Managing Money

Don’t Pass Up Any Tax-Advantaged Opportunities

The IRS provides very few opportunities for individuals to accumulate money in a tax-advantaged account, so it’s important not to pass up on these chances when they’re available. Many federal employees don’t realize that they may make an annual IRA contribution in addition to their TSP contribution. This is true even when contributing the maximum allowable to the TSP.

To be clear, you must have eligible compensation income to contribute to an IRA, which includes wages from employment, commissions, self-employment income and nontaxable combat pay, among other sources. For married couples, both spouses may contribute to an IRA even if only one spouse has eligible compensation.

There are limitations on how much someone may contribute to an IRA. For 2021, the annual IRA contribution limit is $6,000 for those younger than 50 and $7,000 for those 50 and older. Taxpayers may contribute 100 percent of eligible compensation up to the contribution limits.

Like the TSP, IRAs come in traditional and Roth versions, which provide similar tax benefits as their TSP counterparts. Both the Roth TSP and a Roth IRA are funded with after-tax contributions, which simply means income tax is owed on the compensation income used for the contributions. The magic of both the Roth TSP and a Roth IRA is in the tax treatment of the earnings. The earnings in a Roth account grow tax-deferred while they remain in the Roth account and will be tax-free with a qualified withdrawal.

Like the traditional TSP, traditional IRAs may be funded with pre-tax dollars, which

LIKE THE TSP, IRAS COME IN TRADITIONAL AND ROTH VERSIONS, WHICH PROVIDE SIMILAR TAX BENEFITS AS THEIR TSP COUNTERPARTS.

means the income used for the contributions has not been taxed at the federal level. This is true for most states as well, but state rules vary and some do tax traditional retirement plan contributions. The earnings in both the traditional TSP and traditional IRA grow taxdeferred, and, along with the pretax contributions, are taxed upon distribution.

Unlike the traditional TSP, a traditional IRA may be funded with after-tax (nondeductible) contributions. And unlike the after-tax contributions made to a Roth account, the earnings on nondeductible traditional IRA contributions accumulate on a tax-deferred basis and are taxable upon distribution.

But rather than leave the nondeductible contributions in a traditional IRA, the real opportunity comes when using a nondeductible traditional IRA contribution to fund a Roth IRA through the so-called backdoor Roth strategy discussed later in this column.

The backdoor Roth strategy comes into play when a taxpayer’s income is too high to contribute directly to a Roth IRA. The income phase-out limits for a Roth IRA are $124,000 to $139,000 for single tax filers and $198,000 to $208,000 for joint tax filers.

There are no income limits prohibiting someone from making a traditional IRA contribution. There are, however, income limits to determine whether the contribution will be deductible or nondeductible when a taxpayer is covered by an employer retirement plan.

The phase-out limit for a covered taxpayer filing as single is $65,000 to $75,000. For married couples filing jointly, the phaseout limit for a covered spouse is $105,000 to $125,000, and for a spouse who is not covered by an employer retirement plan,

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the phase-out limit is $198,000 to $208,000. If neither spouse is covered by an employer retirement plan, or if single and not covered, a traditional IRA contribution may be deductible regardless of income.

As previously mentioned, the back-door Roth strategy may be used when a taxpayer’s income is too high to contribute to a Roth IRA directly. This strategy involves two steps: the first is to make a nondeductible traditional IRA contribution, and the second is to convert the nondeductible contribution to a Roth IRA. The Roth conversion will be nontaxable if the conversion consists of only the nondeductible contribution.

Please note, however, that taxpayers who have existing pre-tax contributions and/or earnings in a traditional IRA (including SEP and SIMPLE IRAs) will not be able to convert the nondeductible contributions tax-free due to the IRS’s pro rata rule.

Not to worry though, as it’s possible to isolate the nondeductible contributions for a tax-free conversion using the strategy I outlined in the November 2020 issue of NARFE Magazine.

MARK A. KEEN, CFP®, IS PARTNER, KEEN & POCOCK, AND AN INVESTMENT ADVISER REPRESENTATIVE AND REGISTERED PRINCIPAL OF THE STRATEGIC FINANCIAL ALLIANCE INC. (SFA). SECURITIES AND ADVISORY SERVICES ARE OFFERED THROUGH SFA.

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