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How to Earn Tax Free Income - Part II

7/11/2013

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We talked about one of the best know tax-free gain in this post, now we will discuss another well known method to get tax free gain - Roth IRA.

Roth accounts have two big tax advantages.

1st Big Advantage: Tax-Free Withdrawals

Unlike traditional IRA withdrawals, qualified Roth IRA withdrawals are federal-income-tax-free (and usually state-income-tax-free too). What is a qualified withdrawal? In general it is one that is taken after the Roth account owner has met both of the following requirements:

  1. You had at least one Roth IRA open for over five years.
  2. You reached age 59 1/2, are disabled, or dead.

2nd Big Advantage: Exemption from Required Minimum Distribution Rules

Unlike with a traditional IRA, the original owner of a Roth account (the person for whom the account is originally set up) isn't burdened with the obligation to start taking required minimum distributions (RMDs) after age 70 1/2 or face a stiff 50% penalty. Therefore, you can leave a Roth account untouched for as long you live. This important privilege makes the Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth IRA money to help cover your own retirement-age living expenses).

Making Annual Roth Contributions

The idea of making annual Roth IRA contributions makes the most sense for those who believe they will pay the same or higher tax rates during retirement. Higher future taxes can be avoided on Roth account earnings because qualified Roth withdrawals are federal-income-tax-free (and usually state-income-tax-free too).


The downside is you get no deductions for Roth contributions.

So if you expect to pay lower tax rates during retirement, you might be better off making deductible traditional IRA contributions (assuming your income is low enough to permit deductible contributions), because the current deductions may be worth more to you than tax-free withdrawals later on.

The absolute maximum amount you can contribute for any tax year to a Roth IRA is the lesser of (1) your earned income for that year or (2) the annual contribution limit for that year.

Basically, earned income means wage and salary income (including bonuses), alimony received (believe it or not), and self-employment income. For 2013, the Roth contribution limit is $5,500 or $6,500 if you’ll be age 50 or older as of year-end. This assumes you’re unaffected by the AGI-based phaseout rule explained immediately below.
  • For 2013, eligibility to make annual Roth contributions is phased out between modified adjusted gross income (MAGI) of $112,000 and $127,000 for unmarried individuals.
  • For married joint filers, the 2013 phaseout range is between joint MAGI of $178,000 and $188,000.

Key Point: If your MAGI is too high for annual Roth contributions, consider converting a traditional IRA into a Roth account, as explained below.

Making Roth Conversions

A few years ago, an income restriction made individuals with MAGI above $100,000 ineligible for Roth conversions. The restriction ceased to exist in 2010. Now, even billionaires are eligible for Roth conversions. That is an important break, because conversion contributions are the only way to quickly get large amounts of money into a Roth IRA. However, it is important to keep in mind that a conversion will trigger taxable income. So you need to consider the federal income tax hit that will accompany a conversion. There may be a state income tax hit too. Consult your tax adviser before pulling the trigger on a conversion.


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