If you’ve been around the blog, I’m sure you’ve noticed that I’ve written much on the Roth IRA 2010 conversion event.  It’s been getting a ton of buzz as many are eager to enjoy the tax free benefits of the Roth IRA.  As with anything, just because your neighbor is doing it, doesn’t mean you should.   We took a closer look of the some of the unforeseeable consequences of the Roth conversion and uncovered some potential pitfalls that you may have if you convert without knowing all the facts.  Another important issue for parents who have children going to college soon is the impact that a Roth conversion can have your kid qualifying for financial aid.  Tax free is nice for down the road, but converting too much could leave you with a hefty tuition bill.

Benefits of the Conversion

As of now, you won’t pay any taxes for any money in the Roth.   And if you’re a believer that taxes having a greater chance of going up then down, then why not pay the tax now and enjoy tax free growth later on?  Another benefit pertains to estate planning.   Seniors that reach 70 1/s are not required to take out their required minimum distributions in a Roth and if they never use the money; can pass the money on to their heirs tax free.

Roth Conversion and Your FAFSA

There’s no “if’s”, “and’s”, or “but’s” about it, a conversion is what is its and that “is” taxable.    Many forms of scholarships, grants, and loans are based on the household income.  In the event, you do a sizeable conversion, you’ll see the your AGI rise and the financial aid office take a closer look.

The dollar amount you convert must be reported on your FAFSA (Free Application for Student Aid).   Here’s a definition of the FAFSA form straight from their site:

The Free Application for Federal Student Aid (FAFSA) is the form used by the U.S. Department of Education to determine your Expected Family Contribution (EFC) by conducting a “need analysis” based on financial information, such as income, assets and other household information, which you (and your parents if you are a dependent student) will be asked to provide. The form is submitted to, and processed by, a federal processor contracted by the U.S. Department of Education (ED), and the results are electronically transmitted to the financial aid offices of the schools that you list on your application.

FAFSA is the application used by nearly all colleges and universities to determine eligibility for federal, state, and college-sponsored financial aid, including grants, educational loans, and work-study programs.

Bottom line it’s all about the Benjamin’s and how many you have of them.  If your AGI is higher because of an sudden increase due to a conversion, it could mean less financial aid to pay those tuition bills.

A New York Times article offered an example. Take a hypothetical family of four with total 2010 income of $75,000 and one college student. For every $10,000 of taxable income stemming from a Roth conversion, the parents’ expected annual contribution to that student’s education would go up by $3,200 in a FAFSA estimate.¹

Financial Aid Looks at More than One Year

When it comes to your income, financial aid considers more than just one year.   As you know (or you will now), the default election to pay the tax on the conversion is to defer this year (2010) and split the remaining portions 50/50 over 2011 and 2012 tax years.  Essentially, doing a conversion today could affect your chances of financial aid well until 2013.

What if Your Kids Are Young?

Then regarding college and financial aid, it shouldn’t matter.   Now that still doesn’t mean that a Roth conversion is right for you.

The potential long-term benefits of a Roth IRA conversion are considerable. Double check with your financial advisor or tax professional to see if the decision is appropriate before you elect to make the move.

Citations.

¹ bucks.blogs.nytimes.com/2010/04/16/how-a-roth-i-r-a-conversion-can-hurt-financial-aid/ [4/16/10]

photo credit: Quack the Wooley Duck

This is another guest post from JoeTaxpayer.  On my blog, I’ve shared several articles that discussed the Roth IRA conversion event of 2010 in great length and detail.  While this is can be a great opportunity for many, there are several instances that a conversion does not.  I looked to JoeTaxpayer to share some pros and cons of the Roth IRA conversion and for unforeseen consequences that could result.

photo credit: KayVee.INC

There’s been much hype regarding the ability for anyone to convert their retire money to Roth regardless of their income. Many professional planners and writers of financial blogs have offered compelling reasons why one should convert. Today, I’d like to share some scenarios where you might regret that decision.

You don’t have a crystal ball

All signs point to higher marginal rates, this is one factor that prompts the advice to convert, but who exactly would that impact, and by how much? Let’s look at the first risk of regret. You are single, and an above average wage earner, just barely in the 28% bracket. (This simply means your taxable income is above $82,400 but less than $171,850, quite a range). Any conversion you make now is taxed at 28%, by definition. You get married, and start a family quickly, your spouse staying home. That same income can easily drop you into the 15% bracket as you now have three exemptions, and instead of a standard deduction, you have a mortgage, property tax and state tax which all put you into Schedule A territory and a taxable income of less than $68,000. Now is when you should use the conversion or Roth deposits to take advantage of that 15% bracket, before your spouse returns to work and you find yourself in the 25 or 28% bracket again. It’s then that you should convert enough (or use Roth in lieu of traditional IRA) to ‘top off’ your current bracket.

Life isn’t linear

It’s human nature to expect the next years to be very similar to the past few. Yet, life doesn’t work quite that way. The person who makes more money year on year, from their first job right through retirement is the exception. For more people, there are layoffs, company closings, major changes in family status, disability, and even death. Except for permanent disability or death, the other situations can be considered opportunities to take advantage of a full or partial Roth conversion. If one should become disabled, the ability to withdraw that pretax money at the lowest rates is certainly preferable to having paid tax on it all at your marginal rate.

Transferring your 401(k)

The Roth conversion is available for holders of 401(k) (and other) retirement accounts as well as holders of traditional IRA accounts. Back in October 07, I cautioned my readers on a somewhat obscure topic they need to be aware of when considering a transfer from the 401(k) to their IRA and the same caution exists for conversion to a Roth. Net Unrealized Appreciation refers to the gains on company stock held within your 401(k). The rules surrounding this allow you to take the stock from the 401(k) and transfer it to a regular brokerage account. Taxes are due only on the cost of that stock, not the current market value. The difference up to the market value at time of sale (thus the term Net Unrealized Appreciation) is treated as a long term capital gain. Current tax law offers a top LT Cap Gain rate of 15%. A loss of 10% or more if you are in the 25% bracket or higher and convert that company stock to a Roth.

Taking Money At Retirement

Given the low saving rate of the past decades, all projections point to fewer than the top 10% of retirees coming close to ‘retiring in a higher bracket.’ Consider how much taxable income it would take to be at the top of the 15% bracket in 2010. For a couple, the taxable income needs to exceed $68,000. Add to this two exemptions, $3,650 ea, and an $11,400 standard deduction. This totals $86,700. Using a 4% withdrawal rate, it would take $2,167,500 in pretax money to generate this annual withdrawal. What a shame it would be to pay tax at 25% to convert only to find yourself with a mix of pre and post-tax money that puts you toward the bottom of that bracket. Whose marginal rates do you believe will rise? Couples making less than $70,000? I doubt it. What’s the risk? That you should be in the 25% bracket at retirement? That’s still break even in the worst scenario.

What About Your Beneficiaries

While a tax-free inheritance might be great for the kids, a properly inherited, properly titled Beneficiary IRA can provide them a lifetime of income. Consider, if you leave a portion of your traditional IRA to your grandchild, a 13 year old, his first year RMD (required minimum distribution) will only be about 1.43% of the account balance. For a $100,000 account left to him, this RMD falls shy of the current $1900/yr limit before he is subject to the kiddie tax. To insure that he doesn’t withdraw the full remaining amount at 18 or 21, consult a trust attorney to set up the right account for this purpose. If left to your own adult children, the advantage can go either way depending on their income and savings level.

Are You a Philanthropist?

photo credit: ckaiserca

If you don’t have individual heirs you wish to leave your assets to, the ultimate poke at Uncle Sam is to leave your money to charity. No taxes at all are due. Leaving Roth money to charity just means that our government already got its piece of the pie.

Avoiding Roth IRA Conversion Regrets

Today, I’ve shared with you some scenarios that are cause for regretting a conversion. As I always caution my readers, your situation may differ from anything I addressed here, and your unique needs are all that matters. If you have any questions on when or if a conversion makes sense for you, post a comment and we’ll be happy to discuss.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Please see a tax professional before implementing any sort of IRA conversion. Joe TaxPayer is not affiliate or endorse by LPL Financial.

Securities offered through LPL Financial, Member FINRA/SIPC

Roth IRA Rollover from 401k

Whenever you leave your job, you have a decision to make with your 401k plan. Typically, most people will initiate a 401k rollover to a traditional IRA. A common question that I’ve been getting lately is if you can roll over your 401k into a Roth IRA and how you do it.  Or if you have been contributing to a Roth 401k…..then what are your choices? Let’s see if I can help you make “cents” of the situation. Here’s how you rollover 401k into a Roth IRA.

If you like this article you may also like:  401k Rollover Options to IRA, 7 Common Mistakes When Rolling Over Your 401k, 401k Rollover Offers Wide Range of Benefits Also, be check out everything about the Roth IRA Rules.

Roth IRA Rollover Rules From 401k

Reminder: You must be separated from your employer to roll your 401k into a Roth IRA. You CANNOT do this if you are still working for the same company and/or employer (unless your over 59 1/2).

Prior to January 1, 2008 you were simply not able to directly rollover your 401k into a Roth IRA.  If you wanted to do so you had to complete a two-step process.  (Keep in mind that this would also apply to old Simple IRA’s, SEP IRA’s and 403b’s, 457, and qualified pensions, too)

1. Open a Traditional IRA.
2. Convert the Traditional IRA to a Roth IRA.

Since you were a converting to a Roth IRA you had to follow the Adjusted Gross Income limits (had to be less than $100,000 for 2009).  Of course, in 2010 these limits disappear.  I say “of course” because I’ve already written a few posts on the topic.

Just because the law changes made it available to rollover into a Roth IRA doesn’t mean that you can do it.  Doing so all depends on your plan administrator.  For example, recently I had two clients who intended to roll their old retirement plans into a Roth IRA.  One client had an old military retirement plan- Thrift Savings Plan (TSP) and the other had a old state retirement plan.  Upon helping each of them complete the paperwork, I came across an interesting discovery.   The TSP rollover paperwork had a box that you could mark if you wanted to rollover the plan into a Roth IRA (The instructions added to make sure you had a Roth IRA already established).  The state retirement plan did not give that option.   So the only option was to open a traditional IRA to accept the rollover then immediately convert it to a Roth IRA.  If that seems like a hassle….it is.   The state retirement plan is not the only one that I’ve encountered with this.  Many 401k’s and 403b’s have had the same “No-Roth IRA Rollover” option.  This option is supposed to be mandatory in 2010, but some still do it on a voluntary basis.

Recap on Roth IRA Conversion Rule

For 2009, you and/or your spouse are limited to $100,000 AGI to do the the Roth IRA conversion.  That also applies to converting from a 401k, as well.  In 2010, anybody will be able to take all their traditional IRA’s and old retirement plans and convert them to a Roth IRA.  The amount you convert will be taxed, but you can spread the bill over three years. (The tax would be deferred in 2010. Then 50% would be paid in 2011 and the rest in 2012.)

For 2011, these rules have stayed in force and don’t see to be going away.  The only difference now is that you have to pay all the tax in the year that you actually convert.

How Do I Rollover if I Receive the Check?

photo credit: amanky

If you receive a distribution check from your 401k rollover to a Roth IRA then chances are they will hold around 20% for taxes. If you want a direct 401k rollover to a Roth IRA, you may want to send that check back to your employer 401k provider and ask to be sent all of your eligible retirement distribution directly to your new Rollover IRA account (not as a check, or they will just give you 80% again). You have 60 days upon receiving the check to get the money into the Roth IRA- no exceptions!  So don’t procrastinate on this one.

What About the Roth 401k?

If you employer offers a Roth 401k and you were savvy enough to take part, the path to a rollover is that much simpler.  No need for a conversion here.   You would simple just roll the Roth 401k directly into the Roth IRA.  That’s what I call “simply satisfying”.

How You Can Rollover Your 401k by Following These Steps

1. You have to have a Roth IRA open/established before you can do any of this.
2. Don’t forget about the AGI limits if you are doing this in 2009 (Does now apply 2011 and thereafter).
3. Rolling from a traditional 401k to a Roth IRA will be a taxable event.

*Restrictions, penalties and taxes may apply.  Unless certain criteria are met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.

In 1982 the Violent Femmes released the title track to their debut album “Gone Daddy Gone” that went on to be an epic album.   Almost just an epic event is the lifting of the $100,000 AGI (Adjusted Gross Income) restriction for individual or couples that are looking to do a Roth IRA Conversion.   As it stands right now, for any tax payer no matter your filing status, you are unable to do a conversion if you exceed this limit.  Most everybody knows (if not, then you know now) that in 2010 these restrictions are lifted and anyone and their brother will be able to do the Roth Conversion.  If this applies to you, here are some tips to get you prepared for the Roth IRA Conversion event when the restrictions are officially “gone daddy gone”.

2010 the AGI Limits are "Gone Daddy Gone"

If this article was helpful, you may also want to check out these posts as well: 7 Things To Know About The 2010 Roth IRA Conversion, Roth IRA Time To Convert, 7 Things To Know About Roth IRA 2009.

Start Preparing Now For The Conversion

Basically, there are two ways that you can prepare you for the  Roth IRA conversion in 2010.

Initially, you need to review all of your old retirement plans that you may have.   This can include: traditional IRA’s, SEP IRA’s, Simple IRA’s, old 401k’s, old 403b’s.   Once you get those sorted out, add them up to get an approximate total value.   Once you get the sum, you’ll now have a sense of what your tax bill will be.   A couple things to consider:

1. Most likely your accounts are down if they were anywhere close to the stock market.   This could make it that much more of an attractive opportunity to convert.
2. Remember that when you convert in 2010, you have the option to deferring the tax over 2011 and 2012 at a 50/50 split.  This option is only available in 2010.

Also, keep in mind that although you can split the tax between those two years (2011 and 2012), the actual tax that is due will be based on your tax bracket in that year.

Example

You have a $50,000 old traditional IRA that you want to convert to a Roth IRA in 2010.   You elect to split it over the 2011 and 2012 tax years so that you claim $25,000 of ordinary income in 2011 and then again in 2012.   If for some reason your income is abnormally higher (raise in salary as an example) in 2011, you’ll end up paying more in tax that year than you would have previously.  In short, it’s not based on your tax bracket in the 2010 year.

The “Backdoor” into a Roth IRA using Traditional IRA

Many people have wanted to take advantage of the Roth IRA for the past several years, but couldn’t because they surpassed the Roth IRA phaseout limits.  Many then settled for the pretax substitute of the traditional IRA.   The only problem with the traditional IRA (other than paying taxes at retirement) is that after certain income limits you no longer get a tax deduction for contributing to one.   You still get the tax deferred growth, but that’s it.

If you are an active participant (making annual additions or accruing a benefit) in a company plan and make more than $65,000 as a single taxpayer in 2009 (or $109,000 as a married joint taxpayer) then you are disqualified from taking the full deduction.  What you are then left with is the nondeductible IRA.

Introducing the Nondeductible IRA

In the past, there was nothing all that attractive about the nondeductible IRA.   With 2010 just around the corner, the nondeductible IRA has become a very popular tool to allow high wage earners a way into the Roth IRA- a “backdoor” way.  A high wage earner can contribute to a nondeductible IRA with the sole intentions of converting it in 2010.

By contributing to the nondeductible IRA, you will only be responsible to pay what gains you’ll have from now until you convert in 2010.   If 2009 will be the first year to contribute, then unless you happen to pick a one in a million shot, your tax liability should be minimized.

The Five Year Rule

One last consideration when converting to a Roth IRA is the five year rule.   As when you make a contribution into a Roth IRA, you have the same five year holding period for the earnings applies to the conversion amount. This is the amount that you will be able to take tax and penalty free.  (Remember: When you contribute new money to a Roth IRA its only the earnings that have to wait 5 years not the contributions). Here’s a few things to consider:

1. The five year holding period begins January 1st of the year that you convert.  For example, if you converted on November, 1st 2008 then the five year holding period began on January 1st of that year.
2. If you have already converted in the past, then each new conversion begins a brand new 5 year holding period.  Let’s say you were able to previous able convert in 2006 and you plan to convert again in 2010, then each of those conversions would be subject to their own 5 year holding period.
3. Lastly, if you decide to convert and then change your mind, you always have the option to recharacterize.  Recharacterization of an IRA is the equivalent to a mulligan on the golf course.

*Restrictions, penalties and taxes may apply.  Unless certain criteria are met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.

Securities offered through LPL Financial, Member FINRA/SIPC

4 Things Making You Poor

Do you always feel that that you can never catch up financially?  For many, the rate race seems like a never ending cycle.  You got to work, clock in, get your paycheck and your left scratching your head what you can do to get yourself on financial track.   If you feel alone, don’t. There are many things you can do to get your investment situation on track, but for the mean time, here’s four things that are making you poor that you can change today.

1.  Throwing extra cash in your checking account.

It’s definitely very wise to save and have a good chunk in savings.   You should keep at least 8 months worth of emergency funds (12 months if your income is unpredictable) in a high-yield savings account.   But over and above that, your missing out on the potential to earn more.  Consider doing a CD Ladder.   Just stop losing money by not taken advantage of the opportunity to potentially earn more.

2. Giving in to 401k Temptation

Doesn’t that new TV sound tempting?  Or maybe you just realized that you need to buy new tires and are not sure where you are going to get the funds (because you haven’t done #1).  Then it dawns on you- your 401k! Stop right there before the thought goes even further. Your 401k is not your savings account.  That’s your nest egg for down the road, so keep your hands off.  If you decided to take it, figure on paying a minimum 20% in tax plus a 10% penalty if you’re under 59 1/2. Giving away 30% to Uncle Sam is a sure way make yourself poor really quick.

3.  Leaning too heavily on a 401k.

If you’re single and earn less than $116,000 a year, or are married and filing jointly and earning less than 169,00k, congratulations! You are now allowed to participate in one of the greatest retirement investments of all time.  I’m talking about the Roth IRA.  Investing in a Roth IRA means you set aside money now, watch it grow for decades and then cash out without paying a dime in taxes. A recent study found that only 15% of American households have a Roth IRA.  Are you part of the 85%?  Don’t be.  Here’s what you need to about the Roth IRA rules for 2009.

4. 2010 tax bill- Save up Now.

In 2010, anybody will be able to take all their traditional IRA’s and old retirement plans and convert them to a Roth IRA.  The amount you convert will be taxed, but you can spread the bill over three years.  You might want to start saving for the tax bill now, because the 2010 conversion event will be an opportunity you will want to capitalize on.  May end up being the best money move you’ve ever made.

Securities offered through LPL Financial, Member FINRA/SIPC

Roth IRA Rules for 2009

Iknow, I know.  Another post on the Roth IRA?  I wouldn’t write about it again, if I didn’t feel it wasn’t important to write about.  If you haven’t realized this, the Roth IRA and Roth 401k will have a huge impact on retirement planning over the course of the next several decades and it’s important to understand how the rules work.

For the Gen X and Gen Y crew, the Roth IRA will be an important piece of their investment arsenal.  Actually, for anybody under the age of 50 the Roth IRA rules as the best retirement plan option in this writers humble opinion.  I don’t want to isolate all my baby boomers out there.  Depending on your planning needs, the Roth IRA could make sense for you as well.  For 2009, there have been some significant changes in the Roth IRA rules and phaseout limits.  Here’s what you need to know on the Roth IRA rules for 2009.

Update: Check out 7 Things to Know About Roth IRA for 2010.

If this article was helpful, you may also want to check out these posts as well: 7 Things To Know About The 2010 Roth IRA Conversion, 2009 401k Contribution Limits Have Increased, 2010 Traditional IRA to Roth IRA Conversion Tax Rules

1.The annual contribution limit for 2009 has stayed at $5,ooo.

If you are over the age of 50, the “catch up” contribution has stayed at $1,000.  That’s a a total of $6,000 for the baby boomer looking to maximize their retirement savings.

2.Roth IRA Conversion Rules.

As I stated previously, if your income limits allow, you may want to convert to a Roth IRA with the market being down as much as it is.  The only downside is that you have to fit the tax bill all this year (not actually due until April 15th, 2010).  If you wait until the 2010 Roth IRA Conversion Event you have two things to consider:

• The IRS is allowing you to spread that tax bill over two years and the taxes are not completely due until 2012.
• If the market does recover in 2009 (fingers crossed, knock on wood, click my heels three times…) and your investments appreciate, you’ll be fitted with a larger tax bill.  Decisions, decisions.

3. The Roth IRA Savings Account

One of the coolest things about the Roth IRA is that you can pull out your contributions at any time, which is a huge difference that it’s Traditional IRA and 401k counterparts.  Basically, it allows to treat your Roth IRA like a savings account having access to your money whenever you need it.  Is it really that simple?  Kind of.  Here’s a few things to keep in mind.

• It just applies to your contributions (money you put in), not the earnings or interest you make off those contributions.  The earnings are subject to the IRS Qualified Distribution Rule. Here’s more info on the Roth IRA distribution rules.
• If you put $5,000 in your Roth IRA and buy one stock (or any other investment for that matter) and it loses value, you can’t withdraw the $5,000.  It’s based on the actual investment value.

4. Free Money, Then Tax Free Money

As much as I love the Roth IRA, it doesn’t mean it’s the first place you need to stick your retirement savings.  If your employer’s 401k offers a match, take the free money.  After the 401k match, then it’s time to get the tax free money of the Roth IRA.

In case you missed that…..Roth IRA = Tax Free Money.

5. Roth IRA Phaseout Limits Have Increased

For those that may have missed the “tax free” boat last year, the good news is that the IRS has increased how much you can earn in 2009 and still be able to contribute.  For a single filer, the phaseout range begins at $105,000 AGI and is completely phased out at $120,000.  For a joint filers (this is good news for me), the phaseout range starts at $166,000 and phases out at $176,000 AGI. You must stay in the phaseout ranges to qualify for a Roth IRA.

6. Change Your Mind on Converting? Just Recharacterize

Without getting too detailed (you can read more in another post), if you do convert and decide you want to go back to the Traditional IRA rules, you can do what’s called an IRA recharacterization.

7. Don’t Get Confused About 2010

The 2010 conversion event allows you to convert your traditional IRA’s or old 401k’s into Roth IRA’s no matter your income limit or AGI.  That doesn’t mean that anybody can make a “new” contribution for 2010.  For example, let’s look at a joint filer that makes $225,000 AGI.  They would be allowed to convert to a Roth IRA, but not be allowed to put in any new money.  Probably won’t make a difference when you consider let’s say converting $70,000 to a Roth IRA vs. adding a new contribution of $5,000.   Time value of money will make the $70,000 conversion a nice little tax free nest egg waiting for you at retirement.

*Restrictions, penalties and taxes may apply.  Unless certain criteria are met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.

Securities offered through LPL Financial member FINRA / SIPC.

The 2010 Roth IRA Conversion event can’t get here soon enough.  As you may know, this is the time that anybody will be able to convert their traditional IRA’s to Roth IRA’s no matter your income level.  But currently as it stands now, if you make over $100,000 AGI Married Filing Jointly, your left counting the days until you are allowed to do so.

Common Misconception on Converting

A few people I’ve talked with thought that everybody had to wait to convert until 2010.  This is not the case. In fact, for many of you that have been contemplating whether to convert your former traditional IRA to a Roth IRA, now might be the year to do it.  With the recent decline in the market for 2008, chances are you’ve seen your investment accounts drop in significant value.  If you have a traditional IRA or a 401(k) at a previous employer, this might be the opportunity to convert that into a Roth IRA.

Why Is This A Good Time To Convert to a Roth IRA?

Reason being, when you convert to a Roth IRA, you have to pay the ordinary income tax on the converted amount.   By converting this year, your IRA’s have most likely dropped significantly and you will then have less to pay ordinary income tax with.  Sure it’s not exciting to see your account drop 30-40%, but if you could sock that away in a Roth IRA, think of all the tax free money down the road……woo-hoo!

Roth IRA Conversion Example

If your traditional IRA or previous 401(k) is worth $15,000, that would mean that you would have to claim $15,000 of income that year and then pay the according tax.  But let’s say that same 15,000 is currently worth $10,000 due to the recent market downturn, you then would pay less ordinary income tax on the converted amount; thus making it a timely opportunity to convert to a Roth IRA in a down market.

Before You Get Too Excited

Please keep in mind that currently if you individually or jointly make over $100,000 or modified adjusted gross income, you cannot take advantage of this opportunity.  Your first window of opportunity will not be until the year 2010, which then depending on the value of the accounts  might be another time of considering converting to a Roth IRA.

Update: Check out my latest post that shares some real life scenarios and tax consequences of converting a Traditional IRA to a Roth IRA.

Other good reads:

• Moment On Money: Every Cloud Has a Silver Lining
• Five Cent Nickle: Roth IRA Conversion In a Down Market
• My Dollar Plan: Roth IRA Conversions

*Restrictions, penalties and taxes may apply.  Unless certain criteria is met, Roth IRA owners must be 59 1/2 or older and have held the IRA for 5 years before tax-free withdrawals are permitted.

Securities offered through LPL Financial member FINRA / SIPC.

IRA Recharacterization Rules

As the stock market continues its roller coaster of 2009, many are seeking for positive news.  While I’m sure that there are many good buys out there, one thing that is certain are that we can look to benefit from tax savings.  How, you ask? Well, in down times, one thing that investors can look forward to is to take advantage of things such as tax loss harvesting in taxable investment accounts, which involves selling depreciated holdings to take advantage of losses that can offset other income.  Not only in taxable accounts, but we may also be able to take advantage of retirement accounts as well. This is what’s called IRA Recharacterization.  Some of the issues can be complex; but with a little bit of information, we can try to make sense and explain the rules.

The Roth IRA Conversion

As you may or may not know, Roth and traditional IRAs are retirement vehicles that allow you to shelter income from taxes.  In a Roth IRA, withdrawals can be tax-free and as an investor, you are not required to take distributions at the age of 70 ½ as you would with a traditional IRA.  The trade-off, of course, is that with the Roth IRA there is no tax deduction like you would get with a traditional IRA or a 401(k).

In a market as such, some investors may have done what’s called a conversion where they have converted their traditional IRA to a Roth IRA.  This could be advantageous for some that are looking to take advantage of the tax-free withdrawals in the Roth IRA.  The one drawback by converting is that when you do convert from a Roth IRA to a traditional IRA, the entire amount is treated as ordinary income, which means we will have to claim that amount on your income taxes for the year and pay the appropriate income tax.  For those that had converted for 2007, the value that was converted then, if invested in the stock market, most likely is worth less now.  As an example, if you had $20,000 in your traditional IRA that you converted last year that value may be worth only $15,000 today.

IRA Recharacterization Rules

A couple rules to keep in mind if you are trying to recharacterize a conversion from a Roth back to a traditional is that you are not allowed to reconvert back to a Roth within the same tax year or within 30 days of the IRA recharacterization. In other words, an IRA that has switched to a Roth earlier this year and then switched back can’t be reconverted to a Roth this year. The reconversion has to be delayed until at least January 1 or if later, 30 days after the IRA was switched back to the traditional.

Example of IRA Recharacterization

For example, somebody in a 30% federal income tax bracket who converted a $20,000 IRA last year in 2009 would owe approximately $6,000 in taxes.  If the account was fully invested in the stock market, it may be possible that account is now worth down to 15,000 due to market depreciation. Assuming that the value of the investments in the account didn’t change between the time of the back and forth switch, the tax bill would be reduced to $2,100.

These rules governing IRA conversions are complex.  It’s crucial to get them straight.  You have until October 15th of the calendar year following conversion to switch back to a traditional IRA.  By the time you read this post, chances are that time has already passed for 2008, but if you had done a conversion in the beginning of 2009, it may be something to consider for next year.

Don’t Forget The Capital Loss

Other tax saving opportunities that you can take advantage of in a down year in the market also has to do with offsetting investment gains up to the $3,000 capital loss that you’re allowed . One thing you should know is that if you do have an investment that is down, you are able to sell that off, take advantage of the $3,000 capital loss, but due to the wash sell  rule, it prohibits you from repurchasing that same investment within a 30-day time period.

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Are you ready for the Roth IRA conversion?

A very exciting thing is getting ready to occur! Are you ready? You know how excited I am about the Roth IRA.  Well, something exciting is getting ready to occur within the Roth IRA realm that many do not know about. What is it?  It’s the 2010 Roth IRA conversion event.

If this article was helpful, you may also want to check out these posts as well: Roth IRA- Time To Convert ,7 Things You Need to Know About the Roth IRA Conversion for 2010, Roth IRA Conversion Tax Rules.

The 2010 Roth IRA Conversion Is Coming

Currently, if you have money in a traditional IRA and you want to convert it to a Roth IRA, you are unable to do so if your Adjusted Gross Income is greater than $100,000 a year. This is especially frustrating if your income is greater than the Roth IRA Phaseout Limits that leaves you without being able to take advantage of one of the greatest retirement planning tools. Don’t be depressed yet. There is still hope. Drum roll please……Introducing the 2010 Roth IRA Conversion Event. What happens in 2010 is that these income limits will become extinct, so that anyone, no matter your income limit, can convert from traditional IRAs to Roth IRAs.

Tax Ramifications

The one thing to be knowledgeable about is that we will have an income tax consequence due to this action, but the IRS has implemented a favorable tax treatment upon doing this. The favorable tax treatment works like this:

• Usually if you convert from a traditional to a Roth, you are then burdened with the tax owed that current year, based off your ordinary income tax rate.
• But the IRS has graciously allowed you to defer your tax owed in 2010, to where you only have to pay half of the tax burden on your 2011 return, and the remaining half on your 2012 tax return.
• It’s a  nice little incentive if you are considering converting your traditional IRA  or old 401k’s to a Roth IRA because of this favorable tax treatment.

This strategy is not right for everyone. As usual, you want to talk to your tax professional or financial planner before implementing this strategy.