Attention: Retirement savers in Illinois, Kentucky, Oklahoma, and nine other states — if you are contributing to a Roth IRA, you may save hundreds of dollars in state income tax if you use an alternative strategy that I call deduct-and-convert.
Not everyone qualifies but it’s worth checking if you live in those states. The strategy involves making a contribution to a traditional IRA and immediately converting from the traditional IRA to a Roth IRA.
I didn’t invent this strategy. The inspiration came from the poster 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 (not recharacterize) from the traditional IRA to a Roth IRA immediately.
Who Qualifies for Deduct-and-Convert?
You must live in the right state and have the right income to qualify for Deduct-and-Convert. You also must want to contribute to a Roth IRA to begin with.
Live In the Right State
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|
|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. Six other states — Arkansas, Colorado, Georgia, Iowa, 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.
State laws change. Make sure to double-check with tax form instructions and publications from your state’s tax authority to confirm that the state still exempts some income from an IRA distribution from state income tax.
Have the Right Income
You must have enough taxable compensation (“earned income”) to contribute to an IRA. This minimum income requirement is the same for both Traditional IRA and Roth IRA. Investment income, retirement income, and Social Security benefits don’t count. The income must be taxable compensation for your work (a job or self-employment).
You also must qualify for a tax deduction on contributions to a traditional IRA. This maximum income qualification depends on your total 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. The IRS lists the maximum income in IRA Deduction Limits. I also have them in Deductible IRA Income Limit.
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 when you live in one of those right states.
If you simply 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 from the Traditional IRA to Roth IRA
If you opened a new traditional IRA, just convert the entire balance in the Traditional IRA. 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.
Make sure you use the right terminology when you deal with the IRA custodian. You want to convert from the Traditional IRA to a Roth IRA, not recharacterize your contribution from Traditional to Roth. There’s a difference and the difference is important.
There is no minimum waiting period for the conversion. If your custodian is administratively capable, you can convert on the next day after your contribution is received. If your contribution must clear first, the wait is usually less than a week.
Step 3 – Claim a Deduction on Your Federal Tax Return
Tax software will automatically claim the deduction for you when you tell it that you contributed to a Traditional IRA and the software sees that your income qualifies for a deduction. The deduction on the federal tax return also reduces your state income tax when you live in one of the right states.
Step 4 – Report the Roth Conversion on Your Federal Tax Return
You will receive a Form 1099-R from the IRA custodian next year when you convert from a Traditional IRA to Roth. When you enter the 1099-R into tax software, the software will generate Form 8606 and make it taxable because you are taking a deduction for the contribution. The deduction and the taxable 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 whole different question. Deduct-and-Convert assumes that you want to contribute to a Roth IRA. 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.
Leaving it in the Traditional IRA and keeping the federal income tax deduction may very well be a better strategy depending on your income trajectory. 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
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