The age old Roth vs. Traditional IRA based on income question

[bittheory]

Hello fellow mustacians. So, I've been pretty good about maxing my Roth IRA the past couple of years. I was always told that Roth is the way to go vs. traditional by people who were never truly as financially literate as I once imagined. So, that's what I always did. But after diving deep into the personal financial planning world, I'm starting to think that traditional is the right choice for me simply due to the tax deferment in sequence to my somewhat high AGI. But first, some stats:

-I make 92K a year at my job, and as of this year, contribute to my SIMPLE IRA plan my employer offers at 6% with a 3% match.
-I freelance/side hustle and earn about 10K a year on that.
-I own a rental home that yielded approx 2.5K over the past few years on my tax returns.

Last year's tax return's AGI was 95K, and this year is shaping up to be very similar, perhaps a bit less since I now deduct 6% of my paycheck into my SIMPLE IRA. So, I have a few questions.

-Do traditional IRA contributions reduce your AGI? IE: I make 100K in AGI, but contributed 5K to my tIRA. Would be new AGI be 95K? I ask because there's a 98K AGI limit if you're covered by an employer plan, which I am.
-Can I setup a spousal tIRA and deduct those contributions as well? She stays at home with the kid and doesn't work.
-Would it be a good idea to see how my tax return is looking in March next year before deciding if I should make my Roth or tIRA?

I'm out here on end of year tax planning island, and I need a little help figuring out what to do.

[terran]

The traditional IRA reduces AGI, but not the modified AGI. You modified AGI must be below $98k if married filing jointly for a Traditional IRA to be fully deductible. You're right on the line, so that would make the decision easy. If it's deductible I'd probably do it.

You probably already found it, but if not you might find this helpful: https://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/2016-IRA-Contribution-and-Deduction-Limits-Effect-of-Modified-AGI-on-Deductible-Contributions-If-You-ARE-Covered-by-a-Retirement-Plan-at-Work

[MDM]

The traditional IRA reduces AGI, but not the modified AGI. You modified AGI must be below $98k if married filing jointly for a Traditional IRA to be fully deductible. You're right on the line, so that would make the decision easy. If it's deductible I'd probably do it.

You probably already found it, but if not you might find this helpful: https://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/2016-IRA-Contribution-and-Deduction-Limits-Effect-of-Modified-AGI-on-Deductible-Contributions-If-You-ARE-Covered-by-a-Retirement-Plan-at-Work

+1

Also, your SIMPLE IRA contributions and any self-employment 401k contributions will reduce your MAGI, so if you contribute the maximum to those you would easily be eligible for the full tIRA deduction.  You can always contribute the full $11K to a tIRA now, then recharacterize (not convert) the exact required amount to a Roth before next April 15 if you are above the $98K MAGI.

See http://forum.mrmoneymustache.com/investor-alley/deciding-between-roth-and-traditional-ira-based-on-marginal-tax-rate/ for more details.

[MoonShadow]

There is another consideration here than just what has been mentioned before.  The Roth IRA has other 'benefits' that a traditional cannot replicate.  Namely, it can function as an "emergency fund" in a family fiscal crisis, well before 59.5 years of age; for which the traditional cannot without suffering a 10% additional tax.  This is because, since contributions have already been taxed before entering into a Roth, those contributions can be withdrawn from a Roth without issues, once your first contribution is 5 years old.  This may not be relevant to yourself, since you already mentioned that you have been funding a Roth for several years; so it might be large enough (of contributions) that you don't need to consider additional emergency funds.  Or you might have emergency funds held elsewhere.  But I think that just about every teenager should get a Roth once they have their first part-time job; and try to put the max into it every year til at least age 25; no matter how much they make.  This can then be ignored & left to grow, or whatever, and still form a small crisis fund & life 'insurance' policy that cannot expire.  If a teenager gets their first job at 16, opens a Roth with their first paycheck; and manages to sock away the max every year (a tall order, I admit) for the first 9 years; they will have just about $50K in contributions.  Tax issues aside (and odds are good that every teen's lowest lifetime tax burden will be in their first 9 years) $50K can make a wonderful backstop for just about any personal, fiscal crisis.

[Gone Fishing]

As far as the spousal IRA goes, yes you can set up an IRA for her even though she doesn't work.  The "not covered by a retirement plan at work" limits will apply to her on the top end of income restrictions, and your earned income will apply to her on the bottom end.

As far as funding now or later goes, you can always "recharacterize" your contributions if need be, which is just a fancy way of saying switching your contribution (for that tax year) from TIRA to ROTH IRA or vice versa.  It is usually as simple as a quick phone call to your investment firm.  The deadline for recharacterizations is Oct 15th of the following tax year.  You can even do it after you have filed, you just have to file an amendment to reflect the change. 

[bittheory]

Thanks for responding, everyone. I had no idea I could recharacterize my IRA contributions. That by far seems like the best plan for me. I'm assuming I can do that for a spousal IRA, as well?

Is there a good resource about recharacterizing, I'm a little confused about the Oct 15th deadline. So I can contribute to a tIRA up until April 15, then if I need to recharacterize into Roth, I have until Oct 15 to do that?

[MDM]

Thanks for responding, everyone. I had no idea I could recharacterize my IRA contributions. That by far seems like the best plan for me. I'm assuming I can do that for a spousal IRA, as well?

Yes, any IRA.

Is there a good resource about recharacterizing, I'm a little confused about the Oct 15th deadline. So I can contribute to a tIRA up until April 15, then if I need to recharacterize into Roth, I have until Oct 15 to do that?

See https://www.bogleheads.org/wiki/IRA_recharacterization

[Cathy]

...I'm a little confused about the Oct 15th deadline. So I can contribute to a tIRA up until April 15, then if I need to recharacterize into Roth, I have until Oct 15 to do that?

Sort of.

A contribution to an IRA is deemed to have made on the last day of the preceding taxable year "if the contribution is made on account of such taxable year and is made not later than the time prescribed by law for filing the return for such taxable year (not including extensions thereof)". 26 USC § 219(f)(3). If your taxable year is the calendar year, then the deadline to contribute to an IRA for 2015 is April 15, 2016. 26 USC § 6072(a).

The deadline for making "adjustments" to contributions (what the IRS and posters here call "recharacterisations") is different. The adjustment must be effected on or before "the date prescribed by law (including extensions of time) for filing the taxpayer's return for such taxable year". 26 USC §§ 408A(d)(6)(A), (d)(7). If your calendar year is the taxable year, the maximum extension of time in most (but not all) cases is an extension until October 15. 26 USC § 6081(a). However, in order to benefit from such an extension of time, it actually has to be granted to you. Subject to certain conditions, you can obtain an extension until October 15th by filing Form 4868. 26 CFR 1.6081-4(b). You could file that form now to secure yourself the benefit of the extension.

If you elect not to file Form 4868 or otherwise obtain an extension, then the deadline for recharacterisations (assuming your taxable year is the calendar year) is only April 15th. However, the Secretary of the Treasury has generously promulgated a regulation authorising retroactive extensions of the deadline, subject to conditions. Specifically, you can obtain an extension until October 15th (even if you failed to ask for one originally) if you, among other conditions, (a) timely filed your original return and (b) comply with certain procedural requirements including writing "FILED PURSUANT TO § 301.9100-2" on top of the amended return that you file to effect the retroactive extension. 26 CFR 301.9100-2(b), (c), (d).

If you want to keep things simple, you can file Form 4868 and that will lock in October 15th as being the deadline (subject to the fact that the Secretary retains the authority to revoke an extension on 10 days' notice: 26 CFR 1.6081-4(d)). If you fail to file Form 4868, you may not be able to recharacterise after April 15th without filing an amended return to request a retroactive extension pursuant to 26 CFR 301.9100-2, even though Roth contributions are normally not reported on returns.

The IRS has also discussed the above points in Publication 590-A under the heading "Extension". Please note that, like all secondary sources, IRS publications "do not have the force of statutory enactment nor do they supersede judicial decisions". Schott, Inc. v. Kalar, 20 CalApp4th 943 n 4 (CA Ct App 1993). That is also true of my posts.

[bittheory]

There is another consideration here than just what has been mentioned before.  The Roth IRA has other 'benefits' that a traditional cannot replicate.  Namely, it can function as an "emergency fund" in a family fiscal crisis, well before 59.5 years of age; for which the traditional cannot without suffering a 10% additional tax.  This is because, since contributions have already been taxed before entering into a Roth, those contributions can be withdrawn from a Roth without issues, once your first contribution is 5 years old.  This may not be relevant to yourself, since you already mentioned that you have been funding a Roth for several years; so it might be large enough (of contributions) that you don't need to consider additional emergency funds.  Or you might have emergency funds held elsewhere.  But I think that just about every teenager should get a Roth once they have their first part-time job; and try to put the max into it every year til at least age 25; no matter how much they make.  This can then be ignored & left to grow, or whatever, and still form a small crisis fund & life 'insurance' policy that cannot expire.  If a teenager gets their first job at 16, opens a Roth with their first paycheck; and manages to sock away the max every year (a tall order, I admit) for the first 9 years; they will have just about $50K in contributions.  Tax issues aside (and odds are good that every teen's lowest lifetime tax burden will be in their first 9 years) $50K can make a wonderful backstop for just about any personal, fiscal crisis.

This is exactly why I was told Roth is the better choice. However, we've been good about saving into an emergency fund, thus replacing the need for Roth withdrawals. For a lot of people, Roth is the better choice for this benefit alone, however. But for most mustachians, probably not.

[robartsd]

If you start saving for retirement early when your tax bracket is low because you have low income, then Roth is the obvious choice (but many feel their income is not yet sufficient to save for retirement). The biggest probem here is that it can't function as an emergency fund (without penalty) for the first five years. I plan to encourage my (future) kids to contribute to a Roth as soon as they have earned income (I also plan not to give them any unearned allowance - instead I'll offer them chores that they can do for pay in addition to any required unpaid chores). To entice them to save I will likely offer some sort of match. If they contribute to a Roth IRA by their 13th birthday, they would then be able put any emergency fund savings their as a young adult and have a great head start on saving for retirement if they never use the emergency fund.

If you already have high income when you start saving for retirement, then traditional makes sense - especially for mustachians who would be maxing out retirement accounts and continuing to invest in taxable accounts. The emergency fund function of the Roth is of little importance because by the time the account qualifies for penalty free withdraw of contributions you expect to have large savings in taxable accounts that should be used first. Of course a backdoor Roth applies once income is high enough that traditional IRA contributions are no longer deductible and Roth conversions during early retirement may be an important part of tax strategy and access to funds before regular retirement age.

[seattlecyclone]

The biggest probem here is that it can't function as an emergency fund (without penalty) for the first five years.

This is false. You may withdraw your contributions at any time penalty free, no exceptions.

[MoonShadow]

If they contribute to a Roth IRA by their 13th birthday, they would then be able put any emergency fund savings their as a young adult and have a great head start on saving for retirement if they never use the emergency fund.

I had my first job at 13, but this is rare these days.  My daughter tried very hard as a 15 year old to get a summer job this year, but everywhere she went they said that they require teens to be 16 now.

However, it would still work if your kid did a modeling or acting job.  It's possible for a toddler to get a Roth, if they are modeling for toddler clothes, and they got paid for it.  Even a single $200 gig would work.

[MoonShadow]

The biggest probem here is that it can't function as an emergency fund (without penalty) for the first five years.

This is false. You may withdraw your contributions at any time penalty free, no exceptions.

I'm going to have to challenge this statement.  My understanding is that there are two 5 year long rules with the Roth that have to be obeyed.  The first is that the Roth must be open and initially funded for 5 years before even contributions are penalty free.  The second is that rollover funds must age in place for 5 years before they can be withdrawn as a contribution.

[terran]

The biggest probem here is that it can't function as an emergency fund (without penalty) for the first five years.

This is false. You may withdraw your contributions at any time penalty free, no exceptions.

I'm going to have to challenge this statement.  My understanding is that there are two 5 year long rules with the Roth that have to be obeyed.  The first is that the Roth must be open and initially funded for 5 years before even contributions are penalty free.  The second is that rollover funds must age in place for 5 years before they can be withdrawn as a contribution.

No, seattlecyclone is correct.

See: https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/

The 5-year rule for Roth contributions is used to determine whether a withdrawal of growth will be tax-free as a "qualified distribution" from a Roth IRA.

and

... the second 5-year rule applies not to (new) Roth contributions, but to Roth conversions from traditional pre-tax retirement accounts, and determines whether Roth conversion principal will be penalty-free.

You can always withdraw the amount you put directly in to a Roth IRA without penalty.

[seattlecyclone]

The biggest probem here is that it can't function as an emergency fund (without penalty) for the first five years.

This is false. You may withdraw your contributions at any time penalty free, no exceptions.

I'm going to have to challenge this statement.  My understanding is that there are two 5 year long rules with the Roth that have to be obeyed.  The first is that the Roth must be open and initially funded for 5 years before even contributions are penalty free.  The second is that rollover funds must age in place for 5 years before they can be withdrawn as a contribution.

The first five-year rule is commonly misunderstood. It restricts how long you must have the account open and funded before receiving a "qualified distribution." In order to take a qualified distribution, you also need to be either over 59½, disabled, dead, or a first-time home buyer. For most cases where your Roth IRA is being used as an emergency fund, the distribution will fail the second test regardless of how long the account has been open, therefore the five-year rule for qualified distributions is completely irrelevant. In these cases we need to look at the tax rules for non-qualified distributions. The 10% early distribution penalty only applies to the taxable part of such distributions (including any amounts that were taxed upon conversion to Roth within the past five years). A return of contributions is not taxable, therefore it's also not penalized.

[MoonShadow]

You can always withdraw the amount you put directly in to a Roth IRA without penalty.

That is great news!  Thanks, both of you!

[TomTX]

Look seriously into a "solo" or "individual" 401k for your side gig income.

https://investor.vanguard.com/what-we-offer/small-business/individual-401k

[bittheory]

Look seriously into a "solo" or "individual" 401k for your side gig income.

https://investor.vanguard.com/what-we-offer/small-business/individual-401k

I will. As it grows, I'll get more serious about setting one up. Is it fairly simple?