Traditional IRAs and Roth IRAs

Question Asked:

Should my wife and I contribute to a Roth IRA or a traditional IRA? We both participate in our respective employer's 401(k) plan. What if our income is too high?

Answer:  You are wise to augment your 401(k) retirement plans by saving additional retirement funds in your IRAs. After all, you are responsible to save for your own retirement. The extra $5,500 you contribute to an IRA every year may not seem like much now, but you will be surprised what compound growth can do over time.

If you and your wife save $11,000 at the beginning of every year in an IRA that grows at 7 percent per year, after 20 years your contributions of $220,000 will be worth more than $482,000. After 30 years, your contributions of $330,000 will be worth over $1.1 million. If that IRA is a Roth, your withdrawals will be tax-free.

Everyone with earned income is eligible to contribute to a traditional IRA. Income limitations only dictate how much is tax-deductible. Roth IRAs have different rules. If your income is too high, you can't contribute directly to a Roth. Contribution eligibility in 2014 begins to phase out for married couples when their adjusted gross income reaches $181,000, and eligibility ends at $191,000. The phase-out range for single taxpayers is $114,000 to $129,000.

If your income is higher than the above limits, there is a back door. IRS rules allow traditional IRA owners to convert their IRA to a Roth without regard to income. If you want to contribute to a Roth in 2014 but your income is too high, you can first contribute to a traditional IRA and then convert it to a Roth.

But be careful. No problem if you don't already have an IRA. But if you do, the IRS says you can't pick and choose which IRA you convert. You must prorate and pay tax on any previously untaxed amounts in all your IRAs.

Untaxed amounts include dollars you rolled over from a retirement plan and dollars that you contributed and deducted on your income tax return. Previously taxed amounts — your cost basis — equal the total of the non-deductible contributions you made.

Here's an example. Let's say you have a $50,000 rollover IRA from a former retirement account, a separate $50,000 traditional IRA that holds $25,000 of cost-basis (non-deductible) contributions and $25,000 of earnings, and a new $5,000 IRA with a $5,000 cost basis.

Your total IRA value is $105,000 and your total cost basis is $30,000. If you convert your new $5,000 traditional IRA to a Roth, you will owe tax on $3,572 (subtract $30,000 from $105,000, divide by $105,000, and multiply by $5,000).

High income earners without traditional or rollover IRAs can open an IRA, contribute $5,500 ($6,500 if age 50 or older), and then convert the whole $5,500 to a Roth with no tax consequence. If you are a high-income earner with IRA accounts you should check with your current 401(k) plan administrator and ask if the plan allows you to move your pre-tax IRA money into your 401(k). Some plans will allow this, and if so, you can move the pre-tax money to your 401(k) and convert the remaining non-deductible money and future annual traditional IRA contributions tax-free.