Trad IRA: most overlooked lower income tax benefit over Roth

[crowd79]

It is generally accepted by most people, pundits, investors, etc that if you are lower income (10-15% tax bracket) that a Roth IRA makes more sense over a Traditional.

However, one thing often overlooked is the "Savers Credit", where if your AGI falls below certain thresholds, the govenment gives you tax credits, in essence, a matching contribution to your retirement plan. If you contribute to a Traditional IRA, you can deduct your contributions (like a 401k), thus lowering your AGI enough to qualify for up to $1,000 per person tax credit if you were able to get your AGI below $17,250 for 2012.

Let's say, for example (before taking into consideration a Roth or Trad IRA) someone had lowered their AGI to $22,000 after taking their usual yearly deductions (mortgage deduction, etc, etc). If he/she chooses to fund and max out a Traditional IRA at $5,000 for 2012, he/she can deduct that from taxes, bringing AGI down to $17,000, and thus qualifying for up to possibly a $1,000 credit from uncle sam. With a Roth, you cannot do this. He/she will still get a $200 credit (for being below $28k AGI and contributing to a Roth....the cutoff for this highly beneficial credit is somewhere around there....) but that is an $800 difference.

Just something to consider and think about. People talk about getting a "matching" first from your employer first before diverting funds elsewhere after only that has been met. Well, how about maximizing your matching from the gov't...if you can do so?

Jeff

[papito23]

Yes, found this out via BHs. Grabinar made note of it in 2010... and the credits is not just for low incomes. Ex. An above-median-income in much of the country - $57,500-$67,500 - is still within shooting range of a 10% credit for a jointly-filing couple with $10K to contribute to a Trad. IRA. Similar credit thresholds bumps of 10 or 30% can be made for couples in the $34,500 - 47,500 range who have $10K to contribute. (see the 8880 form).

From my initial research years ago, Roth IRAs were very highly sold. Not a slam dunk, it turns out. Wish I had known this years ago (would have saved me the entirety of my Fed tax bill ~$1500). Some of my obsessive research will pay off it seems!

And parents, don't forget this Trad. IRA trick with the Earned Income Tax Credit. If you are in the phaseout range (starting $22,300+ for Married-joint filers, up to $42.1K for one kid, $47.2K for 2, and $50,270 for 3+), ... and have investment income, you can move back up the phaseout ladder (worth $16 per $100) by making a contribution that cancels out the amount of your investment income (see here). 16% instant return? Sure, I'll take that. EITC pub 596 here.

[retiredjg]

However, one thing often overlooked is the "Savers Credit", where if your AGI falls below certain thresholds, the govenment gives you tax credits...

It's true. The "saver's credit" does get overlooked. Thanks for making the point.

[Alan S.]

Note that for EIC purposes, a TIRA contribution will reduce AGI, perhaps down to the amount of earned income, however there is still a 3,200 investment income limitation to apply the credit. If your investment income per the worksheet exceeds 3,200 you won't be eligible for the EIC at all even if your TIRA contributions offset the investment income included in AGI.

Quite often to get the max Savers credit benefit, you would use the TIRA deduction to reduce AGI to the top of the 50% savers tier, and at that point you will probably recover 100% of your tax liability, so there is no benefit from reducing AGI further. You might have to make a greater IRA contribution than the 2k max used in calculating the credit to get your AGI into the 50% tier. However, if your AGI is under the top of the 50% savers tier you would benefit from doing a Roth conversion up to the top of the tier and the credit will cover the taxes on the conversion. Or of course, reducing the TIRA contribution will also raise AGI to that point. There is plenty of flexibility under the IRA rules to allow number crunchers to manage their AGI after the end of the CY to exactly the optimal figure for the savers credit.

While few taxpayers in the 50% savers tier have much disposable income, if they have more IRA contribution headroom after making a TIRA contribution to get to the top of the 50% tier, they can then make the rest of their annual contribution to a Roth IRA since there is no longer a need to lower AGI. If these IRA contributions have already been made early in the year and do not match up to the desired AGI target, you can simply recharacterize the amount needed to the other type of IRA that will result in your AGI ending up at the top of the 50% tier. This opportunity is mostly used by early retirees who are working part time to keep busy and also have funds available to make the IRA contributions.

There are other lesser benefits from managing AGI for the 10% and 20% tiers as well, but in these tiers you are unlikely to reduce your tax liability to -0- unless you are itemizing.

[papito23]

Note that for EIC purposes, a TIRA contribution will reduce AGI, perhaps down to the amount of earned income, however there is still a 3,200 investment income limitation to apply the credit. If your investment income per the worksheet exceeds 3,200 you won't be eligible for the EIC at all even if your TIRA contributions offset the investment income included in AGI.

Great point. I'm watching this very closely given that you lose 100% of that juicy EITC if you are $1 over. Watch especially capital gains and checking account promotions (1099-INT). For 2013, this limit will bump to $3,300.

If these IRA contributions have already been made early in the year and do not match up to the desired AGI target, you can simply recharacterize the amount needed to the other type of IRA that will result in your AGI ending up at the top of the 50% tier. This opportunity is mostly used by early retirees who are working part time to keep busy and also have funds available to make the IRA contributions.

Does this mean I could re-characterize this February for my 2012 contributions (should I find it more advantageous)? Does this work either way? My plan was to forego contributions until tax time of the following year to get the optimal balance. I think the opportunity cost of being out of the market would be worth skipping the paperwork hassle of a recharacterization. Though I suppose I could invest in taxable until the time came (then - whoops - a big capital gain, pushing my investment income above $3300 and dashing my plan to save hundreds by losing thousands... ouch).

[crowd79]

Quite often to get the max Savers credit benefit, you would use the TIRA deduction to reduce AGI to the top of the 50% savers tier, and at that point you will probably recover 100% of your tax liability, so there is no benefit from reducing AGI further. You might have to make a greater IRA contribution than the 2k max used in calculating the credit to get your AGI into the 50% tier. However, if your AGI is under the top of the 50% savers tier you would benefit from doing a Roth conversion up to the top of the tier and the credit will cover the taxes on the conversion. Or of course, reducing the TIRA contribution will also raise AGI to that point. There is plenty of flexibility under the IRA rules to allow number crunchers to manage their AGI after the end of the CY to exactly the optimal figure for the savers credit.

So, for example, say if someone only needed to contribute $4,000 to a Traditional IRA to get them below the $17,250 threshold to qualify for the maximum 50% credit, and had $1,000 left over to max out, they could then contribute that to the Traditional as well (lower AGI to $16,250) , but then convert that amount to a Roth w/o paying any taxes on the conversion? This would raise AGI to the breaking point of $17,250, but still keep them barely below the $17,250 threshold to still qualify for the max credit (& probably get all taxes back). Is this what you are trying to indicate here?

[Alan S.]

To Papito,

Yes, you can recharacterize a 2012 contribution as late as 10/15 of the following year (extended due date). You can change all or part of your contribution from Roth to TIRA or from TIRA to Roth. The earnings loss or gain accompanies the transfer to the other IRA type, but for 2012 tax reporting purposes your original contribution type would change (more TIRA equals deduction that lowers AGI) and less TIRA means lower deduction and higher AGI. You can also remove some or all of your contribution and recharacterize all of part of what is left. Of course, all this flexibility increases the risk of error, so be careful. You cannot reverse a recharacterization because a recharacterization cannot be recharacterized again. All things considered, for most people it might be safer to wait until AGI is final and then make the optimum contribution as you indicated.

crowd,

Yes, but if you are able to contribute more, just make your 1,000 contribution to a Roth IRA as that will leave your AGI the same. If you did the 5k TIRA and then converted 1,000 your AGI would also be OK, but then your Roth conversion will have a 5 year holding period to avoid the 10% penalty. A regular Roth contribution does not. Using conversions requires more planning accuracy because the conversion distribution needs to be done by 12/31, whereas you can tweak your regular contributions up to 4/15. If you really wanted to keep your options open for a conversion, for example in a situation where you have alot of AGI headroom, you can take a distribution the last week in December, hold the money in taxable and within 60 days after you know your AGI, you can complete the rollover to a Roth IRA for the amount you want and roll the rest back to the TIRA it came from. Even though that conversion is not completed until 2014 for example, it is reported on your 2013 return because the distribution took place in 2013.

[crowd79]

crowd,

Yes, but if you are able to contribute more, just make your 1,000 contribution to a Roth IRA as that will leave your AGI the same. If you did the 5k TIRA and then converted 1,000 your AGI would also be OK, but then your Roth conversion will have a 5 year holding period to avoid the 10% penalty. A regular Roth contribution does not. Using conversions requires more planning accuracy because the conversion distribution needs to be done by 12/31, whereas you can tweak your regular contributions up to 4/15. If you really wanted to keep your options open for a conversion, for example in a situation where you have alot of AGI headroom, you can take a distribution the last week in December, hold the money in taxable and within 60 days after you know your AGI, you can complete the rollover to a Roth IRA for the amount you want and roll the rest back to the TIRA it came from. Even though that conversion is not completed until 2014 for example, it is reported on your 2013 return because the distribution took place in 2013.

I'm sorry, but wouldn't "taking a distribution (from Trad IRA) the last week of December and holding it in taxable, lada, lada, lada, etc...." wouldn't that trigger a tax penalty against the Traditional IRA for taking money out? I am not quite understanding that. Seems like if I know by the end of 2013 that I have some AGI headroom (for example, knowing I'll be well below $17,750 for 2013) heading into 2014, then I can convert $xxx from what already exists in my Traditional IRA into a Roth IRA up to that $17,750 AGI threshold without having to pay taxes on the conversion, assuming I were to get all taxes back regardless. Is that possible?

Now for 2012, is it unfortunately too late to do this trick? I could possibly have enough room to move $500 from Trad to Roth while still remaining under the $17,250 threshold.

[Alan S.]

There is no penalty if the rollover is completed within 60 days, and in any event there is never a penalty for a Roth conversion which is a two part process, distribution and rollover.

It is certainly possible to convert an amount that increases your AGI up to the top of the 50% savers tier. But the distribution portion of the conversion must be processed before the end of the calendar year to be reportable in that calendar year. For 2012, if you made a TIRA contribution already and your AGI is $500 short of the top of the 50% savers tier, you could recharacterize $500 of that contribution as a Roth IRA contribution. That will increase your AGI by $500 and effectively create the same end result as converting $500. If you have not yet made 2012 IRA contributions, you can split the contributions between Roth and TIRA to affect your AGI, and would not have to process a recharacterization.

[crowd79]

Just did my taxes with TurboTax. I managed to get my AGI down amazingly low to $17,247 for 2012, getting me into the 50% saver's credit and effectively eliminating my total Federal tax liability for 2012.....and I have $500 left over to contribute to and fund a Roth IRA for 2012 w/o affecting the Saver's Credit threshold.

[steadyeddy]

I'm in the 15% tax bracket with quite a bit of headroom and moderate savings, but I still don't have low enough AGI to qualify for the saver's credit so I use Roth 401k and IRA.

Is this roughly right?

Low Income - Deductible Traditional with Saver's Credit
Moderate Income - Roth
High Income - Deductible Traditional
Highest Income - Non-deductible Traditional with Conversion to Roth

[grabiner]

Is this roughly right?

Wiki article link: Traditional versus Roth

Low Income - Deductible Traditional with Saver's Credit

This is an issue of the specific numbers. The best thing to do is to contribute exactly enough to a Traditional IRA to get into the next Saver's Credit category if you are close. If you are in the 10% category and can't get to the 20% category (fairly common), then you might as well use the Roth. If you need to use the Traditional IRA to get into the 10% category, then $2000 in a Roth costs you $2000, but $2000 in a Traditional IRA costs you $1500 ($300 tax and $200 Saver's Credit) for an effective 25% tax rate, which makes the Traditional IRA better. (And if you are only $1000 above the threshold, you should use $1000 in a Traditional IRA and $1000 in a Roth.)

Moderate Income - Roth

Usually, this is right if you are in the 15% tax bracket and aren't in the phase-out range for any tax credits. It may also be right in the 25% tax bracket if you are maxing out and expecting to retire in the same bracket; this might happen early in your career if you expect to be in a higher bracket in later years (and thus will either make 401(k) contributions or have a pension).

And if you aren't eligible for deductible contributions to a Traditional IRA (because you have an employer plan and make too much money), then you should use the Roth rather than a non-deductible Traditional IRA.

High Income - Deductible Traditional

This isn't a matter of high income but of eligibility. If you are eligible to deduct Traditional IRA contributions (because you have no employer plan), then you should use them even in a high tax bracket.

Highest Income - Non-deductible Traditional with Conversion to Roth

And this is what you should do if it is your only option. If you make too much to contribute to either a Roth or deductible traditional IRA, then a backdoor Roth IRA is the best way to invest.

[Kernschatten]

Note that for EIC purposes, a TIRA contribution will reduce AGI, perhaps down to the amount of earned income, however there is still a 3,200 investment income limitation to apply the credit. If your investment income per the worksheet exceeds 3,200 you won't be eligible for the EIC at all even if your TIRA contributions offset the investment income included in AGI.

Great point. I'm watching this very closely given that you lose 100% of that juicy EITC if you are $1 over. Watch especially capital gains and checking account promotions (1099-INT). For 2013, this limit will bump to $3,300.

This is something I missed out on for this very reason. It was a bit mind blowing to discover too. Someone with an income 17K higher than mine would still be eligible for the EITC because they didn't have capital gains. Needless to say, I know this now and it won't be happening again.

[Kernschatten]

However, one thing often overlooked is the "Savers Credit", where if your AGI falls below certain thresholds, the govenment gives you tax credits...

It's true. The "saver's credit" does get overlooked. Thanks for making the point.

My AGI is at the "right" level and my contributions to a Roth IRA and TSP are there, but I've been getting a very low Saver's Credit. It looks like this is due to capital gains.

In short: If your Saver's Credit is calculated to be higher than your tax from gains on Form 8880 Credit for Qualified Retirement Savings Contributions --- Line 13, then you get the lesser amount (amount equal to tax from gains).

Code: Select all

To figure Form 8880 Line 13, I follow this line of succession:   Form 8880 Line 13 >> References --- Line 11 >> References 1040 Line 46 >> Brings us to 1040 Line 44 "Tax" >> Brings us to the "Qualified Dividends and Capital Gain Tax Worksheet---Line 44" >> Point 19 on the worksheet is the "tax on all taxable income" and is used to fill 1040 Line 44.

So, if didn't have any capital gains, my Saver's Credit would be calculated off of my AGI and the credit would be higher.

I'd be interested if anyone knows a legal way to work around this.

[Alan S.]

You are reading the form incorrectly. Cap gains does not affect the savers credit beyond it's inclusion in basic AGI. It's just another part of your AGI.

Note that line 13 you refer to should be line 13 on the 8880, not on Form 1040. Form 8880 also limits your credit if you have other credits by applying the other non refundable credits first and the savers credit is what is left to bring your taxable income to -0-.

http://www.irs.gov/pub/irs-pdf/f8880.pdf

[Kernschatten]

You are reading the form incorrectly. Cap gains does not affect the savers credit beyond it's inclusion in basic AGI. It's just another part of your AGI.

Note that line 13 you refer to should be line 13 on the 8880, not on Form 1040. Form 8880 also limits your credit if you have other credits by applying the other non refundable credits first and the savers credit is what is left to bring your taxable income to -0-.

Assuming you are referring to me, Alan, I am not so sure that I am reading the forms incorrectly...

I did note and reference that line 13 is on 8880, not on 1040. I don't refer to Form 1040 line 13.

8880 Line 14 is clear to me -- if Line 10 (Saver's Credit based on contributions) is more than 8880 Line 13, then Line 13 must be used instead of the traditional Saver's Credit calculation. When I follow Form 8880 Line 13, that tells me to subtract Line 12 (credits to which I have none) from Line 11 (Form 1040 line 46 >> Line 44 "Tax").

When I run the numbers by hand on paper, I come up with the same result that TurboTax and TaxSlayer output -- a small Saver's Credit. When I then change my gains, the Saver's Credit goes up and down. When I tweak the short-term gains in TurboTax/TaxSlayer, I see the Retirement Savings Contribution Credit flex up and down.

[Alan S.]

If you do not have any of those credits to subtract, your line 10 savers credit is unaffected. But when you change your cap gains it will change your tax AND your AGI.

You are changing your gains which can result in a combination of different effects.
For increased gain:
1) Your AGI goes up and that could reduce your savers tier credit factor
2) If gains are ST, your taxes also go up. That could result in a larger savers credit if the former amount of credit was limited by your prior tax bill.
3) LT gains are taxed at 0, so they will not change your basic tax bill, but those gains still increase your AGI

For reduced gain or increased loss:
1) AGI is reduced - that could increase the savers tier credit factor
2) If short gains are reduced, your basic tax bill decreases. This could result in a smaller savers credit since credit is not refundable

Any other income change such as wages or interest will have the same mixed result as above except that LT gains have the additional variation of a 0 tax rate, ie your basic tax bill may be unchanged but your AGI still rises or falls.

[papito23]

Note that for EIC purposes, a TIRA contribution will reduce AGI, perhaps down to the amount of earned income, however there is still a 3,200 investment income limitation to apply the credit. If your investment income per the worksheet exceeds 3,200 you won't be eligible for the EIC at all even if your TIRA contributions offset the investment income included in AGI.

Great point. I'm watching this very closely given that you lose 100% of that juicy EITC if you are $1 over. Watch especially capital gains and checking account promotions (1099-INT). For 2013, this limit will bump to $3,300.

This is something I missed out on for this very reason. It was a bit mind blowing to discover too. Someone with an income 17K higher than mine would still be eligible for the EITC because they didn't have capital gains. Needless to say, I know this now and it won't be happening again.

Better late than never! Staring at tax forms for hours on end really has paid off for me.

I mentioned this above, but if you are in EITC phase out, remember to contribute to a T-IRA (or 401K maybe??) an amount equivalent to your investment income. (See this discussion, HT: 555)

[Kernschatten]

If you do not have any of those credits to subtract, your line 10 savers credit is unaffected.

I see this as well. However, since my line 13 is smaller than my line 10, line 10 is disregarded and line 13 is carried into line 14. Line 14 (in essence, 13 too) is what I then see applied as the Saver's Credit.

2) If gains are ST, your taxes also go up. That could result in a larger savers credit if the former amount of credit was limited by your prior tax bill.
2) If short gains are reduced, your basic tax bill decreases.

Yes, this is exactly what I observed and is what had me a bit confused as to why you stated that gains don't affect the savers credit. Gains went up - credit went up to match the tax on them.

This could result in a smaller savers credit since credit is not refundable.

This right here is the key. I went into this thinking that the credit was refundable like the EITC and that it was something that could be increased. Now I know otherwise. I've learned that the way the various forms work out, it guarantees to do nothing more than reduce owed taxes to zero... which is why my credit was so small to begin with.