Tax refund and IRAs

[avstraq]

Hi Mustachians, I posted this in the YNAB forums too so I apologize for people who are in both groups.

I just did my taxes last night but haven't submitted them yet. We overpaid our taxes last year so I'm due for a refund. DW and I are in our late 30s and don't have any IRAs set up (I have a 401k through work). I know what you'll say, but rest assured that now that we have the full knowledge, we'll dive in quickly. When we get the refund, we'll start our Roth IRAs (full for me and partial for her--the refund won't be enough) for 2013--deadline is April 15, 2014. However, when I played around with the numbers, if I contribute to a traditional IRA (with this same refund money and before April 15th), our refund would increase and we'd be able to fund both our accounts almost fully (my deductible contribution stops at $5300). Our tax bracket remains the same for either of these approaches. Caveat, we may be entering a higher tax bracket for 2014.

Question: which is the better option for me? Am I just blinded by the extra refund cash?

[sherr]

Well to answer your most direct question, the choice of Roth vs Traditional IRA is the same regardless of whether the money is coming from a tax refund or regular income. It all boils down to a question of whether the marginal tax rate of your current tax bracket is higher than your average tax rate in retirement. If yes, then traditional is better, if no then Roth. This means that if you're in the 25% bracket or higher than traditional is almost certainly a mathematically better choice, at lower brackets it's less clear.

However, I'm not sure your first option makes sense. You can contribute to a 2013 IRA until April 15th, yes. But that's because April 15th is the tax deadline. You'd have to announce on your 2013 taxes the money you contributed to your IRA in 2013, which kind of precludes you from using refund money to fund a 2013 IRA doesn't it? I suppose you could file, get the refund, invest, and then file an amended tax return, but don't forget that extra step.

[madage]

However, I'm not sure your first option makes sense. You can contribute to a 2013 IRA until April 15th, yes. But that's because April 15th is the tax deadline. You'd have to announce on your 2013 taxes the money you contributed to your IRA in 2013, which kind of precludes you from using refund money to fund a 2013 IRA doesn't it? I suppose you could file, get the refund, invest, and then file an amended tax return, but don't forget that extra step.

From IRS Publication 590:

Filing before a contribution is made.    You can file your return claiming a traditional IRA contribution before the contribution is actually made. Generally, the contribution must be made by the due date of your return, not including extensions.

What the OP proposes is acceptable to the IRS. No amended return is required unless the IRA contribution is not made by the deadline.

[avstraq]

Hi Sherr, thanks for the reply. The IRS allows you to basically "pledge" the amount you're contributing to your traditional IRA--I'll just have to follow through (by April 15th) or else I need to file an amendment. Roth IRA contributions don't need to be reported at all since they're not tax-deductible.

I'd like to think my tax bracket in retirement will be less, but who knows? :-) We're currently in the 25% bracket but may move up to 28% this year. I agree that the choice will be the same whether it's from my refund or regular income--but I did need someone to tell me this. Thanks!

[avstraq]

Thanks, Madage! Our replies crossed in cyberspace :-)

[sherr]

Hi Sherr, thanks for the reply. The IRS allows you to basically "pledge" the amount you're contributing to your traditional IRA--I'll just have to follow through (by April 15th) or else I need to file an amendment. Roth IRA contributions don't need to be reported at all since they're not tax-deductible.

I see.

I'd like to think my tax bracket in retirement will be less, but who knows? :-)

Well there's certainly a little bit of crystal-ball gazing going on, but in general if you're on this forum I think it's practically a certainty that your average tax rate in retirement will be less than 25%. Especially if you own a paid-for house, your yearly expenses in retirement (aka the "income" you withdraw from your retirement accounts), even for a relatively lavish lifestyle (take MMM for instance), are not likely to be very much above what many people would consider poverty level income, so I would be very much surprised if taxes were to raise much for us by the time we've retired.

We're currently in the 25% bracket but may move up to 28% this year. I agree that the choice will be the same whether it's from my refund or regular income--but I did need someone to tell me this. Thanks!

In that case keep in mind that a much more immediate concern for you is that since you have a 401k at work you can't deduct contributions to a Traditional IRA if you make over a certain amount. There are limits to being able to contribute to a Roth too, but they are higher. So you may actually have no choice and have to go with the Roth (or you could choose to contribute to a Traditional IRA and not deduct your contributions, but there's not as much point in that).

http://retireplan.about.com/lw/Business-Finance/Personal-finance/Who-Can-Make-Tax-Deductible-Contributions-to-IRAs-.htm

[schimt]

In that case keep in mind that a much more immediate concern for you is that since you have a 401k at work you can't deduct contributions to a Traditional IRA if you make over a certain amount. There are limits to being able to contribute to a Roth too, but they are higher. So you may actually have no choice and have to go with the Roth (or you could choose to contribute to a Traditional IRA and not deduct your contributions, but there's not as much point in that).

http://retireplan.about.com/lw/Business-Finance/Personal-finance/Who-Can-Make-Tax-Deductible-Contributions-to-IRAs-.htm

Just to add a note, the link above referes to 2009 taxes and the limits and requirments are slightly different for this year. See the IRS link below

http://www.irs.gov/Retirement-Plans/2013-IRA-Deduction-Limits-Effect-of-Modified-AGI-on-Deduction-if-You-Are-Covered-by-a-Retirement-Plan-at-Work

[avstraq]

Thank you both for the links. I did do the calculations (as I pointed out in my first post) and my wife is allowed to deduct the full amount ($5.5k) of a traditional IRA whereas I can only deduct up to $5k.

[wtjbatman]

A tIRA is likely a better option for you than a Roth due to your current tax rate, but regardless some people prefer Roths due to a bit more freedom with distributions, plus the fact that you will be able to withdraw your money tax-free, whereas who knows what the tax situation will look like in 30 years when you retire and attempt to start withdrawing from your tIRA. If you think taxes are likely to be lower in the future than they are now, I have some oceanfront property in the desert to sell you.

[jat9449]

My family intends to commit about 75% of our refund to our 2013 IRA contributions. I did a lot of number crunching to find the "sweet spot" in terms of biggest return. From what I've read you have to use IRS Form 8888 to automatically direct deposit the money into your IRA account(s). We use Vanguard and I was able to set up the direct deposit for the tax return from the forms they provide. My problem is how to alert Vanguard that we want the money from the refund to be applied to our 2013 contributions and not our 2014 contributions. When I called Vanguard, the gentleman acted like I was bat-shit crazy and had no clue what I was talking about. Has anyone effectively done this? Or knows how to ensure that it's done correctly? I would hate for everything to go through and then Vanguard files the contributions for 2014...and then be up shit creek.

[tomq04]

No reason to screw around, take the money and deposit it your self.  Ensure you get a 2013 contribution.

[MissPeach]

You can also roll the tIRA to a Roth at a later point in time if you ever decide you want to go with a Roth. You will have to pay taxes at the time of conversion but it's an option.