Here we are folks! It’s tax season and tax preparers, financial professionals and individual tax warriors across the country are furiously gathering and entering data into their computers and answering questions in TurboTax to get everything wrapped up by the tax deadline.
Thanks to the usual tax day falling on a weekend and Emancipation Day in Washington DC, this year’s deadline is Tuesday April 18th 2017. If you enter your data correctly, TurboTax is generally pretty good about making the correct tax calculations and explaining the various options and implications of your tax situation.
One area where TurboTax can come back with answers that taxpayers aren’t expecting is in regard to IRAs, and it is often to tell you that your IRA deduction isn’t allowed or isn’t deductible. That's typically bad news! There are many rules to keep track of for IRAs but two of the most basic rules can trip you up at tax time.
First, to take a deduction, you must have earned income (at least the amount of the deduction). That means that if your income comes from savings, dividends and investments, your income doesn’t qualify. This can happen to individuals who may have retired on the early side and no longer have wage income, but aren’t 70 1/2 yet and would still like to make contributions to take advantage of the favorable tax treatment.
If you find yourself in this “ineligible to contribute” situation, your tax software should trigger a warning and you’ll have to take action. You’ll have to take the money that you contributed out of the IRA by the tax deadline and you’ll owe a small penalty on the earnings. And if you don’t get it out by the deadline the penalty rises pretty quickly, so best to just try and avoid the situation altogether. So if you don’t have earned income, or a very unique situation where there is an exception, you’ll have to forgo the contribution.
A second surprise that some taxpayers encounter is that there is an income limit to be eligible to make a contribution to a ROTH IRA and an income limit to be eligible to take a tax deduction for a Traditional IRA. The charts here show the income thresholds and phase outs for the different account types and filing status for 2017.
With income limits, it can be difficult to predict if your income will be over or under the cap until the year is over. Which is why it’s a nice benefit to be able make a contribution for the prior year (e.g. 2016) up and until the tax deadline of the current year (e.g. 2017). That way you can evaluate the options, see where your income ends up, and make the choice that best suits your situation and goals.
That still leaves you with the age-old question, which is better, a ROTH IRA or a Traditional IRA and should you consider a strategy such as making a non-deductible traditional IRA contribution?
The general rule of thumb is that if you have a longer time horizon for the investment and you expect to be in a lower tax bracket when you retire, ROTH is better. But time horizons and tax brackets over long periods of time can be very hard to predict, so going with a hybrid strategy – some invested in each type of account – is also a viable strategy.
If you have investment or tax investment related questions or would like to discuss your specific situation and get some help determining what is the best option for you, we’d be happy to help. Give us a call or use the big blue button at the top of the page to schedule an appointment.