Attention retirement savers in Illinois, Kentucky, Oklahoma, Delaware, North Carolina, South Carolina, and seven other states: if you are contributing to a Roth IRA, you may be able to save hundreds of dollars in state income tax if you use an alternative strategy I call deduct-and-convert.
Not everyone will qualify but it’s worth checking if you live in those states. The strategy involves making a contribution to a traditional IRA and immediately converting it to a Roth IRA.
I didn’t invent this strategy. The inspiration came from Bob’s not my name on the Bogleheads investment forum. Bob’s not my name credited it to another poster bdpb. Because the procedure is similar to Backdoor Roth, Bob’s not my name calls it Backdoor Both. I think deduct-and-convert describes it better.
What is deduct-and-convert?
Deduct-and-convert is a different way to contribute to a Roth IRA. If you qualify, you will save hundreds of dollars in state income tax when you first contribute to a traditional IRA and then convert it to a Roth IRA immediately.
Who qualifies for deduct-and-convert?
1. You must live in a state that exempts some income from an IRA distribution from state income tax. Some states give it to all taxpayers. Some only give it to people above a certain age.
|Minimum Age||$ Cap (if less than IRA contribution limit)|
|Delaware (DE)||None||$2,000 if under age 60|
|Michigan (MI)||59-1/2 if born before 1952|
|New York (NY)||59-1/2|
|North Carolina (NC)||None||$2,000|
|South Carolina (SC)||None||$3,000|
Six states — Illinois, Kentucky, Oklahoma, Delaware, North Carolina, and South Carolina — give the exemption to all taxpayers, although the latter three have a dollar cap lower than the annual IRA contribution limit. Seven other states — Arkansas, Colorado, Georgia, Iowa, Michigan, Mississippi, and New York — only give the exemption to taxpayers above a certain age.
If you live in other states, sorry, no deduct-and-convert for you.
2. You must qualify for a tax deduction on contributions to a traditional IRA. This qualification depends on your income and on whether you are covered by a workplace retirement plan, and if you are married, whether your spouse is covered by a workplace retirement plan.
For 2011 and 2012, the limits on your Modified Adjusted Gross Income (“Modified AGI”) are as follows:
|Not covered by a workplace retirement plan, not married||Unlimited||Unlimited|
|Not covered by a workplace retirement plan, married filing jointly but spouse is not covered by a workplace retirement plan either||Unlimited||Unlimited|
|Not covered by a workplace retirement plan, married filing jointly but spouse is covered by a workplace retirement plan||$178,000 or less (phase out to $188,000)||$181,000 or less (phase out to $191,000)|
|Covered by a workplace retirement plan, single or head of household||$59,000 or less (phase out to $69,000)||$60,000 or less (phase out to $70,000)|
|Covered by a workplace retirement plan, married filing jointly||$95,000 or less (phase out to $115,000)||$96,000 or less (phase out to $116,000)|
Why should I use deduct-and-convert if I qualify?
If you qualify for deduct-and-convert, you get a tax deduction on your state income tax when you first contribute to a traditional IRA. When you convert the traditional IRA to a Roth IRA, the income from the conversion (subject to the dollar cap, if any) is exempt from state income tax. If you just contribute directly to a Roth IRA, you don’t get a tax deduction on your state income tax. Therefore deduct-and-convert lowers your state income tax compared to a direct contribution to a Roth IRA.
How exactly do I deduct-and-convert?
Step 1 – Contribute to a traditional IRA
Open a traditional IRA at the same place where you have your Roth IRA. If you already have a traditional IRA there, you can use the existing account. Make a contribution to the traditional IRA as usual.
Although you have until April 15 to make the contribution for the previous year, it’s easier if you complete the contribution and the conversion before December 31 in the current year. That way both the deduction and the conversion appear on the same tax return.
Step 2 – Convert the traditional IRA to Roth
If you opened a new traditional IRA, just convert the whole account. If you used an existing account, convert the amount you contributed. Different IRA custodians have different procedures for this. Some let you do it online. Some ask you to fill out a paper form. If you don’t know the procedures, ask them.
There is no minimum waiting period for doing the conversion. If your custodian is administratively capable, you can convert on the next day after your contribution is received.
Step 3 – Claim a deduction on your federal tax return
Traditional IRA contributions are an above-the-line deduction. If you qualify, you can claim it whether you itemize your deductions or you use the standard deduction. On Form 1040 for 2013 tax year, IRA deduction is line 32.
Step 4 – Report the Roth conversion on federal tax form 8606
When you convert a traditional IRA to Roth, you report it on federal tax Form 8606. Because you are taking a deduction for the contribution, your conversion will be taxable. The deduction and the conversion come out to a wash on your federal income tax, but the conversion income will be exempt from your state income tax if you live in those states and you meet the age requirement if your state has one.
It’s too much work!
If you are doing it for the first time, maybe. If you follow the steps, it’s not that hard. The second time will be easier. The third time will be a breeze. It’s up to you whether you want to save hundreds of dollars a year. Think of it as a free iPad if it helps motivate you.
Should I leave it as traditional and not convert?
That’s a different question. This post assumes you want to contribute to a Roth IRA. With deduct-and-convert, you end up at the same place as making a direct contribution to a Roth IRA but you save hundreds of dollars in state income tax along the way.
If you question the wisdom of contributing to a Roth IRA in the first place, please read my previous post The Forgotten Deductible IRA.
Reference: Backdoor Both — have your cake and eat it too, Bogleheads.org