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IRA Mysteries Revealed!

Christine Benz

For a savings vehicle that only allows you to make a contribution of a little more than $5,000 a year, IRAs are certainly governed by a lot of byzantine rules. There are Roth and traditional IRAs, deductible and nondeductible, each governed by its own peculiar rules regarding contributions, income limits, and withdrawals.

And don't even get me started on rollovers, conversions, and recharacterizations. If you were to do a Web search of "IRS Publication," it's no wonder that "IRS Publication 590"--the one that lays out the rules on IRAs--jumps to the top of the list of suggested search terms.

But if you play your cards right--or roll over a good chunk of change from an employer plan--an IRA can be key component part of your retirement portfolio. Given that fact, plus the many complexities involved with the IRA wrapper, it's probably no wonder that so many people have questions about their IRAs.

I tackled one of those questions--the difference between a Roth and traditional nondeductible IRA--in a column last week (http://news.morningstar.com/articlenet/article.aspx?id=617936), but there are plenty more where that came from, based on the comments that have flowed in from readers during the past seven days. This week, I'll tackle four more.

Can you contribute to both a Roth IRA and a nondeductible IRA in the same year?
Yes, you can, but the total contribution to Roth and traditional IRAs must not exceed the limits--in 2013, that's $5,500 for people under age 50 and $6,500 for people over 50.

Splitting contributions between Roth and traditional IRAs will tend to make the most sense for people who are eligible to make both a traditional deductible IRA contribution and a Roth contribution and aren't sure whether their tax rates will be higher or lower in retirement than they are today. Dividing contributions between both account types allows the saver to hedge: If their tax bracket ends up being lower in the future, they'll be glad they took the tax break upfront by making a deductible contribution when that deduction was most beneficial. If their tax bracket goes up, they'll be happy they made a Roth contribution and can take tax-free withdrawals in retirement, thereby skirting taxes at a higher level. (As a side note, the same logic applies to the idea of splitting Roth and traditional contributions to a 401(k). If you have no idea what your tax bracket will be in retirement, why not make both types of contributions?)

By contrast, for individuals whose only choice is to make a contribution to a traditional nondeductible IRA and a Roth (either directly or through the back door) will benefit less from splitting their contributions. They're not receiving a tax break on their nondeductible contribution; instead, they're only getting tax-deferred compounding, which the Roth offers, too. (So does a good tax-efficient mutual fund, for that matter.) But the Roth also offers tax-free withdrawals and doesn't necessitate required minimum distributions, making a Roth contribution much preferable to investing in a nondeductible IRA and leaving it there.

I often see the income limits on IRA contributions expressed as a range--for example, $178,000-$188,000 for married couples for Roth IRAs. What does it mean if my income falls between those two amounts?
What you're referring to is what tax geeks call the "phase-out range." If you're part of a married couple filing jointly and your modified adjusted gross income falls below $178,000, you can make a full contribution to a Roth; if it's above $188,000, you can't make a direct contribution at all, but you can get in through the back door. If it's between $178,000 and $188,000, you're in the phase-out range and can make a partial contribution. Traditional IRAs have phase-out ranges, too--$59,000 and $69,000 for single filers and $95,000 and $115,000 for married couples filing jointly.

The amount of your allowable contribution is determined by looking at how much you're over the low end of the phase-out range, then dividing that number by the total phase-out range. For example, say a 45-year-old married person has a modified adjusted gross income of $180,000. Her income is $2,000 over the low end of the phase-out range for married couples ($178,000), and the total range is $10,000 (the difference between $178,000 and $188,000). Her allowable Roth contribution amount will therefore be docked by 20% (her $2,000 overage divided by the total phase-out range of $10,000.) Thus, she can make a $4,400 contribution ($5,500 reduced by 20%) to a Roth in 2013.

A complicated mess? You bet. Thus, if it looks like you're at risk for falling into the phase-out range, it may well make sense to make a nondeductible IRA contribution and then convert to a Roth shortly thereafter because contribution limits don't apply to either maneuver. That way you're avoiding the phase-out range altogether, as well as the possibility of partial contributions. This maneuver won't be attractive if you have other traditional IRA assets, however, for reasons outlined in this article (http://news.morningstar.com/articlenet/article.aspx?id=364861).

You noted in a previous article (http://news.morningstar.com/articlenet/article.aspx?id=547153) that if you have pretax assets in an IRA, you can avoid taxes on your backdoor Roth IRA by rolling those pretax IRA assets into your new employer's 401(k). But if the employer allows IRA rollovers, does it matter if the rolled IRA is a mix of deductible contributions and rollovers from a prior employer's 401(k)?
Opening a new nondeductible IRA and then converting to a Roth IRA shortly thereafter (the backdoor IRA maneuver) won't typically result in a tax bill--unless, that is, you have other traditional IRA assets that have never been taxed. If you have other traditional IRA assets, the portion of the conversion that is taxable will be based on your ratio of IRA assets that have been taxed (nondeductible contributions) to those IRA assets that have never been taxed (monies rolled over from traditional 401(k)s, deductible contributions, and investment earnings). For this reason, the backdoor IRA conversion may not be a good strategy for people with other traditional IRA assets, such as rollovers from previous employers' 401(k)s.

However, as you note, a possible workaround is to roll pretax traditional IRA assets into a current employer's 401(k). In so doing, you can effectively get those monies out of your IRA kitty, thereby starting with a clean slate with your new nondeductible IRA contribution.

In the past, the Internal Revenue Service made a distinction between assets that got into an IRA because they were rolled over from a previous employer's 401(k) plan and those that got into the IRA because the account owner contributed funds directly to the IRA from the get-go. (The former was called a conduit IRA and the latter a contributory IRA, and if these two account types got mashed together, the account was said to be 'commingled.') The IRS has since relaxed that distinction, however. Now, if you choose to do a reverse rollover--that is, move money from your IRA to your employer's 401(k) because you intend to do a backdoor IRA--you only need to make sure of three things: 1) that your employer's plan allows such a transfer; 2) that you're contributing only pretax IRA monies to the 401(k) (you cannot move aftertax IRA assets (that is, nondeductible IRA contributions) into a 401(k)); and 3) that your 401(k) plan is a worthy receptacle for new assets.

I have an account, Account A, with traditional IRA money. Could I open a new account, Account B, and make use of the backdoor conversion option for that account only and leave the Account A money in the traditional account? Or is the IRS mixing both accounts and mandating the tax regardless of which account was converted?
As appealing as your strategy sounds as a means of doing a tax-free backdoor IRA when you already have other traditional IRA assets, the IRS "pro rata" rule pertains to all of your IRA assets. Therefore, the tax treatment of your new IRA--Account B--would be based on the ratio of money that has never been taxed in all of your IRAs relative to any aftertax monies in all of your IRAs. Assuming you put $5,500 of aftertax dollars into Account B but had $100,000 in pretax dollars in Account A, your conversion of Account B would be more than 95% taxable, because more than 95% of your total IRA assets have never been taxed.