Trad IRA Conversion to Roth: Should I bother? [What is "earned income"?]

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Happy2BeFree
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Trad IRA Conversion to Roth: Should I bother? [What is "earned income"?]

Post by Happy2BeFree » Tue Mar 13, 2018 10:02 pm

[Question updated, see below. --admin LadyGeek]

Hi,
I just had my taxes done and hope I can glean some wisdom from the board.

I contributed about $3k to a traditional IRA last year for tax year 2017. ($3k was my freelance income for the year.) After business deductions, I was able to deduct only about $1k, since that was my net income. So I guess I should have contributed only $1k to a traditional IRA to get the deduction and then the rest to my Roth.

Should I recharacterize that $2k to a Roth IRA? I assume I won't have to pay taxes on it? I also assume that I'll have to submit tax form 8606 to do this? (I already signed off on my tax return, so it will have to be submitted after the fact.) And is there a deadline for submission of this form and for recharacterization? (If I do this, I'd like to submit this form with my 2018 tax returns, if possible.)

I will be well within the 12% tax bracket for tax year 2018 (and, most likely, going forward). Does a Roth even make sense? And is it worth doing a recharacterization for $2k? (It would go into Wellesley in either IRA.)

Thanks very much for your help!

JBTX
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Re: Trad IRA Conversion to Roth: Should I bother?

Post by JBTX » Wed Mar 14, 2018 12:37 am

Happy2BeFree wrote:
Tue Mar 13, 2018 10:02 pm
Hi,
I just had my taxes done and hope I can glean some wisdom from the board.

I contributed about $3k to a traditional IRA last year for tax year 2017. ($3k was my freelance income for the year.) After business deductions, I was able to deduct only about $1k, since that was my net income. So I guess I should have contributed only $1k to a traditional IRA to get the deduction and then the rest to my Roth.

Should I recharacterize that $2k to a Roth IRA? I assume I won't have to pay taxes on it? I also assume that I'll have to submit tax form 8606 to do this? (I already signed off on my tax return, so it will have to be submitted after the fact.) And is there a deadline for submission of this form and for recharacterization? (If I do this, I'd like to submit this form with my 2018 tax returns, if possible.)

I will be well within the 12% tax bracket for tax year 2018 (and, most likely, going forward). Does a Roth even make sense? And is it worth doing a recharacterization for $2k? (It would go into Wellesley in either IRA.)

Thanks very much for your help!
Is this your only earned income? If it is, you can only contribute to an IRA, whether it is traditional or Roth, up to your earned income amount, which is $1000. It seems you have contributed $2000 too much, if I am understanding you correctly. Changing it to Roth isn’t going to do you any good, and I doubt it is even an option.

retiredjg
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Re: Trad IRA Conversion to Roth: Should I bother?

Post by retiredjg » Wed Mar 14, 2018 8:33 am

My understanding is that you cannot contribute more than your net compensation for the year. If that was $1k, you get to contribute $1k to tIRA, Roth IRA or a combination of the two. It has nothing to do with deductible or non-deductible contributions.

It appears to me you have a $2k excess (unless there was another job you have not mentioned). You can have the extra $2k withdrawn (contact your custodian and tell them you made an excess contribution and let them handle it) or you can pay a 6% excise tax and leave the money for next year's contribution (there is a form for that).

If you have the extra $2k returned/withdrawn, the earnings associated with that $2k will come back to you as well. You will need to add that to your 2017 taxes (the taxes you are doing now).

JW-Retired
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Re: Trad IRA Conversion to Roth: Should I bother?

Post by JW-Retired » Wed Mar 14, 2018 8:46 am

Happy,
You mentioned Wellesley so your account appears to be with Vanguard. Phone them and they will know exactly what to do about you making too large a contribution.
JW
Retired at Last

Happy2BeFree
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Re: Trad IRA Conversion to Roth: Should I bother?

Post by Happy2BeFree » Wed Mar 14, 2018 9:09 am

Oh, thank you all, so much! I actually earned $3k last year, and that was my only earned income, reported on my 1099-misc. I assume that's considered gross income?

So you cannot contribute to an IRA (Roth or trad) an amount equal to your gross earned income? You can contribute only that amount to your net earned income (after business deductions)?

Yes, I'm at VG. So once I have VG return that extra $2k (plus any extra it earned over the year) to me, I can't contribute that to a Roth? Just want to make sure I understand you correctly. And I have to report it on my 2017 tax return, which has already been completed and possibly filed?

Thank you!

Happy2BeFree
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What constitutes earned income for trad/Roth IRA contributions?

Post by Happy2BeFree » Wed Mar 14, 2018 10:57 am

[Thread merged into here, see below. --admin LadyGeek]

I'm stumped.

If I earn $3k on a freelance job and have no other earned income for the year, I cannot contribute $3k to a trad or Roth IRA for that year? I have to subtract whatever deductions I take on that job and figure out the NET earned income I have and that's what I can contribute to either a trad or a Roth? How would I know ahead of time, then, what to contribute?

Thanks!

Chuck
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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by Chuck » Wed Mar 14, 2018 11:02 am

You wouldn't, but you can wait until April 15 of the following year to make your contribution.

mhalley
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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by mhalley » Wed Mar 14, 2018 11:05 am

You don't have to take any deductions. Whatever amount you earned, you can put into the roth. You don't contribute ahead of time, you always contribute after you earn the money to prevent over contributions. The only time you worry about adjusted gross income is if you make a high income and have to worry about no longer being eligible for the roth.

TravelforFun
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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by TravelforFun » Wed Mar 14, 2018 11:09 am

mhalley wrote:
Wed Mar 14, 2018 11:05 am
You don't have to take any deductions. Whatever amount you earned, you can put into the roth. You don't contribute ahead of time, you always contribute after you earn the money to prevent over contributions. The only time you worry about adjusted gross income is if you make a high income and have to worry about no longer being eligible for the roth.
I think he can only contribute up to his modified adjusted gross income (income minus deductions) or $5,500 whichever is less.

TravelforFun

pshonore
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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by pshonore » Wed Mar 14, 2018 11:11 am

Happy2BeFree wrote:
Wed Mar 14, 2018 10:57 am
I'm stumped.

If I earn $3k on a freelance job and have no other earned income for the year, I cannot contribute $3k to a trad or Roth IRA for that year? I have to subtract whatever deductions I take on that job and figure out the NET earned income I have and that's what I can contribute to either a trad or a Roth? How would I know ahead of time, then, what to contribute?

Thanks!
You also have to reduce the amount by 1/2 of SS resulting from the free lance job. You have until the due date of the return (~April 15) to calculate and make the contribution. If you make an employer contribution to a SEP you have until Oct 15th, but would limited to 20% of net profit after subtract 1/2 of SE.

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Flobes
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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by Flobes » Wed Mar 14, 2018 11:38 am

^ What everyone else says.

* Report $3000 income on your Schedule C.

* Do not take any business deductions.

* You will not owe any federal income taxes on that income.

* You will have to compute Self-Employment tax on Schedule SE.

* You can make an IRA contribution of AGI, which will be your total income minus one-half of the Self Employment tax.

* Compute Form 8880. You will garner a Savers Credit of $1000 for your (>$2000) IRA contribution, whether it is Traditional IRA or Roth IRA.

* That Savers Credit will more cover the Self-Employment taxes that are owed. The balance of the credit will go unused.

* Info from Schedule C, Schedule SE, and Form 8880 all must be entered on the appropriate lines of your 1040. All four go to the IRS.

* In your other thread about the same topic, you said you had your taxes done. Immediately fire whoever did them, for leading you down the path of business deductions, and not informing you of just how simple and beneficial your tax situation is. Or is there something else going on within your business and income that you've not yet told us?

* Also in the other thread about the same topic, you said you've already made a $3000 contribution to a Traditional IRA. If this is true, then you will have to withdraw the excess contribution.

* Also in the other thread about the same topic, you questioned whether recharacterizing to a Roth is a better idea. Yes, it is. Yes you can.

retiredjg
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Re: Trad IRA Conversion to Roth: Should I bother?

Post by retiredjg » Wed Mar 14, 2018 11:56 am

See if you can find your answer here. https://www.irs.gov/pub/irs-pdf/p590a.pdf

Page 8 says "taxable compensation" which makes me think it (the limit) is not what you make before expenses. But page 6 sounds a little different.

Since you "just had your taxes done", they should be able to tell you how much you can contribute to IRA and/or Roth IRA. It has nothing to do with how much of your contribution you can deduct from taxable income though. I think that might be where the misunderstanding is happening.

terran
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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by terran » Wed Mar 14, 2018 12:43 pm

Flobes wrote:
Wed Mar 14, 2018 11:38 am
* That Savers Credit will more cover the Self-Employment taxes that are owed. The balance of the credit will go unused.
This isn't actually quite true. If you look through Form 8880 you'll see that the Savers Tax credit is the smallest of:
1) 10%, 20%, or 50% (depending on income) of $2000
2) 10%, 20%, or 50% (depending on income) of your actual retirement account contributions
3) Your total income tax liability, which is Line 47 - form 1040 minus the credits found in Lines 48 through 50 - form 1040 and Line 22 - Schedule R (Credit for the Elderly or the Disabled).

You then subtract the Savers Tax Credit, and other tax credits from line 47 - form 1040 and put that on line 56 - form 1040. You put Self employment tax (from Schedule SE) on line 57 - form 1040. Total tax (line 63 - form 1040) includes both of of these and some other forms of tax.

So the Savers Tax Credit cannot be more than the total tax on your income, but this does not include self employment tax, so you'll still pay that.

Happy2BeFree
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Re: Trad IRA Conversion to Roth: Should I bother?

Post by Happy2BeFree » Wed Mar 14, 2018 1:09 pm

Thanks, retiredjg. I'll check out the link. I thought I understood how much I could contribute, but I guess I don't.

Happy2BeFree
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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by Happy2BeFree » Wed Mar 14, 2018 1:14 pm

Thanks to everyone who contributed to this discussion. Yes, aside from earned income, I also had unearned and passive income (interest, dividends, etc.), but didn't consider that for an IRA.

I'm still not clear on what constitutes earned income, or what I can actually contribute each year to a Roth or trad IRA. I guess it's more complicated than I'd thought. Perhaps if I take no deductions from my tiny business, I can avoid all this confusion. :oops:

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Re: Trad IRA Conversion to Roth: Should I bother?

Post by mhadden1 » Wed Mar 14, 2018 1:31 pm

Regarding Roth vs. Traditional: this can be tricky for most people, mostly because it involves predictions about the future, which are the hardest kind to get right. The ambiguity results in regular discussions on this forum.

The wiki entry is definitely worth a look:
https://www.bogleheads.org/wiki/Traditional_versus_Roth

When the best choice is not obvious, I think most BHs would support having some of both.
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MarkNYC
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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by MarkNYC » Wed Mar 14, 2018 1:42 pm

Flobes wrote:
Wed Mar 14, 2018 11:38 am

* Report $3000 income on your Schedule C.

* Do not take any business deductions.

* You will have to compute Self-Employment tax on Schedule SE.

* Compute Form 8880. You will garner a Savers Credit of $1000 for your (>$2000) IRA contribution, whether it is Traditional IRA or Roth IRA.

* In your other thread about the same topic, you said you had your taxes done. Immediately fire whoever did them, for leading you down the path of business deductions, and not informing you of just how simple and beneficial your tax situation is.
The situation is not as simple as you make it. First, as was already mentioned, the Savers Credit is limited to income tax, so if income tax is zero then no Savers Credit is allowed.

Second is the issue of omitting otherwise allowable deductions. In most situations, the IRS will not require that allowable deductions be taken on the tax return. One of the limited exceptions to that involves computing self-employment income. IRS Rev. Ruling 56-407 states in part that "every taxpayer, with the exception of certain farm operators, must claim all of his allowable deductions, including depreciation, in computing his net earnings from self-employment for self-employment tax purposes."

Note: For a lengthy and interesting discussion of the issue of intentionally omitting allowable deductions, you can google an article by Villanova law professor James Maule, titled "No Thanks, Uncle Sam, You Can Keep Your Tax Break."

retiredjg
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Re: Trad IRA Conversion to Roth: Should I bother?

Post by retiredjg » Wed Mar 14, 2018 1:48 pm

Happy2BeFree wrote:
Wed Mar 14, 2018 1:09 pm
Thanks, retiredjg. I'll check out the link. I thought I understood how much I could contribute, but I guess I don't.
Well, I'm not sure I understand it right either. It all seems to revolve around the definition of "taxable compensation". I can find a definition of compensation, but not taxable compensation. I'm beginning to wonder if they are the same thing.

Maybe someone who does taxes will jump in here and get us straight.

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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by ivk5 » Wed Mar 14, 2018 2:01 pm

mhalley wrote:
Wed Mar 14, 2018 11:05 am
You don't have to take any deductions.
Even if that were the case, why would you want to be taxed (in current year for Roth, or future year for traditional) on an amount that could be excluded forever from taxation by claiming a legitimate deduction?

Additionally, business deductions reduce SE tax in addition to income tax.

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Re: Trad IRA Conversion to Roth: Should I bother? [What is "earned income"?]

Post by LadyGeek » Wed Mar 14, 2018 3:28 pm

Happy2BeFree - In order to give appropriate advice, it's best to keep all the information in one spot. I moved your updated question into the original and retitled the thread. The combined thread is now in the Personal Finance (Not Investing) forum (tax question).

This isn't a big deal, don't worry about it.
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Chuck
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Re: What constitutes earned income for trad/Roth IRA contributions?

Post by Chuck » Wed Mar 14, 2018 3:42 pm

ivk5 wrote:
Wed Mar 14, 2018 2:01 pm
mhalley wrote:
Wed Mar 14, 2018 11:05 am
You don't have to take any deductions.
Even if that were the case, why would you want to be taxed (in current year for Roth, or future year for traditional) on an amount that could be excluded forever from taxation by claiming a legitimate deduction?
Presumably because the marginal tax rate would be 0% and it would make a greater amount available for contribution to a Roth IRA.

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Re: Trad IRA Conversion to Roth: Should I bother? [What is "earned income"?]

Post by dodecahedron » Wed Mar 14, 2018 3:53 pm

It is not obvious that the IRS will agree that the OP has the right to forego taking deductions for legitimate business expenses.

See this article written by a tax law professor, Jim Maule, who previously worked in the IRS Office of Chief Counsel. According to Professor Maule, the IRS is generally okay with your foregoing taking legitimate deductions with two notable exceptions: computing self-employment tax and computing Earned Income Tax Credit.

Some folks have apparently deliberately skipped taking deductions because they wanted to have more self-employment earned income on their SS records. The IRS says that is not okay, according to Professor Maule--when you are computing self-employment income, you need to take all legitimate business expense deductions.

Foregoing those deductions in computing your self-employment income creates an AIME (Averaged Index Monthly Earnings) figure which is not correct, according to IRS and SSA rules.

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Re: Trad IRA Conversion to Roth: Should I bother? [What is "earned income"?]

Post by pshonore » Wed Mar 14, 2018 4:05 pm

And other folks don't take expenses so as to get a larger Earned Income credit. Once again, that is definitely frowned upon.

What whats the right answer to OP's question? I still think its net business income adjusted by 1/2 of SE tax.

https://ttlc.intuit.com/questions/33087 ... t-3000-net

Happy2BeFree
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Re: Trad IRA Conversion to Roth: Should I bother? [What is "earned income"?]

Post by Happy2BeFree » Wed Mar 14, 2018 6:24 pm

Thank you so much, everyone. This is all so helpful! Much appreciated. :beer

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