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Roth IRA - Is It For You?Tax Updates
Traditional IRAs are familiar to most taxpayers, providing a relatively simple method of saving for retirement AND deferring taxes in the process. But one drawback of the Traditional IRA is that once withdrawals from them begin, distributed earnings and contributions that were tax-deductible get taxed. In contrast, a Roth IRA allows no tax deduction of contributions. However, it does allow tax-free accumulation on the account so that at retirement ALL distributions from a Roth IRA are tax-free, both contributions and earnings. Naturally, to get this tax-free treatment, certain conditions must be met. Lump Sum Accumulation $1 Rolled Over “X” Years
The annual limit applies to all of your IRA contributions in a given year. So, you can contribute to a Traditional IRA and a Roth IRA as long as the combined total does not exceed the annual IRA limits and you meet all of the other requirements. Your income level can limit your Roth contributions. Contributions are gradually reduced (i.e., phased out) for married joint taxpayers with adjusted gross income (AGI) between $167,000 and $177,000.They are reduced for other taxpayers when the AGI is between $105,000 and $120,000. The contributions of married separate taxpayers who lived together at anytime during the year are reduced when the AGI is between $0 and $10,000. The amounts indicated are for 2010. Call this office for the rates for other years. With Traditional IRAs, contributions cannot be made once you turn age 70-1/2. However, there is no such age limit for making contributions to Roth accounts. Handling Roth IRA DistributionsGenerally, distributions from a Roth IRA (unless due to a conversion from a Traditional IRA) are treated as coming first from contributions (principal) on which you have already paid the tax. Therefore, any distribution to the extent of the principal is tax-free. Distributions of earnings are also tax-free (qualified distributions) if: They are not made within the five-year tax period beginning with the first tax year in which you contributed to the Roth account, AND They meet one of the following conditions:
Another big advantage of Roth IRAs over Traditional IRAs is that the former is not subject to the minimum required distribution rules at age 70-1/2. This means that if you don’t need to utilize your Roth IRA for retirement, you can leave it untapped for heirs (who would also get deferral on withdrawals, but would be subject to certain required distribution rules that apply to beneficiaries). Conversions of Traditional IRAs to Roth AccountsBecause of the tax-free nature of Roth accounts, Congress has provided taxable rollover provisions that allow you to convert your Traditional IRAs to Roth accounts. Once you convert, all future earnings in the new Roth account accumulate tax-free. The catch is that the tax on the Traditional IRA must be paid in the year the conversion is made to the Roth. Whether it is beneficial to elect this taxable rollover depends on a number of variables. After 2009, a Traditional-to-Roth IRA conversion can be made by anyone regardless of filing status or income. Prior to 2010, the conversion option is available to anyone, except married taxpayers filing separately, but only if a taxpayer's AGI is $100,000 or less. A special rule applies to conversions made in 2010 allowing a taxpayer to elect to pay the conversion tax all in 2010, or include one-half of the conversion income in 2011 and the other half in 2012. Paying the Tax on ConversionThe taxability of a Traditional IRA to Roth IRA conversion depends on whether or not nondeductible contributions were made to your Traditional IRA. If you did, your Traditional IRA includes amounts that have already been taxed. These post-tax contributions don’t get taxed again when converting to the Roth. However, you must pay the tax on any interest the Traditional IRA earned plus on contributions deducted prior to conversion. Effects of Paying the Tax on a Roth Conversion from IRA Funds The tax on a Roth conversion may be paid either from other funds or from the IRA funds being converted. However, if the taxpayer chooses to pay from the IRA funds, those funds will not be considered part of the rollover. Therefore, they will be subject to early withdrawal penalties if you are under 59-1/2 at the time of the withdrawal. Payment of the tax from the IRA funds can severely limit the benefit of a conversion to a Roth by eroding the capital that can be invested. For example, in a conversion of a $50,000 IRA to a Roth and paying the tax from the conventional withdrawal, only $29,429 (amount left in the IRA after paying taxes and penalties) actually would get invested in the Roth account. The result, shown below in after-tax dollars, assumes a 6% interest rate and an accumulation period of 25 years.
Time Limits on Holding Converted Roth Accounts When a Traditional IRA is converted to a Roth account, the converted amount must be held in the Roth IRA for at least five years; otherwise a penalty may apply. Any converted amount withdrawn before the end of the five-year period, to the extent it was included in income due to the conversion, is subject to a 10% early withdrawal penalty even if you have reached age 59-1/2. After the five-year period has been satisfied, the 10% penalty still applies to distributions of earnings if you have not attained the age of 59-1/2 or an exception applies. Any withdrawal made from a Roth IRA containing converted amounts before the five-year holding period ends are treated as coming FIRST from amounts that were included in income due to the conversion.
The income “catch” for Roth conversions can be averted with appropriate tax planning.That’s why it’s important to consult with your tax advisor before making a final Roth investment decision. Only by looking at your entire tax picture will you really be able to decide whether the Roth option is best for you. Factors That Favor Your Conversion to a Roth
Factors That Don't Favor Your Conversion to a Roth
Saver's Credit The Retirement Savings Contribution Credit, frequently referred to as the Saver’s Credit, was established to encourage low- to moderate-income taxpayers to put funds away for their retirement. Up to $2,000 per taxpayer of contributions to an IRA (traditional or Roth) or other retirement plans, such as a 401(k), may be eligible for a nonrefundable tax credit that ranges from 10% to 50% of the contribution, depending on the taxpayer’s income. The maximum credit per person is $1,000.The contribution amount on which the credit is based is reduced if the taxpayer (or spouse if filing jointly) received a taxable retirement plan distribution for the year for which the credit is claimed (including up to the return due date in the following year) or in the prior two years. If the modified AGI exceeds $27,750 (single), $55,500 (married joint) or $41,625 (head of household), no credit is allowed. The amounts indicated are for 2010. Call this office for the rates for other years. An individual who is under age 18, a full-time student, or a dependent of someone else is ineligible. The credit is in addition to any deduction allowed for traditional IRA contributions.
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