Q&A: Tax credit for Roth IRA contributions

Dear Liz: You told a reader that “contributions to a Roth are never deductible.” This statement is a common misconception and is not correct. You can get a tax credit for Roth IRA contributions as long as you fall under the income limits and itemize on your taxes. The credit phases out at $30,000 for singles and $60,000 for married couples.

Answer: A credit is different from a deduction, but thank you for pointing out a tax benefit that many people don’t know exists.

This non-refundable credit, sometimes called a Saver’s Credit, can slice up to $1,000 per person off the tax bill of eligible taxpayers. The credit is available to people 18 and older who aren’t students or claimed as a dependent on someone else’s return. The lowest income taxpayers — those with adjusted gross incomes under $36,000 for marrieds filing jointly or $18,000 for singles in 2014 — can get a tax credit of 50% of up to $2,000 per person ($4,000 for married couples) contributed to retirement plans. Those plans can include traditional or Roth IRAs, 401(k)s or 403(b)s, 457(b)s and SIMPLE IRAs, among others. The credit drops to 20% and then 10% before phasing out. The average amount saved isn’t spectacular: The IRS said credits averaged $205 for joint filers in 2012 and $127 for single filers, but every bit helps.

One of the problems with this tax break, besides so few people knowing about it, is that many low-income people don’t owe income taxes, so they have nothing to offset with this credit. Another issue is that taxpayers need to file a 1040 or 1040A and use Form 8880 to claim it. Low-income taxpayers often use the 1040EZ form, which doesn’t allow them to claim the credit or alert them that it exists.

Q&A: IRA’s and 401(k)’s

Dear Liz: You answered a reader who asked whether to contribute to her IRA, her Roth IRA or her regular or Roth 401(k) account. I thought that if you have access to a 401(k) at work, you couldn’t make a contribution to an IRA or Roth IRA.

Answer: That’s a common misconception. You can contribute to an IRA even if you have a workplace plan. What you may not be able to do is deduct the contribution. The tax deduction depends on your modified adjusted gross income and phases out in 2015 between $61,000 and $71,000 for singles and $98,000 to $118,000 for married couples filing jointly.

You also may be able contribute to a Roth IRA if you have a workplace plan. Contributions to a Roth are never deductible, but your ability to contribute phases out between $116,000 to $131,000 for singles and $183,000 to $193,000 for married couples filing jointly.

Q&A: Maxing out retirement savings

Dear Liz: My husband and I are in our late 40s. We’re in a good financial position and trying to max out our retirement savings. We have small traditional IRAs and are now above the income limit to deduct contributions to it. We have Roth IRAs that we converted from traditional IRAs several years ago (our income is borderline for being able to contribute directly to a Roth). We also recently got a Health Savings Account that we are maxing out and saving for retirement. But the bulk of our retirement savings is in our 401(k)s, which we max out every year. I hear I should have a mix of pre-tax and after-tax sources of income in retirement. Can I wait until the first year we retire and roll some of my 401(k) into a traditional IRA and then convert it to a Roth, at presumably a lower tax rate due to lower income? Or would it be better to contribute now to a Roth 401(k) at work instead of a regular 401(k), even knowing that our tax rate will probably be lower in retirement?

Answer: You already have a mix of pre- and after-tax sources of income in retirement. Withdrawals from your Roth IRAs will be tax free in retirement, as will your HSA withdrawals if they’re used for medical expenses.

Roth conversions and contributions to Roth 401(k)s make the most sense when you expect to be in a higher tax bracket in retirement, rather than a lower one. Otherwise, you’re giving up a tax break now (your deductible contributions) for what’s likely to be a lesser tax benefit later. Conversions at retirement are particularly tricky, since you may not have decades of tax-free compounding ahead of you to make up for the fact that you accelerated the tax bill.

Talk to a tax pro, but it’s likely that maxing out your regular 401(k)s is the best move.

Q&A: Brokerage follow-up

Dear Liz: You recently explained the insurance limits for brokerage accounts covered by the Securities Investor Protection Corp. I recently retired from the brokerage industry and wanted to add that many firms have additional insurance coverage beyond the SIPC limits.

Answer: Good point. Brokerages often purchase additional coverage from private insurers on top of what’s provided by the SIPC. To find out how much coverage may be available, ask your brokerage or conduct a search with the brokerage name and “how are my accounts protected” as a search phrase.

Q&A: Keeping investments in one brokerage

Dear Liz: I recently retired at 56 and am receiving a pension. My wife is set to retire next year at 56 and will also receive a pension. I chose to leave my 401(k) in my employer’s plan but am planning to consolidate it with my wife’s 457 and four 403(b) accounts once she retires. We also have a portfolio of stock and bond mutual funds. I’d like to consolidate everything at one brokerage firm to simplify record keeping, but what’s the level of risk of having all our investments with one company? We have about $3 million in assets total.

Answer: You can’t combine your retirement accounts with your wife’s, but you certainly can move everything to a single brokerage firm to reduce fees and make it easier to coordinate your investment strategy.

Whether you should is another matter. The chances of a well-established brokerage firm going bankrupt or suffering massive fraud are slim, but it does happen: Lehman Bros. and Bernard L. Madoff Investment Securities are two examples from the 2008 economic meltdown.

Investors have some protection against bankruptcy and fraud when their accounts are covered by the Securities Investor Protection Corp. Protected accounts are insured for up to $500,000 in securities and cash, with a $250,000 limit on the cash.

SIPC uses a concept called “separate capacity” to determine coverage when investors have multiple accounts. You can learn more about coverage limits on its website.
You can expand your total protection by using different types of accounts. Accounts held in your name alone are covered up to $500,000, and you can get another $500,000 in coverage for joint accounts. Your individual retirement accounts and Roth IRAs are also treated separately, and each type of account gets another $500,000 of coverage. (You don’t get $500,000 on each IRA if you have multiple accounts, though. SIPC combines all your traditional IRAs and treats them as one.)
Let’s say you and your wife have individual brokerage accounts as well as a joint account. Then we’ll suppose you each have IRAs as well as Roth IRAs, for a total of seven eligible accounts. That could give you a total of $3.5 million of SIPC coverage.

Of course, the amounts in your accounts may not line up so neatly with the coverage limits. You might not have any Roth IRAs, for example, but have more than $500,000 in that 401(k) you were hoping to roll over to an IRA, or your wife may have more than $500,000 in her retirement accounts (which, if rolled over into one or more IRAs, would be treated as one account). If you leave your 401(k) with your employer, on the other hand, you would be covered under federal employee benefit laws that require defined contribution accounts to be held in trust, separate from the company’s own funds, which would protect your account regardless of its size.

There’s a chance you could be made whole even if your accounts exceed SIPC limits. That was the case with Lehman, where individual retail customers got all their money back. With Madoff, everyone with claims under $925,000 is expected to be made whole, while the remaining claimants have gotten about half their money back in addition to the $500,000 advance SIPC paid out.

But you’ll have to assess your risk tolerance. If you have none, then use more than one brokerage firm.

Q&A: Roth IRA

Dear Liz: I have a 401(k) that has a required annual distribution because I am over 71 1/2 years old. Can I use this distribution as qualified income to invest in a Roth IRA? I have no W-2 earnings, although I do have other income sources that are reported on 1099 forms.

Answer: To contribute to a Roth or other individual retirement account, you must have taxable compensation, which the IRS defines as wages, salaries, commissions, tips, bonuses or net income from self-employment. The IRS also includes taxable alimony and separate maintenance payments as compensation for IRA purposes.

So if the money reported on one of those 1099 forms is from self-employment income, then you can contribute to a Roth IRA. If the form is reporting interest and dividends or other income that doesn’t meet the IRS definition of taxable compensation, then you’re out of luck.
If you don’t have income that meets the IRS definition of taxable compensation, but your spouse does, you may still qualify for IRA contributions, provided you file a joint return that meets the required income thresholds.

Q&A: Capital gains and mutual funds

Dear Liz: Your tax expert’s answer to a person who wanted to roll over a $30,000 capital gain on a mutual fund missed an important point. Since the couple were solidly in the 15% tax bracket with a taxable income under $72,000, they should qualify for the 0% federal capital gain tax rate. (They may, of course, owe state taxes.)

Answer: They may not have had a capital gain at all, as other tax pros have pointed out. When people own mutual funds, the earnings are often reinvested each year. If the couple paid taxes on those earnings, their basis in the mutual fund would increase each year. To know if the couple had any capital gain, we’d need to know that adjusted tax basis. In any case, the original answer — that you can’t roll over the gain on a mutual fund into another investment to avoid capital gains taxes — still stands.

Q&A: How to fund a Roth IRA

Dear Liz: I have quite a bit invested in stocks in a regular brokerage account. I’ve held them for many years, and to sell them would mean huge capital gains taxes. I’d like to move some of these into a Roth IRA, so that I can avoid paying taxes on their appreciation and dividends, since I plan to hold these for quite some time. Is it possible to move these stocks into a Roth IRA without selling and repurchasing?

Answer: Nope. Uncle Sam typically gets his due, with one major exception.

Roths have to be funded with cash, and direct contributions are limited to $5,500 per person per year, plus a $1,000 catch-up contribution for those 50 and over. Your contributions would be further limited once your modified adjusted gross income exceeds $181,000 for married couples and $114,000 for singles, said Mark Luscombe, principal analyst for tax research firm CCH Tax & Accounting North America. A big-enough capital gain, on top of your regular income, could push you over those limits.

If you want to avoid paying capital gains, just hold the investments until your death. Your heirs will get the investments at their market value and can sell them immediately without owing any capital gains. There may be other taxes involved, however. If your estate is worth more than $5 million, it may owe estate taxes, and a few states levy inheritance taxes on heirs.

Q&A: Regular 401(k) vs Roth 401(k)

Dear Liz: I just turned 50. My company has an option to contribute pretax money to a regular 401(k) or after-tax money into a Roth 401(k). Should I put the maximum contribution ($17,500) plus the catch-up ($5,500) into the Roth? Or should I split my contributions?

Answer: Given that you’re close to retirement, putting most of your contributions into the traditional 401(k) is probably the way to go.

Most people’s tax brackets drop once they retire. That means you can benefit from a bigger tax break now and qualify for a lower rate on your future withdrawals.

If you had a few decades until retirement, the math might be different. Younger people with good prospects may well be in a lower tax bracket currently than they’ll eventually be in retirement. In their case, it can make sense to gamble on making after-tax contributions to a Roth 401(k), betting that their tax-free withdrawals in retirement will be worth much more.

You may want to put some money into the Roth 401(k) so you’ll have flexibility with your tax bill in retirement. Being able to choose between taxable and nontaxable options gives you what financial planners call tax diversification. But the bulk of your contributions should still go to the traditional 401(k).

Q&A: An Update

Dear Liz: I think you were way too hard on the young man who said his 30-year-old girlfriend’s lack of retirement savings was a potential deal breaker. You told him to get off his high horse. He was just being prudent.

Answer: It would be prudent to regard massive debt, alcoholism or drug use as deal breakers for a relationship. Elevating the young woman’s lack of retirement savings to this level is just over the top. But let’s hear what the young man himself had to say:

Dear Liz: I want to say thank you for taking the time to write on my question. I was able to find a few charts online and show her [the power of compounded returns]. She got excited about it and is now putting in to get the company match (5%).

Thank you very much for putting me in my place. I did not mean to come across as if I was better. I have been very lucky to have been able to save and be taught about compounding at an early age.

Answer: One of the potential hazards of being good with money is arrogance. We can become convinced that we know better and that other people should do things our way. It takes some humility to understand that not everyone has had the advantages we’ve had or been able to take in the information as we’ve done. Understanding that makes it easier to find compromises in a relationship that work for both parties.
Good luck with your relationship. She sounds like a keeper.