Q: Tax Playa, It's unclear if my wife and I will be eligible to contribute to our Roth IRAs in 2007. There are just too many unknowns, including the fact that my wife will be changing jobs in July. As I see it, we have 2 basic options: 1) Make the contributions during 2007 and possibly
have to "recharacterize". 2) Delay making the contributions until after we've completed our 2007 tax return. Can you comment on the pros and cons of each approach, including how difficult the
"recharacterization" process is? Do you have a better approach?
Bill, Anywhere USA
A: Bill, this is a problem that many people run into, and there is no easy answer.
First, some background:
A Roth IRA features after-tax dollars going in, with earnings tax-free at retirement. This is a great deal, but it isn't available to everybody. There are AGI limits for eligibility to make Roth IRA contributions (themselves capped at $4000 per taxpayer). For 2007, the phaseout range is $99,000-$114,000 ($156,000-$166,000 MFJ, $0 MFS).
Problem--you may not know with certainty at the beginning of the year whether you will be below, within, or above those limits. So what to do if you want to make a Roth IRA contribution?
As you allude to, you have three options. I will list them in ascending order of personal preference:
1. Make a Roth IRA contribution. If you find part or all of your contribution disallowed, have your Roth IRA trustee "recharacterize" the contribution as a Traditional IRA contribution by April 15th. There are no AGI limits on contributing to a Traditional IRA. You certainly won't be able to deduct it, but you at least would have basis in a Traditional IRA that can be exercised later.
There are a few practical problems with this. First, recharacterizations are rare and front-line representatives of banks and brokerage firms tend to be ill-trained. It might get screwed up.
Second, if you are partway through the phaseout range, you may want to split your contribution between your licit Roth amount and the recharacterized Traditional IRA contribution. This could be a headache.
Finally, non-deductible Traditional IRA contributions are not a good deal when compared with paying the 15% dividend and capital gains tax break. Why? Any gains above basis will be taxed as ordinary income, which can run as high as 35%. That 20 percentage point "wedge" is not worth paying just for some deferral of tax.
2. Make a Roth IRA contribution. If you find yourself over the income cap, simply withdraw the money. This makes sense, but only if you instead shift that money over to a taxable brokerage account and invest in tax-efficient instruments like passive stock index funds. You don't have to worry about triggering a penalty, since you are likely just distributing contributions to the Roth IRA, which is always a tax-free transaction.
This option, though, presents the headache of dealing with the 1099-R the next Spring.
3. Hold off on making the Roth IRA contribution until Spring of the subsequent tax year. This is my preferred suggestion.
As with any IRA, you have until April 15th of the next year to make a current year contribution. Under this system, you do lose out on one year's worth of tax-deferred growth. However, assuming you have 10 or more years until retirement, this is a mathematical rounding error. This is the cleanest way to do it, banks and brokerage firms should have no trouble processing it, and you don't have to scramble to get your AGI down in December after contributions have been made.
What if you can't make the contribution after all? That's what taxable brokerage accounts were made for. Find a cheap one, get a cheap stock index fund, and forget about it. You'll still do very well, and with a very small tax wedge.
Historically, there has been about a 9% annual rate of return on stocks. 6 percentage points of that are capital gain, and 3 percentage points are a dividend. Since you normally only pay most capital gains on liquidation, you still benefit from deferral and a low 15% rate. You do pay the 15% rate each and every year on dividends, but that's only an annual tax on one-third of your return. Not a big deal.
Comments