With the lure of tax-free distributions,
Roth IRAs have become
popular retirement savings
vehicles since their introduction
in 1998.
But if you’re a high-income
taxpayer, chances are you
haven’t been able to participate
in the Roth revolution. Well,
that’s about to change.
What are the current
rules?
There are currently three
ways to fund a Roth IRA–you
can contribute directly, you can
convert all or part of a traditional
IRA to a Roth IRA, or you can
roll funds over from an eligible
employer retirement plan
(more on this third method
later.)
In general, you can contribute
up to $5,000 to an IRA (traditional,
Roth, or a combination
of both) in 2008 and 2009. If
you’re age 50 or older, you can
contribute up to $6,000 in 2008
and 2009. (Note, though, that
your contributions can’t exceed
your earned income for the
year.)
But your ability to contribute
directly to a Roth IRA depends
on your income level (“adjusted
gross income”; or MAGI), as
shown in the chart below:
Regardless of whether you
contribute directly to a Roth
IRA, if your MAGI is $100,000
or less, and you’re single or
married filing jointly, you can
convert an existing traditional
IRA to a Roth IRA. (You’ll have
to pay income tax on the taxable
portion of your traditional
IRA at the time of conversion.)
But if you’re married filing separately,
or your MAGI exceeds
$100,000, you aren’t allowed
to convert a traditional IRA to a
Roth IRA.
What’s changing?
In 2006, President Bush
signed the Tax Increase Prevention
and Reconciliation Act
(TIPRA) into law. TIPRA repeals
the $100,000 income limit for
conversions, and also allows
conversions by taxpayers who
are married filing separately.
What this means is that, regardless
of your filing status or how
much you earn, you’ll be able
to convert a traditional IRA to a
Roth IRA.
The bad news? This provision
of the new law doesn’t take effect
until 2010.
So why concern yourself
with this now?
Even though the new rules
don’t take effect until 2010,
there are steps you can take
now if you want to maximize
the amount you can convert at
that time. If you aren’t doing
so already, you can simply start
making the maximum annual
contribution to a traditional IRA,
and then convert that traditional
IRA to a Roth in 2010.
Your ability to make deductible
contributions to a traditional
IRA may be limited if you (or
your spouse) is covered by an
employer retirement plan and
your income exceeds certain
limits. But any taxpayer, regardless
of income level or retirement
plan participation, can
make nondeductible contributions
to a traditional IRA until
age 70½. And because
nondeductible contributions
aren’t subject to income tax
when you convert your traditional
IRA to a Roth IRA, they make
sense for taxpayers
contemplating a 2010 conversion
even if they’re eligible to
make deductible contributions.
And don’t forget that SEP
IRAs and SIMPLE IRAs (after
two years of participation)
can also be converted to Roth
IRAs. You may want to consider
maximizing your contributions
to these IRAs now, and then
converting them to Roth IRAs
in 2010. (You’ll need to set up a
new IRA to receive any additional
SEP or SIMPLE contributions
after you convert.)
But there’s a taxing problem
If you’ve made only nondeductible
contributions to your
traditional IRA, then only the
earnings, and not your own contributions,
will be subject to tax
at the time you convert the IRA
to a Roth. But if you’ve made
both deductible and nondeductible
IRA contributions to your
traditional IRA, and you don’t
plan on converting the entire
amount, things can get complicated.
That’s because under IRS
rules, you can’t just convert the
nondeductible contributions to
a Roth and avoid paying tax at
conversion. Instead, the amount
you convert is deemed to consist
of a pro-rata portion of the
taxable and nontaxable dollars
in the IRA.
For example, assume that
in 2010 your traditional IRA
that contains $350,000of taxable
(deductible) contributions,
$100,000 of taxable earnings,
and $50,000 of nontaxable
(nondeductible) contributions. You can’t
convert only the $50,000 nondeductible
(nontaxable) contributions to a Roth.
Instead, you’ll need to prorate the taxable
and nontaxable portions of the account.
So in the example above, 90%
($450,000/$500,000) of each distribution
from the IRA in 2010 (including any conversion)
will be taxable, and 10% will be
nontaxable.
You can’t escape this result by using separate
IRAs. The IRS makes you aggregate
all your traditional IRAs (including SEPs and
SIMPLEs) when calculating the taxes due
whenever you take a distribution from (or
convert) any of the IRAs.
But for every glitch, there’s a potential
workaround. In this case, one way to avoid
the prorating requirement, and to ensure
you convert only nontaxable dollars, is to
first roll over all of your taxable IRA
money (that is, your deductible contributions
and earnings) to an employer retirement
plan like a 401(k) (assuming you have
access to an employer plan that accepts
rollovers). This will leave only the nontaxable
money in your traditional IRA, which
you can then convert to a Roth IRA tax free.
(You can leave the taxable IRA money in the
employer plan, or roll it back over to an IRA
at a later date.)
But even if you have to pay tax at conversion,
TIPRA contains more good news-
-if you make a conversion in 2010, you’ll
be able to report half the income from the
conversion on your 2011 tax return and the
other half on your 2012 return.
For example, if your only traditional IRA
contains $250,000 of taxable dollars (your
deductible contributions and earnings) and
$175,000 of nontaxable dollars (your nondeductible
contributions), and you convert
the entire amount to a Roth IRA in 2010,
you’ll report half of the income ($125,000)
in 2011, and the other half ($125,000) in
2012.
And speaking of employer retirement
plans…
Before 2008, you couldn’t roll funds over
from a 401(k) or other eligible employer
plan directly to a Roth IRA unless the dollars
came from a Roth 401(k) account or a Roth
403(b) account. In order to get a distribution
of non-Roth dollars from your employer
plan into a Roth IRA you needed to first
roll the funds over to a traditional IRA and
then (if you met the income limits and other
requirements) convert the traditional IRA
to a Roth IRA. And, as described earlier,
you needed to aggregate all your traditional
IRAs to determine how much income tax
you owed when you converted the traditional
IRA.
The Pension Protection Act of 2006
streamlined this process. Now, you can
simply roll over a distribution of non-Roth
dollars from a 401(k) or other eligible plan
directly (or indirectly in a 60-day rollover)
to a Roth IRA. You’ll still need to meet the
$100,000 income limit for 2008 and 2009.
tax on any taxable dollars rolled
over.
One benefit of this new procedure
is that you can avoid the proration
rule, since you’re not converting a
traditional IRA to a Roth IRA. This
can be helpful if you have nontaxable
money in the employer plan
and your goal is to minimize the
taxes you’ll pay when you convert.
For example, assume you receive
a $100,000 distribution from
your 401(k) plan, and $40,000 is
nontaxable because you’ve made
after-tax contributions. You can
roll the $60,000 over tax free to a
traditional IRA, and then roll the
after-tax balance ($40,000) over to
a Roth IRA. Since only after-tax dollars
are contributed to the Roth IRA,
this rollover is also tax free. (Both
your plan’s terms, and the order in
which you make the rollovers, may
be important, so be sure to consult
a qualified professional.)
Is a Roth conversion right for
you?
The answer to this question depends
on many factors, including
your income tax rate, the length of
time you can leave the funds in the
Roth IRA without taking withdrawals,
your state’s tax laws, and how
you’ll pay the income taxes due
at the time of the conversion. And
don’t forget—if you make a Roth
conversion and it turns out not to
be advantageous, IRS rules allow
you to “undo” the conversion (within
certain time limits).
A financial professional can help
you decide whether a Roth conversion
is right for you, and help you
plan for this exciting new retirement
savings opportunity.
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Financial Advisor
Waddell & Reed
888-569-6690
wbrewer40265@wradvisors.com
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