Any PharmD tax expert in here?

[UGAZ]

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I just did my income tax today and found out what a stupid mistake I made. So basically, I opened a traditional IRA last week for me and my wife...each account funded with 5500 (max). Today, I went to my income tax guy and he said I am not eligible for IRA since my income is too high and I already maxed out my 401k at work. My wife is eligible, however. So what would I do with my IRA now? Should I just go ahead and withdraw the money with penalty? Or just leave it there?

 

[pezdispenser]

The income limit ($98k-118k MFJ) only applies to getting a deduction for a traditional IRA. You can still open a traditional IRA when you are over the income limit, but you won't be able to deduct it. You must declare this nondeductible IRA on Form 8606 with your tax return.

Now a nondeductible IRA left as is, is not really worth doing, but they are actually used often to be converted to a Roth IRA. This is what's known as the "Back door Roth".

 

[Caffeine QAM]

Now a nondeductible IRA left as is, is not really worth doing, but they are actually used often to be converted to a Roth IRA. This is what's known as the "Back door Roth".

What's the utility of that?

 

[pezdispenser]

What's the utility of that?

For a nondeductible traditional IRA
- original $5,500 contribution made with after tax money so it will not be taxed on withdrawal
- investment earnings grow tax deferred, so you will pay taxes on these on withdrawal

For a Roth IRA
- original $5,500 contribution made with after tax money so it will not be taxed on withdrawal
- investment earnings are completely tax free as well, so you don't pay any taxes on any withdrawals

But there is an income limit to make a direct Roth IRA contribution of $116k single, $183k MFJ. The way around this limit is called the Backdoor Roth. Make a nondeductible IRA first. There is no income limit for this, and the contribution is with after tax money, just like the Roth. Then convert it to a Roth IRA. You will have to pay taxes on any investment earnings up to that point (should be nothing if you used a money market account and did it within a few days), and from then on, the whole account including principal and earnings will be completely tax free.

 

[ldiot]

Like the other posters said you can't take a tax deduction for the contribution, but you can roll it into a roth IRA and withdraw the gains tax free in retirement which is better than both withdrawing it now with penalty or just leaving it there and paying income tax on it a second time in retirement. In fact roth IRA is probably the most tax efficient investment you can make after maxing your traditional 401k.

 

[xiphoid2010]

What's the utility of that?

Roth IRA grows tax free, so it can be as good as a traditional IRA. There is a income limit on who can contribute to Roth, but the converting from a nondeductible IRA to a Roth gets around that limit, hence "backdoor".

Doing both 401k + backdoor Roth allows you to maximize tax advantaged retirement investment and diversification again tax rate changes in the future.

 

[ldiot]

Roth IRA grows tax free, so it can be as good as a traditional IRA. There is a income limit on who can contribute to Roth, but the converting from a nondeductible IRA to a Roth gets around that limit, hence "backdoor".

Doing both 401k + backdoor Roth allows you to maximize tax advantaged retirement investment and diversification again tax rate changes in the future.

Exactly, plus the "tax diversification" doesn't even require you to choose "tax allocation" since they both have limits so just max them both!

 

[UGAZ]

So should I convert my non deductible IRA to ROTH IRA? I fully acknowledge that this site isn't a tax advising one but I just need opinions from people who have more knowledge in finance. Thanks

 

[pezdispenser]

So should I convert my non deductible IRA to ROTH IRA? I fully acknowledge that this site isn't a tax advising one but I just need opinions from people who have more knowledge in finance. Thanks

Yep. That's what I do.

Remember, if you made your traditional IRA as a 2015 contribution, then make sure you declare it on your 2015 tax return (the one you are doing now) on Form 8606 Part I as a nondeductible contribution.

Now, this is also very important and is a common mistake that causes the IRS to send you a letter to fix. When you convert the nondeductible IRA to a Roth IRA, think of this as a totally separate transaction. You declare this on Form 8606 Parts I and II ***in the year that you do it***. So if you convert it now, in 2016, you will wait until you do your 2016 tax return some time in April 2017 to declare the conversion on that tax return.