IRAs, Roths, and Roller Derby: A Tax-mas Miracle
It’s tax season and some of you might be wondering “How do I hide more money from the government before it’s too late! Also if I use my tax return as toilet paper before sending it in, does that increase or decrease my chances of being audited?” Answering the first question, the only choice you have left to you right now is an IRA. As long as you open it up before you submit your taxes, you can contribute up to $5,500 to one (or $6,500 if you’re over 50). But this article is going to explain more than the boring contribution limits and rules surrounding IRAs. I’m hoping it’ll be a fun, practical guide.
Last Year or This Year?
You can put money in an IRA until April 15th and credit it toward 2015, or you can put money in all year long and put it toward this year. But putting money in for this year requires planning and thoughtfulness…so I’ll just assume you’re in the “crediting to last year” camp. Crediting it toward last year is awesome because you basically pretend you saved money when you actually didn’t, and the feds give you a break on it and let it slide. Plus then you get to actually save money, and put it in this impenetrable fortress of an account that you can’t touch until you’re 60ish. Hooray!
Ok, so the account isn’t actually impenetrable, and you can technically take money out, but you shouldn’t because you’ll get levied with some serious penalties – up to 10% of what you take out (oh yeah, and they’ll tax you on it…because of course they will…’MERICA!). So make sure that when you put money in an IRA, you really, really know you won’t need it until you are no longer young and beautiful. With a few exceptions, there’s no take-backsies.
Traditional or Roth?
You knew there were two different kinds of IRAs right? But I bet you don’t know all the different benefits, limitations, restrictions, and rules of each one. Well that’s what I’m here for. Ok let’s do the basics first. The Traditional IRA isn’t taxed immediately, but it is taxed when you’re old and frail and withdraw the money for retirement or to support your elderly fight club…because it makes you feel alive! The Roth IRA is taxed going in, but after you’ve paid your tax bill once, it never gets taxed again…so, uh, more money to spend on cats or cat fight club. Both types of IRAs can be very beneficial. Let’s talk through some of those benefits.
Roth Benefits Include:
- All earnings are never taxed (this is literally the only tax-free money I can think of that exists today…pretty awesome)
- The principal is taxed today, which means if you don’t make much money, it will be taxed at a low tax rate, so when you’re rolling in dough in retirement, you’ll be safe from the tax man’s higher rates
- No Required Minimum Distributions (RMDs). I’ll go into RMDs at the end…for now just know that not having an RMD is a good thing
- All your money grows tax-free
Traditional IRA Benefits Include:
- Not taxed today, so you get a lower tax bill this year
- When you retire, it is all taxed as regular income, but if you live frugally and don’t have too much income, you might be able to limit or avoid taxes altogether
- No matter how much money you make, you can contribute to a Traditional IRA (yes, there are income limits on Roth IRAs)
- All your money grows tax-deferred
How Do I Choose Just One!?
Well, there are some other things you should know too. First off, there are income limits regarding IRAs. All the numbers I’m presenting here will be for 2016. The numbers change yearly, so if you’re reading this in 2026, it’s probably useless because either a) the tax code has changed dramatically for the worse or b) our alien overlords have finally simplified the tax code for the better, something humans will never be able to accomplish.
And another thing – all the numbers I’m providing are for single people. Specifically young, single people who use Tinder. If you are married, there’s a section for you at the end…also you shouldn’t use Tinder unless you and your spouse are both on the same page about the potential benefits and consequences of an open relationship.
Ok, before we start, let’s get one thing straight. There’s a difference between contributions and deductible contributions. Deductible contribution means you don’t get taxed now on the money. Why does this matter?
Do you make less than $61,000? If so, your Traditional IRA contribution is deductible. That’s what you’d expect, right? Deductible contributions (lowering your current tax burden) is a big benefit of the traditional IRA. But what if you make more than $61,000? Well…you’re out of luck. You can still put the full $5,500 into an IRA, but you just don’t get the immediate tax benefit.
I bet you’re thinking “Nathan, you seem smart and attractive. Also I’m gonna be taxed on this money now and when I take it out in retirement? Why wouldn’t I just put my money in a Roth IRA since I’ll be taxed now but not when I take it out in retirement?” Bingo. You got it. If you make more than $61,000, putting money into a Roth IRA instead of a Traditional IRA is a no-brainer. Otherwise you’ll only get some of the benefits of the Traditional IRA.
Great, that was easy…oh there’s more?
Of course there’s more…this is the United States tax code we’re talking about. It has to be as complicated as possible. Let’s recap real quick. You make less than $61,000? You can choose either a Roth or a Traditional IRA and receive the full benefits of either. You make more than $61,000? You can still choose either, but you’ll only get the full benefits of the Roth IRA.
Do you make more than $117,000 a year? Well, then the Roth IRA is off-limits to you. That’s right, you can’t even make a contribution to one. So if you make a bunch of money, you have a few options.
- Contribute to a Traditional IRA and fail to get the full benefits (just like in the $61K+ situation)
- Don’t contribute to an IRA at all (boo! hiss!)
- Contribute to a Traditional IRA and do a backdoor conversion to a Roth IRA, getting the full benefits of the Roth IRA even though you’re above the income limit!
Clearly option 3 is awesome…but it’s complex. To do this, you basically have to make sure you don’t have any money in a Traditional IRA already or else your tax situation becomes nightmarish. The Backdoor IRA conversion is a meaty topic that deserves it’s own blog post…and of course it’ll get one. But even after you think you know everything about the Backdoor conversion, please, please reach out to a financial advisor before doing it. The consequences of messing it up even once are less than ideal.
Wait! I’m Married. What About Me?
You’re married? Me too! So naturally the rules are even more complex for us. First off, the numbers are different. Anywhere you see the number $61,000 in this blog – replace that with $98,000. And anywhere you see $117,000 – replace that with $184,000. Now these numbers refer to the total income you and your spouse make together. Yeah…they didn’t double the limits which is dumb. If you’re a high-earning power couple, marriage is not a boon to your tax situation. And if you’re a throuple, the tax code is a twisted carnival that perpetually excludes and belittles your lifestyle choices.
Ok but hold on…there’s hope yet. Married people have one thing going for them that single people don’t get. If you are NOT covered by a retirement plan at work (401(k), 403(b), TSP, etc) you can ignore the income rules, even if your spouse IS covered by a retirement plan at work. This mainly helps couples with lopsided income.
So Spouse A – we’ll call her Janet – earns $150,000 as a lawyer, while Spouse B – we’ll call her Tanya – earns only $40,000 as a professional Roller Derby player…because despite how awesome the sport is, Roller Derby just doesn’t have that big of a fan base yet. Where was I? Right, together they earn $190,000, putting them above the $184,000 limit to contribute to their Roth IRAs. Janet has a 401(k), but Tanya doesn’t.
The government recognizes that this is an unfair situation – Tanya is basically prevented from putting money toward retirement because her spouse makes too much money, even though she would be well below the $117,000 limit on her own. So the government says “Janet, since you’re covered by a 401(k) and you and Tanya make a lot of money together, you can’t put anything in a Roth IRA. But Tanya, since you don’t have a 401(k), you can contribute to your Roth IRA this year.”
Everyone wins, and Tanya and Janet roller skate off into the sunset together.
Are We Done Yet?
Nope. There’s even more nonsense to learn about. First, there’s something called Required Minimum Distributions (RMDs). These only apply to Traditional IRAs. Basically it means you have to take money out once you turn 70ish. You’ve been sitting on money for a really long time, and the government wants its taxes, so they require you to take your money out so they can get their grubby little paws on it.
This is less than ideal for a variety of reasons. RMDs might push you into a higher tax-bracket, or mess up your retirement strategy, or worse…you forget to take the RMD and then the government penalizes you on top of the taxes!
Please, stop…just…I can’t
Ok, if you’ve made it this far, you’ve learned enough for today. Are there more rules concerning IRAs…YES. Strong YES. Are they terrible and needlessly complex? YES. But does your good friend Nathan the financial advisor know them all so you don’t have to? Also yes!
For real though, if you don’t make much money, just pick an IRA that works for you. If you make lots of money, just make sure you’re not breaking the basic income level rules for Roth IRAs. If you want to do a backdoor conversion or have a more nuanced financial situation, talk with someone…preferably me or another financial advisor at Monte Largo Financial…but less preferably, an accountant, a lawyer, or even a buddy who’s done it before. Don’t play that game on your own.
See, wasn’t this a better use of your time than the cat video in your Facebook feed?
Nathan is the Chief Financial Advisor at Monte Largo Financial