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By Denise Appleby MJ, APA, AKA, CISP, CRC, CRPS, CRSP
Tax deduction now or tax-free income later? Evaluating which serves a client better—a traditional IRA or a Roth IRA—is a step-by-step process.
Your clients have until April 18, 2023, to make IRA contributions for 2022, and they will need to decide whether to make those contributions to a traditional IRA or Roth IRA. IRA contributions for 2023 can be made by the tax filing due date for 2023.
With a traditional IRA, contributions are tax-deductible for those who qualify. Any earnings will grow tax-deferred but are taxable upon distribution.
With a Roth IRA, contributions are always made from already taxed income. The earnings are tax-deferred but are tax-free for qualified distributions.
A Roth IRA distribution is qualified if it meets the following two requirements:
- It occurs at least five years after the owner funded their first Roth IRA, and
- They are at least age 59½ or disabled when the distribution is made, the distribution is made after death, or the distribution is used for first-time homebuyer purposes. The first-time homebuyer distribution is subject to a lifetime limit of $10,000 for each IRA owner.
While income tax is likely a key driver for the choice, other factors must be considered, including eligibility. To ensure your clients make the right choice, include the following 5-steps in the decision-making process.
1: Make Sure They Received Eligible Compensation for the year
An IRA owner must have received eligible compensation to make an IRA contribution for the year. This compensation generally includes payments received for working or providing services. Examples include wages, salaries, tips, bonuses, professional fees, and self-employment income.
Encourage clients to contact you to determine whether their income qualifies as compensation for IRA contributions.
Important note: contribution cap: An individual’s regular IRA contribution cannot exceed the lesser of 100% of their eligible compensation or $6,000 for 2022 ($6,500 for 2023). If they are at least age 50 by the end of the year, they can make an additional catch-up contribution of $1,000.
How the Backdoor Roth IRA Contribution Works : The Advisor version
2: Check MAGI Limit for Eligibility for Roth IRA Contributions
An individual’s eligibility to make regular contributions to a Roth IRA is based on their modified adjusted gross income (MAGI) limit and tax filing status. The following are the MAGI limits:
| 2022 MAGI limits for contributing to a Roth IRA | ||
| Tax Filing status | MAGI Range | Allowed percentage of contribution limit of $6,000, plus catch-up of $1000 |
| a. All taxpayers other than b. or c. below | $129,000 or less | 100% |
| $129,000 to $144,000 | Partial | |
| $144,000 or more | None | |
| b. Married taxpayers filing a joint return or taxpayers filing as a qualifying widow(er) | $204,000 or less | 100% |
| $204,000 to $214,000 | Partial | |
| $214,000 or more | None | |
| c. Married individual filing a separate return | Less than $10,000 | Partial |
| $10,000 or more | None | |
How the Backdoor Roth IRA Contribution Works : The Advisor version
| 2023 MAGI limits for contributing to a Roth IRA | ||
| Tax Filing status | MAGI Range | Allowed percentage of contribution limit of $6,500, plus catch-up of $1000 |
| a. All taxpayers other than b. or c. below | $138,000 or less | 100% |
| $138,000 to $153,000 | Partial | |
| $153,000 or more | None | |
| b. Married taxpayers filing a joint return or taxpayers filing as a qualifying widow(er) | $218,000 or less | 100% |
| $218,000 to $228,000 | Partial | |
| $228,000 or more | None | |
| c. Married individual filing a separate return | Less than $10,000 | Partial |
| $10,000 or more | None | |
Tax preparation software can be used to determine the amount an individual is eligible to contribute to their Roth IRA.
Tip: If an individual prefers a Roth IRA but their MAGI is too high, they could use the backdoor Roth IRA contribution strategy to fund their Roth IRA. This requires contributing to a traditional IRA and then converting the amount to a Roth IRA. Other factors must be considered, including whether the conversion amount would include a pro-rated amount of pre-tax and after-tax funds.
3: Check Eligibility for Deductibility of Traditional IRA Contributions
Assume that an IRA owner received contributions or benefits under an employer-sponsored retirement plan for the year or is married to someone who does. Their eligibility to claim a tax deduction for their traditional IRA contribution will therefore depend upon their MAGI. The following are MAGI limits:
| 2022 MAGI limits for deducting contributions to Traditional IRAs | ||
| Tax Filing Status | MAGI Range | Allowed percentage of deduction for contribution limit of $6,000, plus catch-up of $1000 |
| a. Single individuals and heads of household who are active participants in a qualified plan/employer plan | $68,000 or less | 100% |
| $68,000 to $78,000 | Partial | |
| $78,000 or more | None | |
| b. Married couples filing jointly if the spouse who makes the IRA contribution is an active participant | $109,000 or less | 100% |
| $109,000 to $129,000 | Partial | |
| $129,000 or more | None | |
| c. IRA contributor who is not an active participant and is married to someone who is an active participant | $204,000 or less | 100% |
| $204,000 to $214,000 | Partial | |
| $214,000 or more | None | |
| d. A married individual who is an active participant filing a separate return | Less than $10,000 | Partial |
| $10,000 or more | None | |
| 2023 MAGI limits for deducting contributions to Traditional IRAs | ||
| Tax Filing Status | MAGI Range | Allowed percentage of deduction for contribution limit of $6,000, plus catch-up of $1000 |
| a. Single individuals and heads of household who are active participants in a qualified plan/employer plan | $73,000 or less | 100% |
| $73,000 to $83,000 | Partial | |
| $83,000 or more | None | |
| b. Married couples filing jointly if the spouse who makes the IRA contribution is an active participant | $116,000 or less | 100% |
| $116,000 to $136,000 | Partial | |
| $136,000 or more | None | |
| c. IRA contributor who is not an active participant and is married to someone who is an active participant | $218,000 or less | 100% |
| $218,000 to $228,000 | Partial | |
| $228,000 or more | None | |
| d. A married individual who is an active participant filing a separate return | Less than $10,000 | Partial |
| $10,000 or more | None | |
Tax preparation software can be used to determine how much of a traditional IRA contribution an individual may deduct.
4: Choosing Between Nondeductible Traditional IRA vs. Roth IRA Contribution
If an individual cannot take a deduction for their traditional IRA contribution, they may still make a nondeductible contribution to their traditional IRA. Amounts attributed to nondeductible contributions are nontaxable when distributed from the IRA, but any earnings will be taxable.
What if they are not eligible to claim a deduction for a traditional IRA contribution but are eligible to contribute to a Roth IRA? Contributing to a Roth IRA would make better tax and financial sense.
Illustration:
John is thirty-five. His tax filing status is single, and his 2022 MAGI is $79,000. John is covered under an employer plan. Therefore, he cannot claim a deduction for his traditional IRA contribution. If John makes a contribution to a traditional IRA, it would be nondeductible. But because his MAGI is below $129,000, he is eligible to make a regular contribution to a Roth IRA. It would make better tax sense for John to make a contribution to a Roth IRA.
Assume that John makes a contribution of $6,000 and does not withdraw the amount until 24 years later when he is 59 ½. Assume, too, that the rate of return is 7%.
The Results of the Roth IRA option for John would be as follows:
- Contribution amount: $6,000
- Earnings: $24, 434
- Deduction: $0.00
- Cost to John: $6,000
- The amount taxed when the full balance is distributed: is $0.00. John gets the earnings tax-free with the Roth IRA, becasue his distribution is qualified.
The results of the Traditional IRA option for John would be as follows:
- Contribution amount: $6,000
- Earnings: $24,434
- Deduction: $0.00
- Cost to John: $6,000
- The amount taxed when the full balance is distributed: is $24,434.
- Check Suitability
If an individual is eligible to contribute to a traditional IRA and Roth IRA, the decision should be based on which is more suitable. A suitability assessment would include factors that reasonably estimate which of the two options would result in the least income tax.
The individual’s current and projected income tax rate (when they likely will be taking distributions) are key factors in determining the applicable amount of income tax.
Consideration should be given to how giving up a deduction on the traditional IRA side compares with getting tax-free income on the Roth side. But, again, the results are based on the individual’s specific tax and financial profile.
5: Splitting the Difference is an Option.
If an individual is indecisive about which IRA to choose, their contribution can be split between both IRAs – if eligible. However, when doing so, they must make sure that the total contributions to both accounts do not exceed the lesser of 100% of their eligible compensation or $6,000 for 2022 ($6,500 for 2023) plus an additional catch-up contribution of $1,000 if they are at least age 50 by the end of the year.
Check for Excess Contributions
Many individuals maintain multiple IRAs. Remind clients to let you know if they made other contributions that resulted in the total being in excess of the allowable limit. If they did, the excess amount must be removed as “return of excess” contributions by their tax filing due date, plus extensions. Any excess contribution not corrected by this deadline will be subject to a 6% excise tax for every year it remains in the IRA.
