Investopedia’s recent article, “2 Ways to Reduce Taxes and Save More for Retirement,” provides two great ways to start accumulating more tax-free retirement savings: a Spousal IRA and a Backdoor Roth IRA Contribution.
Under the usual situations, a person who wants to contribute to an IRA has to earn income. However, there’s an exception, if you’re a non-working spouse. Your working spouse can establish a “spousal IRA” on your behalf. With a spousal IRA, the working spouse can contribute up to $5,500 on an annual basis to the spousal IRA (or $6,500 if the nonworking spouse is over the age of 50), in addition to their contributions in their own retirement accounts. A married couple must file a joint tax return to qualify.
It’s important to consider whether the spousal IRA should be a traditional IRA or Roth IRA. With a traditional IRA, you’re able to deduct the contributions to the spousal IRA from your income, which will decrease your taxes. You then pay taxes when you withdraw money out of your account during retirement (and when you are presumably in a lower tax bracket). With a Roth IRA, you pay taxes prior to making the contributions, so you don’t get an up-front deduction on your income, but you’re able to make tax-free withdrawals from your account once you reach 59½ and have had your account open for a minimum of five years. You can withdraw your contributions from your Roth IRA whenever you want. It’s only when you withdraw the earnings or interest your account has earned, that you must reach the age and five-year account establishment requirements.
If the working spouse earns more than $199,000, direct contributions into a Roth IRA for his or her spouse are not allowed, so a traditional IRA is the only option (but see the backdoor option below). If the working spouse has access to a 401(k) plan at work, contributions to traditional IRA accounts are still allowable, but the working spouse can’t take a tax deduction, if his or her income is more than $121,000, and the non-working spouse loses the deduction, when household income is more than $199,000. Contributions can still be made to traditional IRA accounts, regardless of a household’s income, and when withdrawals are made, the couple is only liable for taxes on the earnings accrued on the non-deductible contribution.
Backdoor Roth IRA Contribution
The IRS doesn’t allow individuals who earn more than $135,000, or couples who earn more than $199,000, to contribute directly to a Roth IRA. But you can still contribute to a traditional IRA, then convert the money to a Roth IRA. Since you already paid taxes on the traditional IRA contribution, the only tax you owe is on the appreciation the money earns prior to the conversion to the Roth IRA. Therefore, you must make certain that you do the conversion quickly to limit the amount of time your money can grow and the amount of tax you owe on that growth, once the conversion takes place.
But there is a gotcha: if you have other IRAs, a conversion becomes significantly more complicated. This is because the IRS prevents individuals with traditional IRAs, containing both pre- and post-tax money, from converting only the post-tax money. However, you can roll all of your pre-tax money into your current employer’s 401(k) plan and leave the post-tax contribution of $5,500 in your IRA, where it can be converted to your Roth IRA.
Reference: Investopedia (April 9, 2018) “2 Ways to Reduce Taxes and Save More for Retirement”