Author Archives: Steve Barnes

How to Train for your Career / Job Using Roth IRA Funds

accreditationWith today’s down economy where there are fewer jobs and competition is more, what can do you if you lose your job? One thing many Americans are doing is going back to school! And for such people, there is good news. You can use money from your Roth IRA account to train for a new career, or to boost your chances of finding employment in your current field by upgrading your skills. For instance, if you were a computer programmer and jobs are scarce in that industry, and you would like to tackle a new career, you could withdraw money from your Roth IRA to pay for nursing / medical school, where the industry is still actively recruiting for qualified people.

IRA Money Can Pay for School

You can use your existing Roth IRA to pay for all your higher education school expenses such as:

  • Books
  • Training equipment / supplies
  • Tuition fees
  • Other school fees

If you use this approach to fund your education, there are certain advantages:

  • The arduous process of applying for and maintaining a student loan can be avoided.
  • There will not be additional debt you are taking on after graduation, unlike millions of other American university students.
  • Flexible schedules with work & school

What School can you Go to?

Higher education does not necessarily mean university education & liberal arts or accounting/computer science courses. If you would like to train to be a certified nursing assistant, a long haul truck driver, an oil/lube mechanic or even a welder, you can use your Roth IRA funds to pay for such trades. If you prefer the more liberal arts education, you can go back to University and study Law or Kinesiology, whatever you feel like! Just make sure whatever you study has an end goal, a career you can embark upon graduation.

Who Else can Train with You?

You can use your Roth IRA account not only to pay for your own education but that of a spouse, children, spouse’s children or your grandchildren. Or even so, all of you (the entire family) can go back to school and use Roth IRA money to fund the expense.

If you have been unemployed for long periods of time and have money sitting in your Roth IRA , now’s a good time to consider using a portion of that money to upgrade your career skills to make you employable again or to re-train in a new industry.

Accredited Schools

While you are free to choose whatever career you want to train for, you must select a university or college that is accredited. Accreditation is a very confusing term because there are hundreds of small private colleges in America that are not ‘accredited.’ The best way is to choose a school that qualifies for financial aid program administered by the Department of Education. You can visit their website at http://www.ed.gov

Accreditation Resources

Accreditation and Licensing – http://www2.ed.gov/students/prep/college/diplomamills/resources.html
Note: This information is derived from this above link, ed.gov.

U.S. Department of Education – A list of all postsecondary institutions that are accredited by agencies recognized by the Secretary of Education.
http://ope.ed.gov/accreditation

U.S. Department of Education – Overview of accreditation in the United States and List of Nationally Recognized Accrediting Agencies.
www.ed.gov/admins/finaid/accred/index.html

National Association of State Administrators and Supervisors of Private Schools – Provides contact information for state licensing agencies as well as links to many of them.
www.nasasps.com

Degree.net – Simple questions to ask about accreditation about earning unaccredited degrees.

How to Better Understand Roth IRA Conversions

roth-ira-conversionRoth IRAs and their sister retirement plans Roth 403b and Roth 401k offer oustanding retirement investing choices for American workers & savers. While most people have heard of these plans, they do not exactly know how to take advantage of them, or yet better understand them. This becomes even more difficult when an employee transitions from one job to another company while leaving behind his retirement plan with the old company, not knowing of the choices available. Effective 2010, the income cap of $100,000 maximum to be eligible to contribute to a Roth IRA is eliminated allowing high income earners to be also eligible to contribute to a Roth IRA. What happens if you are earning over $100,000 a year and have funds in a traditional IRA prior to 2010? Well you can easily convert that traditional IRA in to a Roth IRA and end up paying minimal taxes because of the down stock markets we have had in 2010. Below, we go over some frequently asked questions about Roth IRAs that should help you decide whether it is a good investment option for you.

1) What is the Rule on Income Limits?

It does not matter when you are filing your taxes as single or married filing joint, effective 2010, the $100,000 cap on adjusted gross income for investors will be eliminated. Thus, even if your salary is $200,000 a year, you are still eligible to contribute to a Roth IRA.

2) 2010 is the Year for Conversions, but not the Tax year

Let’s clarify this. While you would do a conversion from a traditional IRA or other plan in to a Roth IRA in 2010, the capital gains or income to be claimed on your taxes will not be done until 2011 and 2012, thus saving you from facing a huge tax bill in 2010. The IRS is aware of this and they have allowed you to claim 50% of your capital gains income in 2011, and the remaining 50% in 2012, thus splitting the bill across 2 years.
Note: You would pay taxes in 2011 and 2012 according to the tax bracket you’re in. For instance, if you made a lot more money in 2012 than 2011, you would pay more of the conversion taxes in 2012 rather than 2011. However, your total conversion tax will be prorated across the 2 years.

3) Tax Implications of a Roth IRA Conversion

Let’s assume Peter wants to convert his traditional IRA to a Roth IRA. Peter says his adjusted gross income for 2010 will be $90,000 and he wants to convert $50,000 of deductible traditional IRA funds to a new Roth IRA ccount. Deductible traditional IRA funds means he has never paid taxes on the money and in fact received a ‘tax deduction’ when he originally made the contribution; let’s just say in 2005. The number 1 test we look for is, is Peter eligible for a Roth IRA conversion? Since his income $90,000 is less than the $100,000 threshold, yes he is eligible! Since Peter would like to convert his $50,000 to a Roth IRA, what is his new tax liability?

New tax liability = $90,000 + $50,000 = $140,000

Notice the total $140k tax liability exceeds the $100,000 AGI threshold but since only $90,000 is his eligible income for that year, he is still okay to do the conversion.

Assuming Peter’s income tax bracket for the year is 25%, his taxes payable on the Roth IRA conversion would be:

Tax on Conversion = $50,000 x 25%

Tax on Conversion = $12,500

Please note that Peter did not have to pay a 10% early withdrawal penalty on his converted amount of $50,000. Before you do your conversion, it is advised to speak to a tax consultant whether you will have to pay this penalty or not. There are special tax scenarios beyond the scope of this article’s discussion.

Note: There is a misconception that some of the converted funds to the Roth IRA can be used to pay for federal taxes owed on the conversion. In the case of Peter, the $12,500 in taxes that he owes; he might think he can take out $12,500 from his $50k conversion to be able to pay for the federal taxes. Do NOT do this! If you do this, you will be taking an early withdrawal penalty and will be assessed a 20% early withdrawal penalty on the $12,500 withdrawn. In summary, Peter should have set aside an additional $12,500 to pay for the federal taxes, aside from his $50,000 conversion to Roth IRA.

4) Save for the Federal Taxes

Knowing that you will split up your federal taxes owing in 2011 and 2012, this gives you ample of time now to start saving for taxes. In the case of Peter, we can save $6,000 in 20 10 to pay for his 2011 share of taxes and save an additional $6,500 in 2011 to pay for his 2012 federal taxes due. The idea here is to start saving soon.

Tax Saving Tips for IRA Investors – After Tax Contributions (Basis), Income in Respect of Descendent, 10% Excess Tax & Substantially Equal Periodic Payments (SEPPs)

tax-dayThousands of IRA investors miss out on important tax benefits each year because they are not familiar with the Tax Act and laws. Others make crucial errors when filing their tax returns. For instance, IRA investors may pay taxes on monies that should have been tax free or pay excise taxes on IRA distributions when these distributions should be free of tax. Our aim in this article is to highlight some IRA tax laws and how you can benefit from them.

ii) Track Basis to Avoid Getting Double Taxed

After-tax IRA balances (also known as ‘basis’) grow in Individual Retirement Accounts (IRAs) from non deductible contributions and IRA rollovers of after-tax amounts. By saying non deductible contributions, we mean you pay taxes on all your earnings now, and will not be taxed when you withdraw them upon retirement, at 65. This is how a Roth IRA works. It is essential we clarify this point, so read this example below:

After-Tax Contributions?

Consider Jackson who earns a $65,000 annual salary. Jackson is currently in the 25% tax bracket and contributes $3500 a month to his Roth IRA. Jackson would therefore pay income taxes of $3500 x 25% = $875 and would contribute $3500 – $875 = $2625 to his Roth IRA. If Jackson expects to be in a 33% tax bracket upon retirement, he will have to pay $3500 x 33% = $1155 upon his retirement. Therefore by making after-tax Roth IRA contributions now and getting taxed at the lower 25%, Jackson avoids having to pay taxes @ 33% when he hits retirement.

Distributions of after-tax balances (basis) is supposed to be tax-free. However, if you fail to keep track of these amounts that you have contributed, any distributions you take will result in you having to pay taxes to the IRS resulting in double taxation. Also, if you do not file IRS Form 8606 (Nondeductible IRAs) to the IRS, you will owe them a penalty of $50 unless you show a valid reason why you didn’t file that form. Consider this example.

Example

John made a rollover contribution of $50,000 from his 401k plan to a Traditional IRA out of which $15,000 was contributed on an after-tax basis. This means distributions of this $15,000 should be tax free because John already paid taxes on them. John, busy as he is, failed to file Form 8606 to the IRS and did not keep track of the amount. John withdrew his entire $50,000 balance from his IRA due to some emergency and included the entire amount as taxable income. This means John paid taxes on his $15,000 contributions that should have been tax-free. Had John filed IRS Form 8606 in the year the rollover occured, he would not have got double taxed on the $15,000 distribution.

Once you make a nondeductible contribution to a Traditional IRA or rollover after-tax amounts, any distributions taken from the IRA will include a prorated amount of pre-tax and post-tax assets. These assets will be broken down into pre-tax and post-tax amounts just like how John has $35,000 pre-tax assets and $15,000 of post-tax assets in his Traditional IRA. Another important point to remember is that if you have multiple traditional, SEP or Simple IRAs with different beneficiaries, you might want to maintain a separate Form 8606 for each type of IRA. Then, each beneficiary will be able to determine their basis (after-tax balances) in their inherited IRAs and file any IRS Form 8606.

Income in Respect of Decedent

Pre-tax IRA assets or balances that are not distributed before the IRA investor’s death are not taxable to the deceased IRA owner. Instead, they will be added to taxable income of the beneficiary for current tax year. However, these assets may be included in the deceased IRA investor’s estate and subject to estate tax. However, if the deceased IRA owner filed IRS Form 706 (United States Estate and Generation-Skipping Transfer form), the beneficiary might be eligible for a federal tax deduction for the total amount of estate taxes listed on form 706. This deduction is known as Income in Respect of Decedent (IRD) and is one of the most important deductions that a beneficiary could get with inherited assets or monies. Unfortunately, it is a deduction least aware of by IRA investors and owners.

Tax experts estimate that failure to claim the Income in Respect of Decedent (IRD) deduction can result in a tax rate of 80% or more on the inherited amount, broken down to a combination of estate taxes paid by the deceased IRA owner and federal/local state taxes paid by the beneficiary who inherits the assets after the death of the IRA owner. Income in Respect of Decedent (IRD) is claimed as an itemized tax deduction on IRS Schedule A and is not subject to the 2% of modified adjusted gross income (MAGI) limit that applies to miscellaneous deductions. If you don’t itemize your IRD deduction, your deduction will not be valid.

Deducting Losses on Roth IRA Investments

It makes sense when we say that greater risk has the potential of yielding greater returns. If you do not want to take risk, you would invest your money in certificates of deposit or money market funds that provide a risk-free interest rate upon maturity. However, these interest rates are lower than the percentage returns provided by riskier stocks. If you make losses on your IRA (Individual Retirement Account) investments, you can deduct them from your tax return ONLY if certain conditions are fulfilled. We look at these conditions next:

1) Withdraw Full Balance to Claim Losses

In order to be eligible to claim losses on your tax return from your IRA investments, you MUST withdraw the entire balance from that account. For example, if you faced a loss of $5000 this year on your Roth IRA account, you must withdraw the full balance from your Roth IRA in order to be eligible to deduct this $5000 allowable capital loss from your tax return. On the other hand, if you faced a similar loss from your SEP IRA, SIMPLE IRA or Traditional IRA, you must withdraw the entire balances from all these Traditional IRAs in order to deduct any losses.

2) Losses on your Traditional IRA

You can deduct losses made on your Traditional IRA only if:

  • the total balance you withdraw is LESS than the after-tax amounts (basis amounts) remaining in your Traditional IRA.
  • the IRA basis is any non-deductible contributions + after-tax IRA rollovers from 403b plans, 457 plans or other qualified retirement plans.
  • you fill out IRS Form 8606 which is used to determine the basis of your withdrawal amounts from your Traditional IRA. IRS Form 8606 is also used to calculate your actual IRA loss to be included in your income tax return, and the total amount of your IRA withdrawal.

Example of a Traditional IRA Investment Loss

  • Beginning January 1st, 2004, John had a Traditional IRA balance of $30,000.
  • $20,000 is the After-Tax balance
  • On December 31st, 2004, John’s IRA lost $13000 in value. This means his Traditional IRA balance is now: $30,000 – $13000 = $17,000
  • This $17000 is now less than the after-tax balance of $20,000.
  • This means John can claim a loss on his income tax return if he withdraws his total balance from his Traditional IRA.
  • His income tax loss deduction would be calculated as follows:

$30,000 January 1st, 2004 Balance
– $13000 IRA Investment Loss for the year 2004
$17,000 Value of his Traditional IRA at Dec 31st, 2004

$20,000 After-Tax Basis Amount
– $17,000 Value of his Traditional IRA at Dec 31st, 2004
$3,000 His Income Tax Deduction from IRA Investment Losses – 2004

ReCharacterization of IRA Contributions or Roth Conversions

Recharacterization is when a 401k participant switches from a Traditional IRA plan to a Roth IRA plan, and due to various # of reasons, switches back to the Traditional IRA plan. When making IRA recharacterizations, individuals have to calculate their earnings and losses on the original value of their Roth Conversions or IRA contributions. It is imperative that these earnings/loss calculations are done correctly otherwise the tax consequences can be severe.

First, the deadline for Recharacterization of a Roth Conversion of IRA Contribution is your tax-filing deadline (April 15th of each year). However, you are eligible to receive a 6 month extension on Recharacterizations which means your deadline is Oct 15th of each year. For example, if you want to Recharacterize a 2004 IRA contribution you made, your deadline is October 15th, 2004.

Why Would I want to Recharacterize my Roth Conversion?

A taxpayer can choose to recharacterize his Roth Conversion for reasons such as:

  • Previous Roth Conversions were ineligible and failed
  • Value of retirement assets have decreased since the Roth Conversion*
  • Individual has a change of mind and wants to switch back to a Roth IRA

* For example, when Roth IRA assets are converted, the taxable amount of the conversion is the initial value when the assets are converted, even if these assets have declined in value. For instance, if a taxpayer converted his IRA assets worth $120,000 in April of 2004, and these assets have since decreased in value to $40,000, the individual will still have to pay taxes on the initial $120,000 he deposited in April of 2004. Who said tax rules are fair!?

Why Would I want to Recharacterize my IRA Contribution?

A taxpayer can choose to recharacterize his IRA Contribution for reasons such as:

  • An individual can recharacterize his Traditional IRA contributions into Roth IRA contributions due to tax-free accumulation and accrual of earnings.
  • An individual can recharacterize his Roth IRA into a Traditional IRA in order to be eligible to make tax deductions on the amount.

How Do I Recharacterize my Roth Conversion of IRA Contributions?

In order to recharacterize your IRA, you must move all the retirement savings and assets from the original IRA into your new IRA plan. Your financial institution can simply do this move by changing the type of IRA, for example from a Traditional IRA into a Roth IRA. Check with your financial institution as to their requirements, plus all the documentation you will need to successfully recharacterize your IRA.

Taking Qualified Roth IRA Distributions – Eligibility & Examples

Any ‘qualified distributions’ you take from a Roth IRA will NOT be included in your taxable income, hence making you exempt from paying taxes. You won’t have to pay taxes on the original principal you contributed nor any taxes on capital gains & earnings you have accumulated. Pretty sweet you think for Roth IRAs, eh? In order for the distribution to be classified as ‘qualified’, it must be taken under 1 of the following circumstances:

the Roth IRA investor must be 59 and 1/2 years or older at the time of the distribution
the Roth IRA investor becomes disabled at the time of taking the distributions
the Roth IRA investor dies and his/her beneficiary receives the assets contained in the plan
the distributions taken from the Roth IRA will be used in the purchase or building of a new home for the Roth IRA holder or qualified family member.This is limited to $10,000 per person per lifetime. Qualified family members include:
–> the Roth IRA investor
–> the Roth IRA investor’s spouse
–> children of the Roth IRA investor
–> grandchildren of the Roth IRA investor
–> parent or ancestor of the Roth IRA investor

Note: Even if one of the above prerequisites is met, the Roth IRA must be atleast 5 years old before any distributions can be taken. This is a very important point to consider. For example if you set up your Roth IRA in March 22nd, 2003, you cannot take any distributions, even if they are qualified, until March 22nd, 2010. If you do, this distribution will not be qualified and you will have to pay the 10% early withdrawal penalty as well as income taxes. A few examples to illustrate these concepts would be useful. Here they are.

Example #1

Jim makes Roth IRA contribution on March 1st, 2002 for $3000. 6 years later on March 1st, 2010, Jim withdraws $5500 from his account (the principal $3000 + $2500 earnings). Jim’s withdrawal is not qualified because he does not plan to purchase a home for the first time, nor is he disabled, plus Jim is not 59 and 1/2 years old or more. Jim will face a 10% early withdrawal penalty + have to pay income taxes on his withdrawal. If Jim had withdrawn only $3000 from his Roth IRA which equals the total contributions he made, he would not be subject to income taxes nor the 10% early withdrawal penalty. This is because Roth IRAs allow you to withdraw up to the maximum contributions you have made and not any earnings on those contributions. Since withdrew the whole $5500 consisting of $3000 principal + $2500 earnings, he will be penalized.

Example #2

Rishi who is 58 years old makes a $3500 contribution to his Roth IRA on April 12th, 1999 for the tax year 1998. On February 5th, 2003, Rishi withdraws $6000 from his Roth IRA consisting of $3500 original principal + $2500 earnings. At this time, Rishi is 62 years old. Will this distribution be treated as ‘qualified’? You bet it is! This is because the 5 year waiting rule has passed. Even though Rishi made his contribution on April 12th, 1999, this contribution was designated for the tax year 1998. Thus from 1998 – February 5th, 2003, the 5 year waiting rule is met. As you can see from here, it is not necessarily the calender years that count; it is when the first contribution was made and for what year it was designated. Also, Rishi is 62 years old which meets the 59 and 1/2 year old requirement. Thus this distribution of $6000 will not be included in Rishi’s taxable income.