Monday, January 25, 2010

Important Tax Changes for 2010.....written by Greg Gann

There are two very important tax differences which distinguish Roth IRA’s from traditional IRA’s. The first is that distributions taken from a Roth are not taxed, provided the Roth has been funded for a minimum of five years and the distributions commence after the recipient reaches age 59.5. The second benefit is that a Roth does not require taking minimum distributions beginning at age 70.5 as do traditional IRA’s. They also can be left for a beneficiary without the beneficiary having to deplete from her inheritance the applicable income taxes, as would be the case for a beneficiary who is left a traditional IRA. A Roth allows annual contribution amounts of up to $5000 or $6000 for folks age fifty and over provided adjusted gross income falls between $105,000- $120,000 for single filers and $167,000-$177,000 for joint filers. Prior to January 1, 2010, in order to convert a traditional IRA into a Roth, adjusted gross income could not exceed $100,000.

Today, however, there are no income limitations as to who is and who is not eligible to convert. In addition, there was an added change provided by the IRS, which only exists for the 2010 tax year. The change is that the IRS has granted the option to claim 50% of the conversion amount as income in 2011 and the remaining half in 2012. If one elects to defer and pay the tax over the two year period, he or she will pay the tax based on his or her tax bracket for that year. This could be more costly and therefore less advantageous if say the taxpayer expected a bonus or other qualifying event that would make 2012 a higher tax year. Because money in a traditional IRA has never been taxed, any distribution from a traditional IRA is considered income in the year in which it is received. Converting from a traditional IRA to a Roth IRA is considered a distribution, and therefore can substantially impact income taxes due in the year of conversion. It can even throw a taxpayer into a much higher tax bracket. This part of a conversion for tax purposes is very clear. Where it gets a little more complicated is for those tax payers who maxed out on deductible retirement plan contributions, but nonetheless funded a traditional IRA with after-tax contributions in order for the proceeds to grow tax deferred.

Unfortunately, we are not permitted to segregate the pre and post-tax contributions thereby allowing the post-tax contributions exclusively to be withdrawn to avoid income taxation when making a conversion, and a specific three step formula must be followed. Step one is to divide the total after tax contribution by the total IRA account balance to come up with a non-taxable percentage. Step two requires multiplying that percentage by the total amount that is desired to be converted. The quotient reached in step two is subtracted in step three from the total amount desired to be converted.

Example: Let’s say we contributed total after-tax contributions to a traditional IRA over the years of $50,000. And, let’s also establish that the total value of the traditional IRA, (including both pre and post tax contributions totals $300,000). And let’s say that we desire to convert $100,000 of the IRA.

Step 1: Total after-tax contributions / Total IRA account balance: ($50,000/ $300,000 = 16.67%)

Step 2: 16.67% x 100,000 = $16,667

Step 3: $100,000 - $16,667= $83,333.

The example illustrates that converting $100,000 from a traditional IRA to a Roth IRA will result in our having to pay additional income tax on 83,333 of income in that tax year. However, there may be a way around this aggregation rule. If an employee’s company retirement plan such as a 401k plan allows rollovers into that company-sponsored plan, then the employee could roll just the pre-tax contributions into that company plan, leaving the IRA with only the post-tax contributions.* This would result in the IRA holding only contributions that have already been taxed, and therefore, a rollover of this amount could avoid the above pro-rata aggregation rules. For self-employed individuals or even part-time independent contractors, it may make sense to open an individual 401k plan for that full or part-time business, particularly if they have made fairly significant non-deductible IRA contributions over the years. In any event, as you can see, there are complex rules relating to Roth IRA conversions, and there is no easy one size fits all answer for all individuals. But, with the present bonus of the option to pay the additional taxes spread over two years as well as the income restrictions being lifted in the 2010 tax year, it may make sense to know all your options. It is also important to note that the decision to convert can be circumvented after the fact through what is called a re-characterization. The re-characterization effectively makes the prior transfer null and void, but the decision must be made by October 15th of the calendar year after the year of conversion. If there were large gains in the IRA account which would result in large taxes, then it might make sense to re-characterize.

Stay tuned. Part two will highlight other significant tax changes for the year.

*Depends on your 401(k) plan. Please see your plan administrator for information on your particular plan. Please talk to your financial advisor and tax advisor for advice on your specific situation prior to executing any strategy as individual situations may vary.