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.