Category Archives: Income Tax

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.