Roth 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.