductible contributions in your traditional IRA. Otherwise, you and the IRS won't know whether you owe tax on future withdrawals from the account and you could end up paying tax twice. The major benefit of making contributions to a non-deductible IRA is that you defer taxation on growth in the account. Now, that is a nice benefit for investments that pay regular dividends, like bonds. You get to skip paying tax on earnings in the account until you withdraw them. However, the record keeping for a non-deductible IRA can be a nightmare. So if you're not extremely organized, don't have a great tax accountant or don't know the exact investments you have in your IRA, I don't recommend entering into non-deductible IRA territory. The downside is that you could wind up paying more in taxes instead of less. So be sure to consult with a tax or financial planner about the pros and cons of contributing to a traditional IRA when you also have a retirement plan at work or play it safe and invest in a Roth IRA if you're eligible or stick with a taxable brokerage account. This show includes lots of detail and numbers. So you may want to review the transcript, which is on the Money Girl page at quickanddirtytips.com. Just look for episode number 302 called Should You Contribute to a Non-deductible IRA. If you're not subscribed to the podcast on iTunes, that's how most people get the show. Subscriptions are free and you get each new weekly episode the moment it's released on the web. To connect with me on Facebook, Twitter, or to submit your money question, you'll find all the links on the Money Girl page at quickanddirtytips.com. I'm glad you're listening to change. That's all for now. Courtesy of Money Girl, your guide to a richer life. 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