Posted on February 4, 2014May 31, 2016 by Jan Roberg

ROTH IRA Strategy for High Income Earners

High income earners are often excluded from the tax-free retirement benefits of a Roth IRA, but you may be able to work around it.

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Perhaps you’ve heard about how great a ROTH IRA is: You put your money in an account and it grows tax free and when you take the money out at retirement time you get it all tax free. Awesome, right? Zero percent is a good tax rate. But if you’re in a high income bracket (see the chart below), you’re not eligible to contribute to a ROTH. But there may be a way around that for you. It’s called a ROTH IRA conversion. Here’s how it works:

Even though your income may prevent you from making a ROTH IRA contribution, there is no income limit for a Traditional IRA contribution. This is important—there is no income limit to making a Traditional IRA contribution. There are income limits as to whether it is deductible or not—but no limits as to your ability to make an IRA contribution.

For example: let’s say you earn $200,000 a year and you have a 401(k) plan at work. You can’t make a ROTH IRA contribution and you can’t have a deductible Traditional IRA contribution either. What you can do is make “non-deductible” contribution to a traditional IRA.

A non-deductible contribution to an IRA pretty much does the same thing as a ROTH—it grows tax free and at retirement it you can take it out tax free. The problem with the non-deductible IRA is that when you take it out, you take it out proportionately with your taxable IRA money.

For example: let’s say you have $20,000 on non-deductible IRA invested and another $80,000 in a traditional IRA that you rolled over from your 401(k) account for a total of $100,000 in IRA funds. You want to take the $20,000 of non-taxable money out. You can’t do it. If you take $20,000 out, the IRS is going to tax $16,000 of it because the non-taxable money comes out proportionately to the taxable money.

(Geek time: 20K + 80K = 100K

20K divided by 100K = .2 or 20 percent

$20,000 times 20% = $4,000 that is tax free

$20,000 – $4,000 = $16,000 taxable IRA)

So this is where the ROTH IRA conversion comes in. If you don’t have any money in a traditional IRA yet, then you can take that non-deductible IRA and convert it to a ROTH IRA with no tax consequences. There are currently no income limitations on doing a ROTH IRA conversion.

If you convert your money into a ROTH IRA, then when you want to take that money out—you’re taking it out of the ROTH. There is no equation determining how much is taxable or non-taxable—it’s all in the ROTH and it’s all non-taxable.

Now if you’ve already got money in a Traditional IRA, this strategy might not work for you because you’d be taxed on those funds during the conversion. If the total amount is fairly low, you might want to consider rolling it all over and taking the tax bite. You’d want to discuss that with your financial advisor and tax person before attempting that.

But if you don’t have any Traditional IRA funds, the non-deductible Traditional IRA contribution and ROTH IRA conversion might be a good strategy for setting aside some tax free retirement income for you.

Incomes where the ROTH IRA is completely phased out (2013):

Married filing jointly: $188,000
Single or head of household: $127,000
Married filing separately: $ 10,000

Posted on October 4, 2011May 31, 2016 by Jan Roberg

Cancelling Your Roth IRA Conversion

Photo by voxtheory on Flickr.com

Whoa, that Roth IRA conversion you did last year seemed like such a great idea at the time didn’t it? I know I thought it was pretty wonderful. But things change and with the stock market tanking, your portfolio is probably not worth what it was back when you did the conversion. For some people, now might be a good time to – here’s the important IRS word: Recharacterize your IRA.

Basically, to recharacterize your IRA, you’re taking all the money that you “converted” and put it back into your Traditional IRA. You will need to talk with your financial adviser and fill out the proper forms to do this. You also have a deadline: you must complete the transaction by October 17th, so you don’t have a lot of time to work with here.

Once you recharacterize your Roth IRA, it will be like it never happened, so you’ll have to amend your tax return to eliminate the Roth conversion that you reported last April and claim a refund. But that might be the smartest tax move you ever made. Let’s take a look at an example:

Porky Pig is in the 25% tax bracket and he made a $10,000 Roth IRA conversion for tax year 2010. The cost of the conversion to Porky was $2500. But now, because of the stock market, Porky’s Roth IRA is only worth $8500. It’s like he paid $325 too much in tax. Is that enough for Porky to make a change? For me it is, but for some people it might not be.

Let’s take a look at Porky’s friend Bugs Bunny. Bugs did a larger conversion; he rolled over $50,000 into a ROTH IRA. Bugs has a tax rate of 33% so he paid $16,500 for his Roth IRA conversion. Bugs also had a bigger portfolio drop than Porky, his Roth IRA went down by 20% to $40,000. Bugs paid $3,300 too much in taxes for his Roth conversion. I would think that $3,300 has got to be too much tax by anyone’s standards.

So what should you do if you made a conversion and your portfolio tanked? First, you’ll want to make an analysis similar to Bugs and Porky’s. What’s the true cost to you in terms of taxes? Don’t forget how much it will cost to amend returns and pay your broker fees. If it makes sense to recharacterize, then by all means, do so.

Don’t get me wrong, I’m still a big fan of Roth IRAs and I still think that the Roth IRA conversion is a great tool, especially for people whose incomes are too high to make regular Roth contributions. It’s just that if recharacterizing your Roth can save you a large amount of tax money, you really should consider doing it.

Can you do a Roth conversion again later? Yes, but you’ll have to wait for at least 30 days before you do it. You’d be reporting the conversion on your 2011 return (unless you wait until 2012.) You would not get the advantage of being able to split the tax payment between two years.

I hope this sheds a little light on the situation. Remember, the deadline to recharacterize your Roth IRA to a Traditional IRA is October 17. Don’t wait until the last minute, remember that your financial adviser will need time to process the paperwork.

Posted on April 1, 2011May 31, 2016 by Jan Roberg

Reporting the ROTH IRA Conversion on your Tax Return

Retirement by Scott Wills

It might have seemed like a simply marvelous idea at the time, but lots of people who did the ROTH IRA conversion are having a bear of a time getting it all sorted out on their income tax returns. If you’re one of those people, hopefully this will help.

I’m going to tell you where the numbers should show up on the form. If you know where things are supposed to go, then you’ll know if it’s right or not. Quite frankly, the most difficult part for me has been using the computer software to get the numbers to go in the right place.

Let’s run a few different scenarios, all using a rollover of $15,000. In all of the scenarios, you’re going to use form 8606 to let the IRS know that you did a ROTH conversion instead of just taking the money out and spending it. This will keep you from being charged the 10% penalty for early withdrawal.

In our first example, you’re rolling over $15,000 from a traditional IRA and you have no basis (meaning you didn’t pay taxes on any of the $15,000.) Down near the bottom of the first page of the 8606 is Part II, the section about ROTH IRA conversions. Question 16 wants to know the amount that you converted: that’s $15,000. Line 17 will be blank, line 18 will be the taxable amount of $15,000. Lines 19 and 20 are based upon if you’re paying the tax in 2010 or if you’re splitting it between 2011 and 2012. If you’re paying the tax this year, then you’ll have the number 15,000 on line 15b of your 1040 form. If you’re putting off paying until next year, then that line will be blank.

One of the questions I’ve been asked is, “If I don’t pay the tax this year, how does the IRS know that I’m supposed to pay it next year?” Line 20. Rest assured, anyone with numbers in lines 20a and 20b will have their returns looked at during the next two years to see if they remembered to pay the tax. I guarantee it.

Our second example still has you rolling over $15,000 and that’s all the money you have in your IRA. What’s different is that you paid taxes on $5000 of that money. Just like before you put 15,000 on line 16, but now you put $5000 basis on line 17. That makes the taxable amount only $10,000. You decide about whether to pay now or later.

Our third scenario is a little trickier. You’re still rolling over $15,000 and your basis is $5,000—the difference this time is that you have a total of $60,000 total in your IRA. Unlike the above example, you can’t just deduct the $5,000 of basis from what you rollover, it has to be proportional to your total IRA amount. 5000/60,000 equals 8.33%. That percentage of 5000 is $417. You’ll put $15,000 on line 16 for the rollover, $417 on line 17 for the basis. That means that the taxable amount on line 18 will be $14,583. (I know, it doesn’t sound as good as the other scenarios does it?) Don’t forget that you still have $4,583 in basis to use if you do any conversions in the future.

And our last scenario, you have $5,000 in basis from before and you made a $5000 non-deductible IRA contribution this year. The $15,000 is your entire IRA. This time, you also have to fill out Part 1 of form 8606. On line 1 you will put $5,000—the contribution you made this year. On line 2 you will put $5,000 the basis you had before. One line 3 your add them together for $10,000. Then you’re going to skip down to Part 2 (unless you had SEP and SIMPLE IRAs) and put $15,000 on line 16. Your total basis will be $10,000 on line 17, and your taxable conversion will be $5,000.

Knowing what form you need and where the numbers go is only half the battle. Getting the numbers to go where they’re supposed to go using computer software can be more challenging than doing it by hand. If you’re using brand name software like Turbo Tax, you can call their expert hotline for help.

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Posted on October 11, 2010May 31, 2016 by Jan Roberg

Roth IRA Conversions-In Plain English

A real deer in headlights, not my husband.

I was having dinner with my husband and was telling him that we needed to think about doing a Roth IRA conversion this year. The more detail I went into, the further his eyes glazed over. Finally, he waved his hand over his head and said, “You do the calculations and let me know if we should or not.” He gets that way when I go into “tax speak.” He’s not stupid either, he understands money, he has an MBA, but taxes tend to give him that deer in the headlights look. I’m guessing he’s not alone. Here’s my attempt at making it easy.

A regular IRA is money that you get a tax deduction for when you put the money in, but you pay taxes on it when you take the money out. If you take the money out before you’re 59 1/2, you also pay a 10% penalty on top of the tax you pay for taking it out.

A Roth IRA doesn’t give you any tax deduction when you put the money in, but when you take it out there is no tax on the withdrawl. The penalty, if you take it out early, is only on the earnings, not the main amount of money. It’s usually very small.

The whole issue of Roth vs regular is Pay Now or Pay Later. Normally I’m a “pay later” kind of person, but I like the benefits of the Roth so much that they often outweigh the disadvantage of Pay Now.

So what’s a Roth conversion? That’s when you have money that you put into a regular IRA and move it into a Roth IRA. When you do that, you will have to pay tax on the IRA money, but you won’t have to pay the penalty.

Why would anyone want to do that? It’s back to pay now versus pay later. It looks like tax rates will go up in the future. Roth IRA money would be tax-free income during retirement and we all like tax free income!

Why is it a big deal now? Normally, you can only convert to a Roth IRA if your income is less than $100,000 — that’s including the money being moved into a Roth IRA because that also counts as income. For this year only, 2010, there is no income limit. Anybody can play.

So what’s the catch? If you do a conversion, you have to pay the tax. You have two choices: 1. You pay all of the tax on the conversion with your 2010 tax return, or 2. You split the tax you pay into two equal installments with your 2011 and 2012 taxes.

Once again, normally I’m a pay later person, but right now Congress hasn’t extended the Bush tax cuts yet. Until we hear otherwise, tax rates are scheduled to go up for 2011. I’d make my decision based upon paying it all in 2010. If things change, then you’ve got options, otherwise, go for pay now.

Do I have to convert all of the money in my IRA to a Roth? No. Only as much as you want/can afford to.

Do you think I should do it? That depends. The younger you are, the more inclined I am to say yes. If you’ve ever put money into an IRA that you didn’t get a deduction for, I’m more inclined to say yes. How are you going to pay the additional tax? If you’re going to take it out of the IRA money you withdraw, then I’m definitely leaning against that. If’ you’ve got it in savings, or have withheld extra and are just giving up a big refund, then you’re good.

Bottom line is: as much as I like Roth IRAs and this is a once in a lifetime opportunity, it also involves paying more taxes. If you have the cash and can afford to do it, I say go for it. If you’re cash strapped already, it’s not such a good choice.