One of the most common dilemmas facing Self-Directed IRA investors is whether they should make annual contributions in pretax or Roth. This article will explore the rules that govern IRA contributions in 2023.

Traditional IRA vs. Roth IRA – Tax Characteristics

Traditional IRA

The traditional IRA is an individual retirement arrangement (IRA) that was established by the Employee Retirement Income Security Act of 1974 (ERISA). It was created to help more Americans save for retirement. In 2023, the maximum IRA contributions are $6,500 or $7500 if you are at least age 50.  Contributions to a traditional IRA are tax deductible, meaning they lower your taxable income for the year(s) you make contributions to the plan. Distributions taken before the age of 59 1/2 are subject to tax and a 10% early distribution penalty. Upon reaching the age of 73, you must take an annual required minimum distribution, or RMD.

Roth IRA

The Taxpayer Relief Act of 1997 introduced the Roth IRA. It is an after-tax IRA which allows any US person with earned income under a set income threshold (under $153,000 if single and $228,000 if married and file jointly in 2023) to make after-tax contributions. The same contribution limits for a traditional IRA are applied to Roths. Unlike a Traditional IRA, Roth IRA contributions are not tax deductible. However, so long as any Roth IRA has been opened for at least five years and the plan holder is at least age 59 1/2, all Roth IRA distributions would be tax free. Further, there are no RMD for Roth-type plans, which is a great estate planning tool.

Who Can Contribute to an IRA or Roth IRA?

In general, in order for one to contribute to an IRA, the IRA owner or his or her spouse must have sufficient earned income. According to the IRS, earned income is defined as wages; salaries; tips; and other taxable employee compensation, whether in the form of a 1099, W-2, guaranteed payment, or net Schedule C income.  Earned income also includes net earnings from self-employment. Earned income does not include amounts such as passive income, pensions and annuities, welfare benefits, unemployment compensation, worker’s compensation benefits, or social security benefits. Hence, if an individual only has passive income or is retired and does not have any earned income during the year and neither does the spouse, the individual would not be able to contribute to an IRA or Roth IRA.

You cannot contribute to your IRA (or your spouse’s IRA) more than you the earned income you have. For example, if you are semi-retired making $10,000 annually, that is the most you can contribute to both plans. Obviously, you can first max out your plan first, and use the remainder for your spouse’s plan. One does not have to contribute to an IRA every year; only when you want to.

Income Limitations for IRA & Roth IRAs

Traditional IRA

It is not widely known that not all individuals with earned income can make a pretax and tax-deductible traditional IRA contribution. He or she may be able to make an after-tax traditional IRA contribution, but the IRS includes an income limitation and certain restrictions on who can make a pretax IRA contribution if they have access to a 401(k) plan at work.

If one is single, has access to a 401(k) plan at work, and earns more than $83,000, he or she cannot make a tax-deductible IRA contribution in 2023. If you do not have access to a retirement plan, there are no income limitations for deductible contributions.

In the case of an individual who is married and files jointly, that limit is $136,000. However, if neither spouse has access to a workplace retirement plan, the joint income limit for deductible contributions is $228,00 for 2023.

Roth IRA

For 2023, if one is married filing jointly and makes in excess of $228,000 or $158,000 if single, he or she is technically not permitted to make Roth IRA contributions. However, beginning in 2010, the IRS removed any income restrictions for making Roth conversions. 

For high income individuals, contributing funds to a Roth IRA is only possible through a solution known as the “Backdoor” Roth IRA. Since that time, the strategy has been used by high income earners to take advantage of the Roth IRA benefits.

Below is a summary of the steps needed to make a Backdoor Roth IRA contribution:

1. Open a traditional IRA
2. Make an after-tax contribution to the plan. Do not treat the IRA contribution as tax deductible on your tax return.
3. Notify your IRA custodian that you want to convert the after-tax traditional IRA to Roth
4. Funds are transferred to the Roth
5. IRA custodian issues a 1099-R in the following year indicating that a no-tax conversion occurred.

If you have no pretax funds in any IRA, the conversion is tax free. However, if you do have untaxed money, a portion of the conversion will be taxable. You cannot choose to only convert after-tax contributions. The IRS will always get their share!

Can I make Pretax & Roth IRA Contributions in the Same Year?

The answer is yes, you can choose how you wish to contribute to your IRA plans. In order to contribute to both types of plans, you will need multiple IRAs – one traditional and one Roth. The next question is should you? Experts agree that not only should you diversify your portfolio, but also when your distributions are taxed.

Every individual’s situation is unique, and some years you may want the upfront tax deduction rather than the future tax benefits. The more time until retirement, the more you can take advantage of the tax-free growth of the Roth IRA. However, no one knows what the future will bring. You can choose to pay a known tax rate now, or wait to pay later (when taxes might be higher). Obviously, the more money you earn, the higher your tax bill is. It’s generally better to pay the taxes when your earned income is not at its peak.

You should consult with a financial advisor to determine if you are better off contributing to a traditional or Roth IRA, or both!