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Opinion: The best tax-free deals for individual taxpayers

There are still ways to earn tax-free income. This is the first
of our two-part series on the best federal-income-tax-free
deals for individual taxpayers.

Tax-free Roth IRAs

Roth IRAs have two big tax advantages.

Tax-free withdrawals

Unlike withdrawals from traditional IRAs, qualified Roth IRA
withdrawals are federal-income-tax-free (and usually
state-income-tax-free too). What is a qualified withdrawal? In
general it is one that is taken after you have met both of the
following requirements:

1. You’ve had at least one Roth IRA open for over five years
when the Roth withdrawal is taken.

2. You’ve reached age 59½, are disabled — or dead — when the
Roth withdrawal is taken.

Exemption from required minimum distribution

Unlike with a traditional IRA, the original owner of a Roth
account (the person for whom the account is originally set up)
is not burdened with the obligation to start taking required
minimum distributions (RMDs) after age 70½ or face a stiff 50%
penalty. Therefore, you can leave a Roth account untouched for
as long you live. This important privilege makes the Roth IRA a
great asset to leave to your heirs — to the extent you don’t
need the Roth IRA money to help cover your own retirement-age
living expenses.

Making annual Roth contributions

The idea of making annual Roth IRA contributions makes the most
sense for folks who believe they will pay the same or higher
tax rates during retirement. Higher future taxes can be avoided
on Roth account earnings because qualified Roth withdrawals are
federal-income-tax-free (and usually state-income-tax-free

The downside is you get no deductions for Roth contributions.
So if you expect to pay lower tax rates during retirement (good
luck with that), you might be better off making deductible
traditional IRA contributions (assuming your income is low
enough to permit deductible contributions), because the current
deductions may be worth more to you than tax-free withdrawals
later on.

The absolute maximum amount you can contribute for any tax year
to a Roth IRA is the lesser of (1) your earned income for that
year or (2) the annual contribution limit for that year.

Basically, earned income means wage and salary income
(including bonuses), alimony received (believe it or not), and
self-employment income. For 2017, the Roth contribution limit
is $5,500 or $6,500 if you’ll be age 50 or older as of
year-end. This assumes you’re unaffected by the AGI-based
phaseout rule explained immediately below.

  • For 2017, eligibility to make annual Roth contributions is
    phased out between modified adjusted gross income (MAGI) of
    $118,000 and $133,000 for unmarried individuals.
  • For married joint filers, the 2017 phaseout range is
    between joint MAGI of $186,000 and $196,000.

Key Point: If your MAGI is too high for annual Roth
contributions, consider converting a traditional IRA into a
Roth account, as explained below.

Making Roth conversions

A few years ago, an income restriction made individuals with
MAGI above $100,000 ineligible for Roth conversions. The
restriction is gone. Now even billionaires are eligible for
Roth conversions. That’s an important break, because conversion
contributions are the only way to quickly get large amounts of
money into a Roth IRA. However, it’s important to keep in mind
that a conversion will trigger taxable income. So you need to
consider the federal income tax hit that will accompany a
conversion. There may be a state income tax hit too. Consult
your tax adviser before pulling the trigger on a conversion.

Tax-free home sale gains

In one of the best tax-saving deals ever, an unmarried seller
of a principal residence can exclude (pay no federal income tax
on) up to $250,000 of gain, and a married joint-filing couple
can exclude up to $500,000 of gain. Naturally, there are some
limitations. You must pass the following tests to qualify.

1. Ownership test: You must have owned the property for at
least two years during the five-year period ending on the sale

2. Use test: You must have used the property as a principal
residence for at least two years during the same five-year
period (periods of ownership and use need not overlap).

3. Joint-filer $500,000 exclusion test: To be eligible for the
maximum $500,000 joint-filer exclusion, at least one spouse
must pass the ownership test, and both spouses must pass the
use test.

4. Previous sale test: If you excluded gain from an earlier
principal residence sale, you generally must wait at least two
years before taking advantage of the gain exclusion deal again.
If you are a married joint filer, the larger $500,000 exclusion
is only available if neither you nor your spouse claimed the
exclusion privilege for an earlier sale within two years of the
later sale.

Prorated exclusion

If you don’t qualify for the maximum $250,000/$500,000 gain
exclusion due to failure to pass all the preceding tests, you
may still qualify for a prorated exclusion amount if you had to
sell your home for job-related or health reasons or for certain
other IRS-approved reasons. For instance, say you’re a married
joint filer. You and your spouse used a home as your principal
residence for only one year before having to move for
job-related reasons. You qualify for a prorated exclusion of
$250,000 (half the $500,000 maximum allowance for a
joint-filing couple, based on passing the ownership and use
tests for only one year instead of two).

Please stay tuned

My next column will cover more tax-free income opportunities.
So please stay tuned for the rest of the story.

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