Rollover IRA Contribution

Submitted by Alice Severson on Tue, 2021-01-26 01:31

Hello and happy new year!

I’m helping my friend with her retirement investments and taxes and wanted to run a few question by the experts.

Here is her situation:
* My friend retired from her employer on December 31, 2019 at age 63.
* Her first pension payment was on January 1, 2020.
* Separately from her pension, she received a paycheck January 10, 2020 for the 2-week period of December 23, 2019 through January 5, 2020 which consisted of only vacation and holiday pay as well as sick leave payout. This paycheck included approximately $900 of 401K contributions.
* She received another paycheck on January 24, 2020 with a $150,000 bonus for volunteering to retire, and this paycheck did not include any 401K contributions.
* In mid-2020, she rolled over her 401K into an IRA.
* Her most recent rollover IRA statement reminded her to make a $7,000 deposit for year 2020.
* Her income tax filing status is Single.

Questions:

1. Is she entitled to make a $7,000 deposit into her rollover IRA for 2020 given that her last day of employment was December 31, 2019, but she still received paychecks in January 2020? I think the answer is yes, since she received 2 paychecks in 2020, so that qualifies as earned income for 2020.

2. If the answer to question #1 is yes, can she deposit the full $7,000 into her rollover IRA, given that she already deposited approximately $900 into the 401K that was rolled over into this IRA? I think the answer is yes, since IRA contributions are separate from 401K contributions.

3. If the answer to question #2 is yes, can she deduct the full $7,000 from her 2020 taxes? She earned the income while she was covered by the employer retirement plan and her MAGI is over $75,000, so I think she cannot deduct the IRA contribution. But she’s no longer covered by an employer retirement plan when she’ll be making the contribution to her rollover IRA, so perhaps she can deduct the IRA contribution?

4. And finally, I understand that pension is not considered earned income, so in future years, she cannot make contributions to her rollover IRA based on her pension earnings. Is my understanding correct?

Thank you in advance for your guidance.

Alice



Submitted by Alan - IRA critic on Tue, 2021-01-26 14:14

She should receive a 2020 W-2 showing earned income in 2020 from which she can make a regular IRA contribution for 2020. However, if she makes the regular IRA contribution into her rollover IRA, that account ceases to be a rollover IRA and that could impair her IRA creditor protection if she lives in a state that provides limited IRA creditor protection. In that case, she should open a separate IRA for the 7000 contribution so the rollover IRA can remain uncommingled.
Agree.
Agree, and her W-2 will likely show Box 13 (Retirement Plan participant) checked. If someone is a participant for even 1 day they are treated as a participant the entire year. Further, the 150k check (severance pay) will cause her to exceed the Roth IRA MAGI limit as well. So her only choice is a non deductible TIRA contribution, reported on Form 8606. If she has no prior non deductible contributions and will not return to work earning similar amounts, she may not want to have to deal with Form 8606 for every year she takes an IRA distribution for the rest of her life. In that case, she might must invest the 7000 in a taxable account.
Yes, you are correct.

Submitted by Alice Severson on Tue, 2021-01-26 20:52

Thank you, Alan. This is super helpful. I appreciate you taking the time to provide detailed explanations.I completely forgot to take into consideration the IRA creditor protection feature, so I’m glad you reminded me. Definitely not worth risking that.I agree that dealing with Form 8606 for every year she takes an IRA distribution is too much hassle for a $7,000 investment, since she does not plan on returning to work. Final questions, for my own education:Regarding (a) opening a Traditional IRA and investing $7,000 in a mutual fund versus (b) investing $7,000 in an ETF in a taxable account, is the main difference that she’ll be paying capital gains tax on the ETF dividends in the taxable account every year? In both the Traditional IRA and taxable account, she will NOT be paying tax on the gain in value of the shares until she sells them, right?Thank you for your guidance on this.Alice

Submitted by Alan - IRA critic on Tue, 2021-01-26 21:10

Selling investments in an IRA is not a taxable event. Only a distribution (or contribution) from or into the IRA has a current tax impact. Changes of investments are not even reported.  However, with a taxable brokerage or mutual fund account, dividends and cap gains declared each year are reportable and can generate a current tax bill, when these events would not in an IRA account.  But if the taxpayer’s taxable income is near the top of the 12 bracket or lower, qualified dividends and Long term cap gains are taxed at 0.  IRA RMDs start at age 72 when some people need to distribute more than they actually need, and these distributions are taxable and can cause more SS income to be taxable as well.

Submitted by Alice Severson on Wed, 2021-01-27 04:56

OH RIGHT! I completely forgot that selling investments in an IRA is not a taxable event, since I’ve been a buy & hold investor for many years now (though this reminds me that I really need to re-evaluate a couple of stock investments). Good point as well about IRA RMDs – that’s exactly what my mom is experiencing in terms of needing to take distributions even though she (fortunately) does not need the money now.I appreciate you taking the time to point out these considerations, Alan. Thank you for helping me yet again.Alice

Submitted by Alice Severson on Wed, 2021-01-27 06:24

Follow-up question, please. I remember hearing about backdoor Roth a while back, so I’ve been reading up on it. Is the reason you did not suggest a backdoor Roth IRA because of the pro-rata rule, which would result in nearly the entire $7,000 non-deductible TIRA contribution being taxed upon conversion to a Roth IRA, since her rollover IRA is over $600K? Thanks in advance for any light you can shed on this. Alice

Submitted by Alan - IRA critic on Wed, 2021-01-27 19:04

You are correct about the pro rata rule effect on conversions. However, in addition if she is retired for good there will be no annual earned income from which to make any kind of IRA contribution including a non deductible TIRA contribution. If she gets another job including a part time job, perhaps her modified AGI will be low enough to make a regular Roth IRA contribution. The back door will never be tax efficient as long as she still has the large rollover TIRA.

Submitted by Alice Severson on Thu, 2021-01-28 00:31

Thank you, Alan. This is very helpful. A decade ago, when I opened my most recent 401K with Fidelity, the representative suggested a backdoor Roth in addition to the 401K, and for a reason I cannot remember now, I decided against it. In hindsight, I think that was a mistake on my part, since I had no TIRA at the time and would have benefited from tax-free Roth distributions later on. Live and learn!

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