Self-Employed? Remember the Roth IRA Option

SAVING MORE FOR retirement is something we should all be doing. If you can save in a tax-smart fashion, so much the better. Making annual Roth IRA contributions is definitely tax-smart, because you can take tax-free withdrawals after age 59½. Of course, Roth contributions are nondeductible. That’s OK because you’ll collect your rightful tax savings on the back end.

However, many successful self-employed individuals have dismissed the idea of making annual Roth contributions for two reasons.

Reason No. 1: You figure your income is too high to qualify.

Reason No. 2: You’ve been fixated on making maximum deductible contributions to your traditional tax deferred self-employed retirement arrangement (such as a SEP plan), and you forgot all about the possibility of making Roth contributions too.

In many cases, both of these reasons turn out to be wrong-headed. Here’s the true story.

My Income Is Too High for Roth Contributions (You May Be Wrong)

It’s a fact that the privilege of making annual Roth contributions is phased out, or completely eliminated, if your modified adjusted gross income, or MAGI, exceeds certain levels. MAGI is the adjusted gross income amount shown on the bottom of page 1 of your Form 1040 with certain add-backs that may or may not apply to you. The MAGI phase-out ranges for 2010 Roth contributions are as follows:

* Unmarried individuals: $105,000-$120,000

* Married joint-filing couples: $167,000-$177,000

At first glance, these phase-out ranges make it look like anyone with robust self-employment income will be ineligible for Roth contributions. Not so fast!

Your MAGI is likely to be considerably lower than the MAGI of another person in roughly equivalent circumstances who is not self-employed. That’s because your MAGI will usually be reduced by things like: (1) home office and computer-related costs (maybe $5,000 or more in write-offs for expenses you would have incurred with or without your business); (2) contributions to a tax-deferred retirement plan (maybe $35,000 or more); (3) health insurance premiums (maybe $5,000 or more); and (4) the write-off for 50% of your self-employment tax bill (maybe $9,000 or more). The point is: A self-employed person like you can have relatively high net business income while still having MAGI that is low enough to allow annual Roth contributions.

For example, say your business will have a healthy net income of $215,000 this year before considering the write-offs listed above. Your MAGI is $161,000 ($215,000 - $5,000 - $35,000 - $5,000 - $9,000 = $161,000), and you are eligible to make a full Roth IRA contribution this year ($5,000 if you will be under age 50 at year-end; $6,000 if you'll be 50 or older). Great! (This assumes you’re a married joint-filer with little or no income from other sources.)

Nondeductible Roth Contributions Are Less Attractive Than Deductible Contributions (You May Be Wrong)

Clearly, it’s a good thing that you can deduct contributions to a tax-deferred retirement plan set up for your self-employed business (such as a SEP plan). However, that doesn’t necessarily mean such contributions are preferable to contributing the same amounts to a Roth IRA instead. The quickest way to evaluate the issue goes like this. As long as your retirement savings game plan includes the following two assumptions, you’re generally well-advised to make a deductible contribution to a tax-deferred retirement plan instead of a Roth contribution.

Assumption No. 1: You will always take the tax savings from making a deductible retirement plan contribution and either invest the money in a taxable retirement savings account or use the money to make a bigger deductible contribution to your plan.

Assumption No. 2: You expect to be in a lower tax bracket during your retirement years than you are now.

In real life, many people are not disciplined enough to follow through with the first assumption; the second assumption looks highly suspect when you consider the ever-expanding federal deficit and politics. While it’s not yet absolutely certain that tax rates will be higher in 2011 and beyond, it’s a darn good bet. If it turns out that you pay higher rates during retirement, you’ll wish you had made Roth contributions when you had the chance.

The Bottom Line

If you’re eligible to make annual Roth contributions (and I bet you are), you should probably take the plunge if you have the cash to do so. If you insist on maxing out on deductible contributions to your traditional tax-deferred retirement plan first, you’ll get no argument from me. Then make your Roth contributions as well, and rest secure in the knowledge that you’ve played the game as heard as you could. Remember: You have until April 15, 2011, to make a Roth contribution for this year, and you can make another one for 2011 as soon as next January.