Focus – Funding Roth IRAs
There is no doubt that Benjamin
Franklin was right when he said “In this world nothing is certain
but death and taxes”. However, what is uncertain about taxes today
is not if, but by how much, they will increase in the future. Economists
and financial experts project that the tax rates will go up in the
future, and as such, taxpayers should look for ways to shelter their
money from those projected increased tax rates. One way of doing so is to
fund the increasingly popular Roth IRA.
Roth IRAs are funded with after-tax (already taxed)
money, which means you do not get a deduction for any contributions you
make. However, the tradeoff is that future distributions are tax and
penalty-free if they meet certain requirements.These requirements are
explained during Ed Slott’s Ed Slott's
Exclusive 2-Day IRA Workshop, Instant IRA Success.
IRAs can be funded from the following sources:
Designated Roth Accounts (DRA): Balances in
Roth 401(k) and Roth 403(b) accounts, referred to as DRAs, can be rolled
over to Roth IRAs, providing the individual meets requirements to make
withdrawals from the DRA.
Roth IRA contributions of up to
$5,000 or $6,000 for individuals who are at least age 50 by the end
of the year. For a married couple, aggregate contributions for the
year can be $10,000 or $12,000 if they are both age 50 or older by
the end of the year.
- Roth IRA
individual can move his balances from his Traditional IRA, SEP IRA
and SIMPLE IRAs to his Roth IRA, providing his modified adjusted
gross income (MAGI) does not exceed $100,000 and his tax-filing
status is not married-filing-separately. This is referred to as a
Roth IRA conversion. The $100,000 MAGI and married-filing-separately
limitations are repealed beginning in 2010, which means everyone can
convert to Roth
While any taxable portion of Roth
conversion amounts are taxable for the year in which the conversion
occurs, the potential for tax-free growth can outweigh the impact of
paying income taxes on the amount at the time of conversion. However, the
following should be noted:
- A partial
conversion is an option. Therefore,
an individual can choose to convert only a fraction of his non-Roth
retirement account balance to his Roth IRA instead of converting the
entire balance in one year.
- Spread the
conversion over several years. Individuals who cannot
afford to pay the taxes on a conversion of a large amount can choose
to convert the balance in smaller amounts each year. For instance,
someone who wants to convert $200,000 in total can choose to convert
$50,000 each year instead of the entire $200,000 in one year.
- The income
tax break. For
conversions done in 2010, the income from the conversion can be
spread ratably over 2011 and 2012.
- Assess the
impact on the tax return. Individuals must understand
the impact of including the conversion on their tax return. The
additional income can impact deductions, phase-outs, exemptions,
credits, taxability of Social Security payments and AMT.
Convert RMD Amounts: Only amounts that are rollover eligible can be
converted to a Roth IRA. Therefore, required minimum distribution
(RMD) amounts must be taken from the retirement account before the
conversion occurs. Otherwise, the conversion will include the RMD
amount and create an excess contribution (of the RMD amount) in the
Convert SIMPLE IRA assets in the first 2 years: SIMPLE IRA assets
can be converted to a Roth IRA only if it has been at least two
years since the first contribution was deposited to the SIMPLE IRA.
If the conversion occurs before the 2-year period, it will be
considered an ineligible conversion by the IRS and subject to a 25%
penalty if the conversion occurs when the owner is under age 59 ½ .
pay your withholding taxes from your IRA: If you request to have
taxes withheld from your Roth conversion, the amount withheld for
taxes is not considered part of the conversion. Instead, it is
treated as a regular distribution and is subject to the 10% early
distribution penalty unless an exception applies. If you cannot
afford to pay the taxes out of pocket, consult with your tax or
financial professional to determine whether it makes sense for you
to do a conversion that year.
Individuals who are considering
converting their non-Roth retirement accounts to Roth IRAs should consult
with a tax professional about the possible tax impact of the conversion
and determine steps that can be taken to reduce or eliminate any negative
impact. For instance, consideration should be given to how the conversion
could affect an individual’s Medicare Part B premium.
Explanations of the
rules that govern IRAs are usually provided in Ed Slott's IRA Advisor
Newsletter. If you are not already a subscriber and want to
get an idea of what the newsletter includes, you can preview past issues before
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Question of the Month
individual converted his Traditional IRA balance to his Roth IRA and
failed to take his RMD amount before the conversion. What should he do?
Answer: He should
first determine the RMD amount that should have been taken from his
traditional IRA. That amount is required to be removed from his Roth IRA
as a return-of-excess contribution. The amount must include any net
income attributable (NIA) and must be removed by his tax filing deadline.
If he filed his tax return by the due date, he receives an automatic
6-month extension to remove the amount, generally to October 15. Failure
to remove the amount by the deadline will result in him owing the IRS a
6% excise tax on the amount of the RMD for each year it remains an excess
contribution in his Roth IRA.
The NIA on the excess amount can be earnings or
losses, and is computed by using a formula provided by the IRS. This
formula can be found in IRS Publication 590, available at www.irs.gov.
Rulings and Other Updates
Guidance on qualified HSA funding distributions: The IRS issued Notice
2008-51, in which they provide additional guidance on qualified HSA
funding distributions (QHFD) from IRAs. Among other things, Notice
2008-51 provides that a QHFD is not subject to income tax or the
10-percent early distribution penalty. In order to qualify for this
provision, the IRA owner must remain an eligible individual during
the entire testing period. According to the IRS, the testing period
begins with the month in which the qualified HSA funding
distribution is contributed to the HSA and ends on the last day of
the 12th month following that month.
- Relief for
Withdrawals of Stimulus Payments: The IRS issued Announcement
2008-44, which provides for tax-free and penalty-free withdrawals of
stimulus payments credited to IRAs, HSAs, MSAs and Section 529
plans, if the amount was credited to the account via direct deposit.
In order to qualify for the exception, the amount must be withdrawn
from the account by the deadline for filing the account
owner’s 2008 tax-return, plus extensions.
Retirement Planning Tip
is a misconception
among some financial professionals that purchasing life-insurance is a
waste of money. But as any member of Ed Slott’s Elite IRA Advisor Group will tell you,
life-insurance can be one of the defining tools for creating an effective
estate plan. Individuals who inherit retirement accounts may need to pay
estate taxes and income taxes, and may find that the only source of money
to cover the expenses is the retirement account. If they inherited
life-insurance proceeds in addition to the retirement account, these
amounts can be used to pay estate taxes, negating the need to make
withdrawals from the IRA (to pay estate taxes). This strategy is
explained in detail in The
Retirement Savings Time Bomb... And How to Defuse It, by Ed
from Ed Slott’s IRA Advisor Newsletter - June 2008 Issue
June 2008 issue of Ed Slott's IRA Advisor is now available online. The
areas covered include the following:
- Only one
IRA to IRA rollover per year is permitted and there is no relief on
mistakes in this area. In this month's issue
we highlight recent rulings where costly errors could not be
- Some of the
tax rebate checks are getting trapped in IRAs. IRS has ruled on how
to remove those funds without tax or penalties.
- IRAs and
Wash Sales: This month's Guest IRA Expert is Mike Jones. He recaps
the IRS ruling stating that the wash sale rules apply to IRAs and
Once-per-Year IRA Rollover Disasters
- No Relief
on Additional Rollover
60-Day Rollover vs. Trustee-to-Trustee (Direct) Transfer
IRA Rollover Rules
to the Once-per-Year Rule
a Tax Stimulus Payment Out of an IRA
the Stimulus Payment (The Tax Rebate) from an IRS
If you do not
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