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What Is A Non-Deductible Traditional IRA?

Many people make too much money to contribute to an Roth. You can get around this problem. High earners can still take advantage of the Roth IRA by contributing to a nondeductible IRA and then converting to a Roth. A nondeductible IRA is simply a traditional IRA for which there is no tax deduction, and it is available to almost everyone with wages or self-employment income.

A non-deductible Traditional IRA is a Traditional IRA that consists of non-deductible contributions. In both Roth IRA and non-deductible Traditional IRA, contributions are non-deductible, meaning that you fund them with after-tax money. The major difference comes from the way earnings are taxed. Earnings are taxed as ordinary income if you withdraw them from a non-deductible Traditional IRA. In contrast, earnings are tax free if you withdraw them from a Roth IRA.

You make non-deductible contributions to a Traditional IRA by setting up and sending money to an IRA custodian of your choice. You do not need to notify the IRA custodian that you are making non-deductible contributions. However, you do need to notify IRS that you have made non-deductible contributions to a Traditional IRA with Form 8606 Nondeductible IRAs when you file your tax return. It is your responsibility to keep track of the basis, the amount of non-deductible contributions, in your Traditional IRA. You can then convert this non-deductible Traditional IRA to a Roth IRA but make sure you get professionals help.

Remember that the IRS treats all of your (but not your spouse’s) non-Roth IRAs as one giant IRA. When you make non-deductible contributions to a Traditional IRA, you’ll have the basis, the amount of non-deductible contributions, reported on Form 8606. When you convert a part or all of your Traditional IRA to a Roth IRA, the conversion amount must contain the non-deductible portion proportionally. For example, if 5% of your non-Roth IRA are non-deductible contributions, then 5% of the conversion amount must be non-deductible contributions, and the rest must come from the deductible contributions, including earnings and rollover contributions. Notice that you cannot just convert the non-deductible part to a Roth IRA.

There are a couple of ways to work around this problem. The proportionate allocation rule does not apply to rollovers from an IRA to a QRP (Qualified Retirement Plan like a 401k) or 403b plan. Instead, a distribution that is rolled from and IRA to a QRP or 403b plan is deemed to come entirely out of the taxable portion of the IRA. This exception is necessary because the nontaxable portion of an IRA cannot be rolled into a QRP or 403b plan. You might therefore consider a rollover from your Traditional and non-traditional IRA back to a 401k or if you qualify as a self-employed business owner who can open a solo 401k, you might rollover your Traditional and non-traditional IRA to a solo 401k.

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Advantages To Seniors Buying Real Estate In A Self Directed Roth IRA

In a self directed IRA you can buy real estate as many people know. The best way for a person about to retire to setup a substantial income stream for life is to buy real estate from your IRA and then rent the property. The rental income can be your retirement income tax free if you are over 59 1/2 and have had the account open 5 years or longer. This article explains why they should use a Roth IRA rather than a traditional IRA to do this.

Normal tax laws have always made real-estate a good tax shelter. Since real estate is generally purchased with a mortgage, tax laws allow you to deduct the annual mortgage interest as well as your real estate property tax. In addition, selling profits are taxed at long term capital gains rates. Owners who live in their property are can exclude up to $250,000 of gain if you’re single and $500,000 if you are married. Those that rent out their property for rental income can additionally depreciate their property yearly for a further annual tax deduction. This, along with the mortgage, property tax and maintenance expenses deductions, can actually shelter the rental income from tax and perhaps other income they receive too.

In some instances, these tax benefits are often too advantageous versus buying and holding rental income property within an IRA. IRA tax rules wipe out the typical real estate tax advantages mentioned above and all real estate deductions are eliminated. And, you can’t live in any property you own within your IRA. However, for individuals about to retire, you can create a substantial income from putting property in a Self Directed IRA. Traditional IRAs only defer taxes on annual real estate rental income. And that, along with all other property gains, will be tax at your income rates when you withdraw them. However, I think that Roth IRA tax rules offer a better alternative and are more competitive with the usual real estate tax advantages. That’s because all yearly earnings and withdrawals are tax free and there’s no minimum required distributions after turning 70 1/2 either as with a traditional IRA.

Let’s consider the advantages for seniors who buy rental investment real estate within their Self Directed Roth IRA when they invest in high rental income real-estate that will significantly appreciate over time. First, they can pull their real-estate investment rental income out tax free for their annual use. A key advantage is that Roth withdrawals won’t produce higher taxation of their Social Security income or loss of some of its benefits. Second, seniors often don’t have a high income themselves. So, they don’t reap much for sheltering income that depreciation, tax and interest deductions would present if bought outside the Self Directed IRA. In fact, seniors receive social security income which is only partially taxed or not at all. Third, when their Roth IRA real estate investment values increase over the years they can do one of several options in a tax free environment. One option is to sell that real estate within their IRA and take out all the cash in any amount tax free. Another option is to distribute that real estate out of the IRA for their own use and if meet the criteria this is tax free as well. If they sell it sometime in the future, its basis for determining capital gains tax would be their total contributions to the Self Directed Roth IRA for real estate purposes. Finally, they could leave the real estate in the Roth IRA so their beneficiary can reap further appreciation of it. The beneficiary must follow required minimum distributions for inherited IRAs but whatever they do take out will be tax free.

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Differences Between Roth IRA and Roth 401k

The first difference that comes to mind when comparing Roth IRA to a Roth 401k is the contribution amounts. For the Roth IRA you can contribute up to $5,000 to your plan and for workers over 50 may contribute an additional $1,000 per year (i.e. $6,000/yr total). The Roth 401k plan has higher contribution limits, allowing employees to save up to $16,500 per year. For workers over 50, the limit is $22,000. Therefore, the contribution limits for a 401(k) are roughly three times higher than that of an IRA. For the Roth 401k plans, the contribution limits are the same as the traditional 401k limits, so this is a definite benefit.

The next big benefit is the income limits. The higher earners can convert to a Roth IRA from a traditional IRA, but they won’t be able to make contributions if they make over a certain income (see my prior blog post for details). Not so for a Roth 401k, in which there are no such restrictions. For example, Roth IRA contributions are off-limits if your modified adjusted gross income in 2011 is higher than $179,000 for married couples filing jointly or $122,000 for single filers. So for some people the Roth 401k is the only way to go or forfeit any government sponsored savings plan.

A nice benefit and advantage to a Roth IRA is that you don’t have to take distributions and essentially the account can exits forever without taking out any of the money. No RMD (required minimum distributions). The Roth IRA can be passed down to the next generation and provide tax-free earnings for that generation and the next. A Roth 401k, on the other hand, will require minimum distributions (RMD) starting at age 70½. If you need the money, you may not mind taking the distributions. But there is a way around it if you prefer to keep your savings working for you tax-free. You could roll the account over from a 401k directly to a Roth IRA but you would pay tax on any portion that was not Roth dollars.

On the flip side, an advantage of the Roth 401k is that the worker’s contributions can be matched by the employer up to a certain percentage. It’s essentially free money from the employer, on top of the employee’s elective deferrals. Just remember that the match portion of the contribution will be treated as a traditional 401k contribution since it goes in as pretax dollars. This is because the employer contribution can’t be taxed and in turn can’t be a Roth contribution. In other words, every Roth 401k has a Roth portion and a Traditional portion depending on where the dollars are coming from and what you elect.

If not in a self directed IRA or solo 401k plan that specifically allows alternative investments, your investment options would be more limited in a employer 401k since you are limited to the investment choices of that employer. On the other hand, a Roth IRA allows investors a great deal more control over their investment choices since they can choose from the wide range of investments for their own accounts. The best way to avoid the limited choices is to open a Self Directed Roth IRA or a Solo 401k Plan which essentially allows you to invest in anything allowed by the IRS. We will talk more about the Solo 401k in future blog posts.

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Traditional IRA Versus Roth IRA For 2011

ROTH IRA

What is it? Government sponsored savings plan that gives tax advantages for individuals to save money for retirement by contributing post-tax dollars.
Contribution Limits? Up to $5,000 of earned income plus $1000 if age 50+. Contribution limits are reduced by amount put in Traditional IRA.
Who is eligible? You must have earned income and MAGI less than $122,000 for single and $179,000 for married couple in order to contribute to plan.
Advantages? Account grows tax free and the funds can be withdrawn tax free at age 59 ½ if the account has been open for at least 5 years.
Tax Deductible? No
Age Limit For Contributions? No limits
Distribution Requirements? None
Withdrawal Penalties? 10% penalty for withdrawals before 59 ½ , however contributions can be taken out any time.

TRADITIONAL IRA

What is it? Government sponsored savings plan that gives tax advantages for individuals to save money for retirement by contributing pre-tax dollars.
Contribution Limits? Up to $5,000 of earned income plus $1000 if age 50+. Contribution limits are reduced by amount put in Roth IRA.
Who is eligible? You must be under 70 ½ and have earned income in order to contribute to plan.
Advantages? Account grows tax deferred until the funds are withdrawn (and then they are taxed at your ordinary income rate).
Tax Deductible? Yes
Age Limit For Contributions? 70 ½
Distribution Requirements? Must make minimum withdrawals at age 70 ½.
Withdrawal Penalties? 10% penalty for withdrawals before 59 ½

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