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.


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



Individual Retirement Accounts (IRA) and Real Estate Investments

Many savers have the idea that if they invest their IRA savings into Real Estate, they will make good profits and increase their retirement savings ultimately. However, there are many pitfalls that could get you in trouble if you do not follow the IRA rules.

Prohibited IRA Transactions

Some specific investments are prohibited in IRAs. These investments are called “collectibles” and include items such as:

  • Artwork
  • Antiques
  • Coins
  • Collectible Stamps
  • Gems

Real Estate is not prohibited, but certain rules and pitfalls can easily make your IRA Real Estate Investment into a prohibited transaction.

Prohibited Real Estate Transactions

  • You can’t sell property to your IRA, nor buy property from your IRA
  • You can’t loan money to your IRA or borrow money from it
  • You can’t use your IRA Savings as Loan Collateral
  • You can’t receive goods and services from your IRA nor provide them from your IRA

Beware, some companies promote real estate investments for IRAs by not properly disclosing all the related rules and prohibitions as stated by the law.This is because they do not want to lose business and you as a client/customer.

Examples of Prohibited Transactions

For example, imagine your IRA purchases a broken-down house that needs lots of repair work and remodelling. You use funds from your IRA to do the remodelling and add value to the house. Later, you sell it at a profit. That is NOT a prohibited transaction yet. However, if the remodelling is done by yourself, or your relative’s local shop, this means you are providing “services” to your IRA. Now THIS is a prohibited transaction.

Another example of a prohibited transaction is when you buy a rental property and also do the work of finding tenants, collecting rent and property management. If you or your relatives do this, you are providing services to your IRA.


IRA Rollovers & Transfers: Similarities, Differences & FAQs

What’s the Difference between an IRA Rollover and IRA Transfer?

An IRA Transfer is when the retirement assets of an individual are transferred from one financial institution (IRA Management & Investment Firms) to another, without the IRA owner taking ownership and risk of the assets. By Transferring their IRA Assets, IRA owners do NOT have to pay tax on these withdrawals and do not risk loss of investments if anything happens along the way. Furthermore, unlike IRA Rollovers, you can carry as many IRA transfers during the taxation year as you’d like, there’s no maximum limit.

An IRA Rollover occurs when a retirement saver rolls over his assets from a Qualified Retirement Plan (example 401k plans) into an Individual Retirement Asset (IRA). Unlike IRA Transfers though, an individual is limited to 1 IRA Rollover every 12 months. There are 3 types of IRA Rollovers, we summarize them below:

1) IRA Rollover

An IRA Rollover occurs when an individual has personally withdrawn money from his IRA Assets for personal use. If this is the case, the individual has 60 days to rollover this distribution to another IRA. If the distribution is not rolled over to another IRA within 60 days, the individual will have to pay the local state & federal taxes as well as a 10% Early Withdrawal Penalty Fee.

2) Qualified Retirement Plan Rollover

A Qualified Retirement Plan Rollover occurs when an individual takes personal possession and responsibility of his IRA assets and does NOT do an IRA Transfer within 60 days. Once the IRA assets are distributed, the plan administrator will withhold 20% of the amount for tax purposes and 80% of the assets will be distributed to the IRA account owner. This complication makes Qualified Retirement Plan Rollovers a less attractive choice.

3) Qualified Retirement Plan Direct Rollover

The Direct Qualified Plan Rollover is probably your best bet. Similar to the IRA Transfer, the IRA Asset owner can rollover his assets directly from one financial institution to another without having to pay any taxes, and the 10% early withdrawal penalty fee. The only exception is that you are allowed to do a Direct IRA Rollover once every 12 months.


Year End IRA (Individual Retirement Account) Statements

If you own a Traditional IRA or a Roth IRA, your IRA Administrator must mail you atleast one year end statement every year. The deadline for this statement is usually January 31st, of the following year. Some of the year end statements you should receive include:

  • Fair Market Value (FMV) Statement
  • IRS Form 1099-R
  • IRS Form 1099-Q
  • Required Minimum Distribution (RMD) Form

Fair Market Value (FMV) Statement

The Fair Market Value Statement, as the name implies, will tell you the fair market value balance of your IRA assets as of December 31st, of the previous year. The Fair Market Value Statement will also calculate your Minimum Required IRA Distributions (RMD) that you must take out. This statement will also include a note that the fair market value of your investments will be reported to the IRS for tax purposes.

Required Minimum Distribution Notice

If at any year you reach the age of 70 and 1/2 and above, you will receive a Minimum Required IRA Distributions notice from your IRA Administrator. For example, if you turned 70 and 1/2 in the year 2004, you will receive this notice by a maximum date of January 31st, 2004. This notice will tell you exactly how much of required distributions you must take out.

IRS Form 1099-R

IRS Form 1099-R reports any distributions over $10 from any pension plans, Individual Retirement Account (IRAs), 403b plans, annuities, etc. Any IRA Re-Characterizations (change from a Roth IRA back to a Traditional IRA) will also be reported on this form.

Roth IRA Contribution Limits & Individual(k) Limits for Self Employed People

The Roth IRA contribution limits for the years 2003, 2004, 2005, 2006 and 2007 were greatly influenced by the Economic Growth and Tax Relief Reconciliation Act of 2002, which advocated for the increase in these Roth IRA contribution limits. A provision of the act known as the “Sunset Provision” made it official these that increases in contribution limits will only last till the year 2010, so now’s a good time to get into the Roth IRA! In 2010, the Congress will look at the total decline in revenues generated from these increased Roth IRA contribution limits, and whether these increases will become permanent or not.

The Roth IRA contribution limits are summarized in the table below:

Year Traditional Roth Traditional Roth Catch Up Simple Simple Catch Up 401k and 403b Plans 401k and 403b Catch Up Plans
2005 $4000 $4500 $10,000 $12000 $14000 $18000
2006 $4000 $5000 $10,000 $12500 $15000 $20000
2007 $4000 $5000 (Indexed) (Indexed) (Indexed) (Indexed)
2010 $5000 $6000
2009 $5000 $6000

Starting 2005, the Roth IRA contribution limits will be $4000, and will increase to $5000 in the year 2010. After 2010, the contribution limit will be incremented by $500 a year to adjust for cost of living and inflation. Therefore, the $5000 you are seeing for the 2009 column may not be entirely accurate, we will probably see $5500 in the column.

Why Should Young People Invest in a Roth IRA?

If you follow the Roth IRA Rules, any contributions you make towards a Roth IRA will grow tax-free for years to come, and with the power of compound interest, your money will grow at even a faster pace! Upon retirement, you will NOT have to pay taxes on your Roth IRA earnings as well. Furthermore, Roth IRAs allow you to invest in many different investments such as Bonds, Stocks, Real Estate, Derivatives, Mutual Funds and more.

A Roth IRA account can be opened until April 17th of the current tax year, and contributions can made starting from the previous year. The current maximum Roth IRA limit for 2006 is $4000. From 2010, the maximum Roth IRA contribution limit will rise to $5000.

Compound Interest & Roth IRA?

If a young saver at the age of 25 invests $4000 a year into a Roth IRA and earns 8% a year on his investment, he will have a huge nest egg of $1.1 million upon retirement (at the age of 65). What’s more, none of this $1.1 million nest egg is taxable upon retirement!

Consider a contra-example scenario. If that same 25 year old young saver invests $4000 a year into a regular taxable savings account earning 8% interest, he would grow a nest egg of $800,000 upon retirement (at the age of 65) – assuming a 15% tax rate.

Characteristics of a Roth IRA Account

  • Distributions or Withdrawals on your contributions from a Roth IRA account can be taken out at any time without incurring the 10% early withdrawal penalty fee in 401k accounts, as well as no taxes payable.
    Note: A Roth IRA is meant for saving towards retirement and withdrawals from your retirement savings account are always discouraged (unless for emergencies and unexpected circumstances).
    Note: Also note that withdrawals from your Contributions are non taxable. However, any earnings you have made on those contributions (such as the 8% interest earnings) is taxable at your local state & federal taxes and subject to 10% early withdrawal penalty fee (if withdrawn before the age of 59 and 1/2).

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.

Differences between Traditional IRA & Roth IRA – 8 Exceptions to the 10% Early Withdrawal Penalty

Interestingly, there are 11 different types of IRAs ranging from Individual Retirement Accounts, Employer and Employee Association Trust Account, Spousal IRAs, Rollover Conduit IRA, etc. The most common are the traditional IRAs and the Roth IRA. In this article, we will explain the differences & similarities between the two.

Traditional IRA

In Traditional IRA, the contributions you make towards the account are not taxed. Whatever capital gains & earnings you make on your IRA are also not taxed up until retirement, when you withdraw money from your account. For example, imagine you made $50,000 this year and contributed $5000 to a traditional IRA. You will be taxed on $50,000 – $5000 = $45,000. Furthermore, your $5000 contribution will grow tax-deferred for many years, until you retire and decide to withdraw it. The setback with this is that your $5000 (which would have probably grown to $50,000 upon retirement) will then be taxed at your ordinary income tax rate.
Note: You can only withdraw this money after you turn 59 and 1/2 years or older. Any withdrawals made before this age will be subject to income taxes as well as a 10% early withdrawal penalty. However if you use the withdrawn funds to finance higher education expenses or for the below list of 8 exceptions, you will not have to pay the 10% early withdrawal penalty.

8 Exceptions that Eliminate the 10% Early Withdrawal Penalty

There are 8 exceptions to the 10% early withdrawal penalty (i.e. withdrawals that are taken before the age of 59 and 1/2). They are for distributions that:

i) Are taken because of the IRA owner’s disability

ii) Are taken because of the IRA owner’s death

iii) Are a series of loan repayments made over the life expectancy of the IRA investor

iv) Are used to pay for unreimbursed medical expenses that exceed 7.5% of the adjusted gross income of the IRA owner

v) Are used to pay for medical insurance premiums if the IRA investor has been unemployed for more than 12 weeks

vi) Are used to pay for the purchase of a principal residence (maximum of $10,000 can be withdrawn). Also, the IRA investor must not have previously owned a home within the last 24 months.

vii) Are used to pay for higher education expenses of the IRA owner or eligible dependants/family

viii) Are used to pay back taxes of an IRS levy placed against the IRA

Traditional IRAs are commonly associated with the old way of investing: certificates of deposits. This stereotype is because most banks sell CDs and they are the ones that offer Traditional IRA accounts for investors. But remember, you are not limited to investing Certificates of Deposit or bonds only, you can make higher risk investments such as cyclical stocks, commodities, futures, ETFs, etc.

What Is an IRA (Individual Retirement Account)? – Introduction, Contribution Limits, Early Withdrawal Penalties, Advantages/Disadvantages

Also known as an Individual Retirement Arrangement, an IRA is a retirement savings plan available to anyone who receives taxable employment income or compensation in a given year. Examples of taxable income include wages, salaries, bonuses, taxable alimony, commissions, fees & tips. An individual can have multiple IRA accounts but the total contribution limits are outlined in the table below.
Note: An individual’s IRA contribution is limited to the lesser of total taxable compensation, or the normal annual contribution limits, whichever is lower.

Year Regular Contributions Catch Up Contributions
2001 $2000 $0
2002 $3000 $500
2003 $3000 $500
2004 $3000 $500
2005 $4000 $500
2006 $4000 $1000
2007 $4000 $1000
2010 $5000 $1000
2009 $5500 $1000

Beginning in 2009, annual IRA contribution limits will increase by $500 adjusted for inflation. All contributions to an IRA are tax-free until withdrawn at the age of 59 and 1/2. Any withdrawals made prior to that are subject to a 10% early withdrawal penalty as well as income taxes owing. There are 8 exceptions to this, see the 8 exceptions below.

Traditional IRA contributions may or may not be tax deductible depending on the tax filing status of the investor. This also depends on the adjusted gross income (AGI) and eligibility to participate in a qualifed IRA retirement plan. Deductibility of contributions becomes zero if the IRA investor’s income falls in between these adjusted gross incomes (AGIs).

Year Filing as Single Filing as Joint
2001 $33,000 – $43,000 $53,000 – $63,000
2002 $34,000 – $44,000 $54,000 – $64,000
2003 $40,000 – $50,000 $60,000 – $70,000
2004 $45,000 – $55,000 $65,000 – $75,000
2005 $50,000 – $60,000 $70,000 – $80,000
2006 $50,000 – $60,000 $75,000 – $85,000
2007 $50,000 – $60,000 $80,000 – $100,000

A working spouse who is not enrolled in employer sponsored IRA can make a tax-deductible contribution of a maximum of $2000 to an IRA each year, even if the other spouse is enrolled in an employer sponsored IRA. When the couple’s combined adjusted gross income reaches $150,000, tax deductibility for such contributions lowers. At an AGI of $160,000, it becomes $0!