It Pays to Take the Time to Understand Roth IRAs

Q: I contribute to a traditional IRA, but don’t deduct the contribution because I have a retirement plan at work and my adjusted gross income exceeds the phaseout range for deductible contributions. I’m wondering if that means that when the money is withdrawn, I won’t have to pay any taxes, either on the contribution or on their earnings, as with a Roth. The reason I didn’t open a Roth is because I own a couple of properties, and I believe you’re only eligible for the Roth if you haven’t bought your first home yet. If you could help clarify this, it would be greatly appreciated.

A: That last part really had me scratching my head, until I realized you were confusing a new benefit of individual retirement accounts with the requirements for starting a Roth. It’s true that the rules for traditional IRAs and Roth IRAs are confusing, but you need to pay better attention. After all, it’s your money at stake.

Here’s a refresher course.

Withdrawals from traditional IRAs are taxable, whether or not you deducted the contributions on your tax returns. If you didn’t deduct the contributions, you get a slight tax break: You don’t have to pay taxes again on the portion of the withdrawals that’s attributable to your original contributions. For example, say you made a total of $10,000 in nondeductible contributions over the years to an IRA that eventually grew to $100,000. Essentially, 10% of your withdrawals ($100,000 divided by $10,000) would not be taxed; you would owe ordinary income taxes on the other 90%.

Withdrawals from Roth IRAs in retirement, on the other hand, are completely tax-free. Contributions to Roth IRAs are never tax-deductible, but who cares, when you get all that nice tax-free money at the end?

So why would you make a nondeductible contribution to a traditional IRA, rather than to a Roth? Well, if you make more than certain income limits ($110,000 for singles, $160,000 for married couples filing jointly), you’re not allowed to contribute to a Roth. Traditional IRAs don’t have income limits to contribute, so anyone with earned income can pitch in.

But if you qualify for a Roth and can’t deduct a traditional IRA contribution, then you should go for the Roth. The choice is between tax-free income in retirement, versus taxable income. In other words, there’s no choice at all.

Owning property has nothing to do with it. Congress passed a law that allows first-time home buyers to take $10,000 out of their IRAs (traditional or Roth) for a down payment. Such withdrawals don’t trigger the usual early-withdrawal penalty of 10% (plus 2.5% in California), but withdrawals from traditional IRAs for a first-time home purchase are subject to income taxes, according to the rules I just outline above.

Now, a qualified tax preparer could have explained all this to you, helped you switch your traditional IRA contributions to a Roth and straightened out the other things you’re probably doing wrong with your taxes. Because you own not only a home but another property, which you most probably rent out, the possibilities for screwing up are multiplied. Remember, you don’t save anything by doing your own taxes if you do them wrong--or miss out on great opportunities such as the Roth.

By the way, you have until Monday, April 17, to correct your mistake for the 1999 tax year. The law allows you to fund an IRA or a Roth IRA for the previous year as late as the tax return deadline.

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Liz Pulliam Weston regrets that she cannot respond personally to queries. Questions can be sent to her at liz.pulliam@latimes.com or mailed to her in care of Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.