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.

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5 hacks to boost your retirement savings

seniorslaptopMany people have trouble saving anything for retirement. But I hear from a fair number of people who are looking beyond 401(k)s and IRAs for more tax-advantaged ways to save.

Many have maxed out their 401(k)s at work, or had their contributions limited because they’re considered “highly compensated employees.” Some don’t have a workplace plan at all, while others want to save more than IRAs allow. Even catch-up provisions–which allow people 50 and over to contribute an extra $5,500 to 401(k)s and an extra $1,000 to IRAs–aren’t enough for some of these super savers.

So here are options for those who have maxed out and caught up:

Opt for an HSA. Health savings accounts, which are coupled with high-deductible health insurance plans, offer a rare triple tax advantage: contributions are tax deductible, gains grow tax-deferred (and can be rolled over from year to year), and withdrawals are tax free if used for medical expenses. Withdrawals are also tax free in retirement, which makes HSAs a potentially better vehicle for saving than the much-loved Roth IRA. (Some say yes, others no.) Speaking of which:

Consider a back-door Roth contribution. If you make too much money, you can’t contribute directly to a Roth. There is a workaround, according to IRA guru Ed Slott, that takes advantage of the fact that anyone regardless of income can convert a traditional IRA to a Roth. You can read more about the strategy here and the potential drawbacks here.

Start a side business. Small business owners are spoiled for choice when it comes to tax advantaged plans. The options range from SEP IRAs to solo 401(k)s to full-on traditional pensions (and baby, you can save a ton of money in those—as in hundreds of thousands of dollars annually). Talk to a CPA about which plan makes the most sense for you.

Use a 457 plan. These deferred compensation plans are often available to state and local public employees as well as people who work for some nonprofits. Like a 401(k), you’re allowed to contribute pre-tax money. Unlike a 401(k), you don’t get slapped with early withdrawal penalties if you take the money out before age 59 (although you will owe income taxes).

Contribute to a regular brokerage account. There’s no upfront deduction, but investments held at least a year can qualify you for favorable capital gains tax rates. This, by the way, is typically a much better option than variable annuities, which tend to have high costs and limited tax advantages for most people.

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.

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5 LAST-MINUTE MONEY MOVES BEFORE 2014

Tax return checkOkay, you’re on overload with all the last-minute shopping, cooking, preparing for guests and/or traveling. But try to squeeze in a few money tasks before year-end. Including:

Contribute to an IRA. You can put money into an IRA even if you have a retirement plan through work, but you may not be able to deduct the contribution if your income is over certain limits. If, on the other hand, your income is low, you could score a valuable tax credit for your retirement contributions. The problem of course is that it can be tough to come up with the maximum contribution of $5,500 ($6,500 for those 50 and over) at year end. Luckily, you have until tax day, April 15, 2014, to make your contribution for 2013. And consider setting up regular contributions to your IRA so you don’t have to scramble for the cash next year.

Make a (back door) Roth contribution. If you can’t deduct an IRA contribution, a better option is to contribute to a Roth IRA. Roth contributions aren’t deductible but withdrawals from the accounts are tax-free in retirement (unlike regular IRA withdrawals, which incur income taxes). If your income is too high to contribute to a Roth directly, you can contribute to a regular IRA and then convert it to a Roth. This works best if you don’t already have a fat IRA account, since your tax bill for the conversion will be based on the total you have saved in regular IRAs.

Use it or lose (most) of it. If you have money set aside in a flexible spending account at work for medical or child care expenses, you typically need to use it up by year end. There are some exceptions: the Treasury Department recently said plan participants can roll up to $500 of unused funds into the next year’s plans, and some employers extend the deadline from Dec. 31 to mid-March.

Accelerate and delay. If you don’t expect a big change in your tax circumstances, it can make sense to delay income into 2014 (by asking your boss to pay a bonus next year instead of this, for example) and to accelerate deductions by paying mortgage, property tax or medical bills for January in December.

Get generous. If you itemize your deductions, you can get a tax break for your charitable contributions. Again, rushing to get those in at the last minute isn’t ideal, so consider setting up regular contributions such as paycheck deductions or monthly payments to your favorite nonprofits. No extra cash? “Noncash” donations—such as clothes or household items—can earn you a deduction as well. They just have to be in good condition and given to a recognized charity.

 

How to start Roth IRAs for your kids

Dear Liz: I would like to start a Roth account for each of my kids. (They’re in their 30s.) Is it better to start an account in my name with them as beneficiaries or to start the accounts in their names?

Answer: Roth IRAs can be a wonderful way to save, but they’re not custodial accounts. You won’t be able to control the accounts or prevent your adult children from spending any money you deposit.

If you still want to help, though, let your kids know you’ll contribute to any Roths they set up. They can open a Roth if they have earned income at least equal to the annual contribution and their incomes are below the Roth limits. The ability to contribute to a Roth phases out between $178,000 to $188,000 for married couples in 2013 and from $112,000 to $127,000 for singles.

Ideally, you’ll contribute to your own Roth first. The limit on contributions is $5,500 this year.

Missed deadline could limit inherited Roth IRA’s benefits

Dear Liz: I inherited my brother’s Roth IRA about three years ago. I find it hard to get any information about non-spousal inherited Roths. Can you tell me more about this type of Roth IRA?

Answer: It may be unfortunate that you didn’t ask sooner.

When a spouse inherits a Roth IRA, he can roll it into his own Roth IRA, and it’s as if he or she was the owner of the inherited funds all along. There’s no minimum distribution requirement, so the money can continue to grow.

If you’re not a spouse, you have the option of transferring it into an account titled as an inherited Roth IRA. You also have the option of taking distributions over your lifetime — which means keeping the bulk of the money growing for you tax-free — but to do that you must begin taking required minimum distributions by Dec. 31 of the year after the year in which the owner died.

If you didn’t start these required distributions on time, you have to withdraw all the assets in the account by Dec. 31 of the fifth year after the year your brother died, said Mark Luscombe, principal analyst for CCH Tax & Accounting North America. You won’t have to pay taxes on this withdrawal, but it would have been better to let the money continue to grow tax-free in the account.