Tax Smart Wealth Building

1. You figure your income is too high to qualify for Roth contributions.

2. You figure a Roth IRA is not that attractive because you believe you’re in a higher tax bracket now than you’ll be in during retirement. Instead, you make maximum deductible contributions to a traditional tax deferred retirement arrangement such as a simplified employee pension (SEP) plan, solo 401(k), or a defined contribution or defined benefit Keogh plan.

In this article, we'll examine why both assumptions may be wrong and why a Roth IRA is a smart way to build a substantial federal-income-tax-free retirement fund — even if you have another retirement plan.

Think Your Income Is Too High? You May Be Wrong

It’s true that the ability to make Roth IRA contributions is phased out, or completely eliminated, if your modified adjusted gross income (MAGI) exceeds certain levels. The phase-out ranges for 2006 and 2007 tax year contributions are shown below. MAGI is the adjusted gross income (AGI) amount reported on the bottom of page 1 of your Form 1040 with certain add-backs that may or may not apply in your situation.

Contributions		For 2007
Unmarried individual MAGI phase-out range	$95,000 to 110,000	$99,000 to 114,000
Married joint filer MAGI phase-out range	$150,000 to 160,000	$156,000 to 166,000

At first glance, these figures do make it look like a self-employed person with a robust income is unlikely to be eligible for contributions. But take another look.

A self-employed individual’s modified adjusted gross income is likely to be considerably lower than the MAGI of another person who is in roughly equivalent circumstances and who is an employee. Reason: Successful self-employed taxpayers usually have hefty deductions for:

• Certain expenses incurred in the business (such as deductions for rent, an office in the home, or a computer system).
• Contributions to a tax-deferred retirement plan (typically, a SEP, a defined contribution Keogh plan, or a solo 401(k) plan).
• Health insurance premiums.
• The write-off for 50 percent of self-employment tax.

These deductions, along with others, are available to self-employed people and are subtracted in arriving at MAGI. Therefore, a self-employed person can have relatively high gross income from his or her business while having a much lower MAGI.

Bottom Line: Many self-employed individuals qualify for Roth IRA contributions without even realizing it. The following example illustrates the point.

Example: A 52-year-old married sole proprietor files jointly with a 51-year-old non-working spouse. Their 2006 AGI is based on the following: Schedule C gross income from the business $210,000 Schedule C expenses (including office in home)    (18,000) Deduction for 50 percent of self-employment tax      (8,411)* Deduction for maximum allowable SEP contribution    (36,718)** Deduction for family health insurance premiums       (6,000) Income from interest, dividends, and capital gains        9,000 Modified adjusted gross income (MAGI) $149,871 * $210,000 minus $18,000 equals $192,000 times .9235 times .029 times .5 equals $2,571 plus $5,840 [$94,200 times .124 times .5] equals $8,411 ** $210,000 minus $18,000 minus $8,411 times .20 equals $36,718

Because the 2006 MAGI in this example is just below the $150,000 joint-filer phase-out threshold, the couple is eligible for Roth IRA contributions despite having a relatively high income from the business. And because both spouses are age 50 or older as of 12/31/06, they can each contribute up to $5,000 to a Roth IRA in their respective names (for a total of $10,000).

Key Point: There’s absolutely no downside to the self-employed spouse making a Roth contribution. In this example, he or she can’t contribute any more to a SEP and is ineligible to make a deductible contribution to a traditional IRA because the joint MAGI is too high. (However, the other spouse has the option of contributing to either a Roth IRA or making a deductible contribution to a traditional IRA based on the circumstances.)

Think a Deductible Plan is the Only Way to Go? You Could be Wrong

Clearly, it’s a good idea to deduct contributions to a tax-deferred retirement plan (such as a SEP) set up for your self-employed business. However, that doesn’t necessarily mean such contributions

More Roth IRA Advantages      At age 70 1/2, you must begin to take withdrawals from a traditional IRA or face steep penalties. But with a Roth IRA, you don't have to take withdrawals at any age, meaning the account can continue to grow tax free.       Contributions can be made as long as you have earned income, no matter how old you are.      A Roth IRA can be passed on to your heirs, who can take tax-free withdrawals for decades if certain steps are taken.

Don't Overlook a Conversion Either     In addition to making contributions, don't overlook converting a traditional IRA to a Roth account. To qualify for a conversion, your adjusted gross income for the year must be under $100,000. However, sometimes self-employed taxpayers have a low income temporarily because they are involved in a start-up business or have a lean year.     That could be a good time to consider a Roth conversion. You may have to pay income tax on the amount placed in the Roth account but you can escape taxes on future appreciation and earnings that accumulate.

are preferable to contributing the same amounts to a Roth IRA. The best way to evaluate the issue in your situation is to look at two assumptions:

Assumption #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 retirement plan contribution.

Assumption #2: You expect to be in a lower tax bracket during your retirement years, which means you're generally well advised to make a deductible contribution to a tax-deferred retirement plan, instead of a Roth IRA.

In real life, though, you may not be disciplined enough to follow through with the first assumption. And the second assumption can also be problematic when you consider the federal budget deficit and politics. If it turns out that you will actually pay higher tax rates during your retirement years because tax rates go up, you’ll wish you had made Roth contributions when you had the chance.

Key Point: Even if both of the above assumptions are true, you should still make Roth IRA contributions if you have cash left over after making the maximum deductible contributions to a tax-deferred retirement plan. In other words, don’t just do one or the other. Contribute to both!

Remember: You have until April 16, 2007 to make a Roth contribution for the 2006 tax year. You can also make a contribution for 2007, as early as you wish this year.