I recently fielded the following question from one of our clients:

“I opened my Roth IRA on September 5th, 2005 .   Can I withdraw the contributions now or do I have to wait until September 6th 2010 so that they will not be taxable or subject to penalty?”

Qualified distributions from a Roth IRA are not included in the recipients gross income, nor are they subject to the 10% penalty for early withdrawal.    

The actual contributions themselves can be withdrawn any time with out tax or penalty.  There is a 5-year holding period from the time of the first contribution into a Roth IRA until the time in which you may be able to withdraw the earnings on those funds without being subject to income taxes and a 10%  penalty.    In addition to satisfying the 5-year rule, in order to avoid the penalty and the tax, you must also satisfy one of the following:  (1)  the distribution must also occur on or after the date that you become age 59 1/2, (2) at or after your death, (3) the distribution is due to a disability, or (4) in conjunction to a first-time homebuyers purchase (up to $10,000). 

Contrary to what one might think, the 5-year clock does not start based on the date that you actually made the contribution, but rather the tax year you made the contribution.  The tax code deems all contributions made during a year as made on January 1st of that year.  In the above example, the initial contribution is deemed to have been made on January 1st, 2005.  Therefore, the taxpayer must wait until January 1, 2010 in order to be able to remove any earnings on those contributions without being subject to the 10% early withdrawal penalty. 

The good news is that any withdrawals are first assumed to come from contributions and then earnings.  Therefore, no amount is included in gross income until all of the after-tax contributions have been withdrawn.   Generally, if an individual receives a distribution of earnings from a Roth IRA that is included in income, they will also be subject to the 10% additional tax for early distributions.

This is final part of a five part series of posts related to Roth IRA Conversions and the rule changes that go into effect on January 1, 2010. As mentioned in prior posts in this series regarding Roth IRA Conversions, I will explain the rules around Roth IRAs, as well as what the recent changes in the law means. I will also provide you with some reasons to convert, as well as some reasons not to convert. In addition, my final post will include some tax planning tips around the Roth IRA.

For other posts in this series, please visit:

Part I: What is a Roth IRA? What is changing about Roth IRA Rules?
Part II: Reasons to Convert to a Roth IRA.
Part III: Reasons NOT to Convert to a Roth IRA.
Part IV: Planning Ideas around Converting to a Roth IRA
Part V: Planning Ideas – What is the Pro-Rata Rule?

In this post, I will review a few more tax planning considerations related to Roth IRAs. It is important to keep in mind that everyone’s situation is different and that these ideas may or may not apply to you. You should sit down with your tax professional and do proactive tax planning prior to doing anything.

Can’t Afford to Convert?  If you are like many taxpayers, you look at the cost of conversion and it is overwhelming.  The good news is that you don’t have to do the entire conversion all at once.  You can convert a small portion of your IRA each year over a several year period – depending upon what you can afford to pay in additional taxes for the year of conversion.  In addition, this allows you to sit down with your tax planner and find out the magic amount that you can convert this year without being pushed into a higher tax bracket.  By planning this conversion out over several years, you may be able to lower the taxes that you pay on the conversion, as well as spread it out over many years.

The Pro-Rata Rule.  Wouldn’t it be great if you could choose to convert your nondeductible contributions and keep the contributions that you deducted as traditional IRAs – thus paying very little, if any tax?  Sorry, but that is where the Pro-Rata Rule comes into play.  When determining the amount of your conversion that was from deductible contributions and the amount that was from non-deductible contributions, the IRS looks at all of your IRAs.  You must add the value of all of them together, then divide by the nondeductible contributions, and this will give you the percentage of any conversion that you make that is tax- free.    This prevents you from converting only your nondeductible contributions.  The good news is that you may be able to use a loophole – the 401(k) loophole below.

401K Considerations.  Balances in 401(k) accounts are not included in the calculations for the Pro-Rata Rules.  In addition, some employer 401(k) plans allow you to rollover your traditional IRA into the plan.  By doing so, it can allow the taxpayer to exclude some or all of their deductible contributions from the calculation.  This will result in a higher percentage that can be converted to a Roth IRA tax free.  In the event that a taxpayer that plans to do a conversion has already rolled their 401(k) into a traditional IRA, they may wish to consider rolling it back to a 401(k) if their employer plan allows.

Due to this Pro-Rata Rule, it is not usually recommended that you convert your 401(k) to a traditional IRA until after you are through with any Roth IRA conversions that you plan to do.  The exception to that would be if you wanted to convert the 401(k) balance to a Roth IRA as well.  Even if you do, it is probably a good idea to sit down with your tax planner to make sure that you structure the timing of the conversions in a manner that will maximize your tax savings.

Minimum Distributions.   As mentioned several times during this series of post, if you are over the age of 70 1/2 and you are taking Required Minimum Distributions (RMDs) from your traditional IRA or workplace plan, you can not include the current years RMD in the conversion amount.  You must pay the necessary tax on that RMD, and then you can convert the remaining balance.  (Note:  There are no RMDs for 2009 because Congress passed legislation to waive them due to the down market – fearing that they would wipe out many peoples retirement accounts.  RMDs are scheduled to resume in 2010.)

This is forth part of a five part series of posts related to Roth IRA Conversions and the rule changes that go into effect on January 1, 2010.  As mentioned in prior posts in this series regarding Roth IRA Conversions, I will explain the rules around Roth IRAs, as well as what the recent changes in the law means. I will also provide you with some reasons to convert, as well as some reasons not to convert. In addition, my final post will include some tax planning tips around the Roth IRA.

For other posts in this series, please visit:
Part I:  What is a Roth IRA? What is changing about Roth IRA Rules?
Part II:  Reasons to Convert to a Roth IRA. 
Part III:  Reasons NOT to Convert to a Roth IRA.
Part IV:  Planning Ideas around Converting to a Roth IRA.
Part V:  Planning Ideas – What is the Pro-Rata Rule?

In this post, I will review some tax planning ideas.  It is important to keep in mind that everyone’s situation is different and that these ideas may or may not apply to you.  You should sit down with your tax professional and do proactive tax planning prior to doing anything. 

Local Taxes.  Have you thought about where you plan to live when you retire?  Where you plan to retire could be a major factor in deciding whether or not to do a conversion – especially if you are close to retirement age.  If you are living in a high tax locale, such as New York, and you are planning to retire in one of the states that currently have no income tax (such as Florida), it may not make sense to convert.  If you convert while still living in the high tax state, you will have to pay a tax when you convert, when you would not be subject to that state income tax when you are in retirement.

The opposite is also true.  If you are currently living in a no state income tax-state such as Alaska, and plan to move to North Carolina for your retirement, it may make sense to convert while you are not subject to state taxation of those funds. 

Of course, as stated in prior post, we can not predict what the tax laws will be in the future.  This obviously applies to the individual states the same way it does to the federal government.  As most of the states are struggling to pay for hefty state employee pensions and Medicaid programs, there is a possibility of higher taxes at the state levels – as well as the implementation of income taxes in current no state income tax states.

Future Tax Rates.  What tax bracket are you going to be in during retirement?  Many individuals expect that their income to be lower during retirement, and thus have a lower marginal tax rate.  If this is the case, it may not make sense to convert.  Why pay tax at a high tax rate now, when you can pay a lower tax rate later? 

Conversely, other individuals may have higher income during retirement – especially once the required minimum distributions from retirement accounts kick in at age 70 1/2. 

Over the Income Limit.  Do you currently want to fund a Roth IRA, but are over the income limits for contributing to a Roth IRA?   You can open a traditional IRA, which is not subject to the income limits that a Roth IRA is, then contribute the maximum amount allowable and convert it to a Roth IRA in 2010.  Depending upon your individual tax situation, the contributions to the traditional IRA may or may not be deductible.  Just remember that if you can not deduct the contribution now, it will not be taxable upon conversion – although any earnings would be.   Many taxpayers have been maxing out their nondeductible contributions to traditional IRAs for several years now in anticipation of converting to a Roth IRA in 2010.

Protect Yourself Against Losses.  In future tax years, you can help to protect your account from losses or at least the taxes on money that you lose.   An individual can hold two Roth IRA accounts – one that is their “new” Roth IRA and one that is their “old’” Roth IRA.   Overtime, the individual will migrate all of the assets to the “old” Roth IRA.  Each year, contribute your funds to a traditional IRA (see “Over the Income Limit” above) and then subsequently convert that traditional IRA to the “new” Roth IRA.    The reason that you want to convert it to a “new” Roth IRA instead of just combining it into your “old” Roth IRA is that the tax law allows you to recharacterize a Roth IRA as a traditional IRA within certain time limits.  By doing this, if the investments in this “new” Roth IRA suffer a loss during the first year, you can recharacterize it as a traditional IRA and eliminate the taxes due from the conversion.  You can then reconvert the assets to a Roth again, at the deflated value, which would create a lower tax due.  This eliminates the possibility that you may have to pay taxes on value that no longer exists (See IRS Publication 590 for timing details surrounding your ability to recharacterize the IRAs).  In the event that the account increases in value, you could then transfer the assets to your “old” Roth after the time to recharacterize the account to a traditional IRA expires.  You can repeat this process each year that  you plan to make contributions. 

If that whole process was not enough pain for you, you can extend it even further to protect from losses in the investments.  You can open a separate Roth for each type of investment that you make with the converted money.  For instance, if you are investing the funds in three different investments, roll the funds into three separate Roth IRA accounts.  This way you can pick and choose which particular investments that you recharacterize – not just which Roth IRA account.  For example, if you had the following three investments:  Investment A that doubles in value during the year, Investment B that stays the same during the year, and Investment C that becomes worthless.    If all three of these investments were held in the same Roth IRA account, the total value would be the same and you would have to pay taxes on the converted amount as such.  If they are in separate accounts, you can pay the tax for the conversation of Investment A and Investment B, then recharacterize investment C as a traditional IRA – thus eliminating the taxes due on that portion of the conversion amount.

Estate Planning.  As discussed in Part III, Roth IRA’s do not have any required minimum distributions once they reach age 70 1/2 like they are required by traditional IRA’s.  If a retiree does not need the funds to live on, the earnings on their investments can continue to grow tax-free inside the Roth IRA.  Another advantage is that beneficiaries do not have to pay income tax on withdrawals that they make from an inherited Roth IRA.    Although, Roth IRA beneficiaries do have to take distributions across their life expectancies, Roth assets are still included in an estates value for Estate Tax purposes.

This is Part III of a series of post related to Roth IRA Conversions and the rule changes that go into effect on January 1, 2010.  As mentioned in prior post of this series regarding Roth IRA Conversions, I will explain the rules around Roth IRAs, as well as what the recent changes in the law means. I will also provide you with some reasons to convert, as well as some reasons not to convert. In addition, my final posts will include some tax planning tips around the Roth IRA.

For other posts in this series, please visit:
Part I:  What is a Roth IRA? What is changing about Roth IRA Rules?
Part II:  Reasons to Convert to a Roth IRA. 
Part III:  Reasons NOT to Convert to a Roth IRA.
Part IV:  Planning Ideas around Converting to a Roth IRA.
Part V:  Planning Ideas – What is the Pro-Rata Rule?

In this post, I will explain some of the common reasons that you will want to consider for not converting to a Roth IRA.  It is important to keep in mind that everyone’s situation is different and that these reasons may or may not apply to you.  You should sit down with your tax professional and do proactive tax planning prior to doing anything. 

Reasons NOT to Convert to a Roth IRA. 

Taxes!  If you convert your traditional IRA to a Roth IRA, you will most likely have to pay income taxes on the amount of your pretax contributions and earnings that are included in the amount that you convert.  If you have $100,000 sitting in your retirement account, this could be a hefty tax bill to absorb.

It is usually not a good idea to convert to a Roth IRA  unless you have other sources from which to pay the taxes other than retirement funds.  Depleting these funds to cover the taxes, offsets the positive benefits derived.  Another downside to paying these taxes with retirement assets is that you are “locking in” you losses that you have experienced over the last couple of years.  Once you cash these investments in, there is no chance for recovery.  In addition, if you are not 59 1/2, you would likely have to pay a 10% tax penalty on the funds you withdraw to pay the tax.

Possibility of Future Surcharge on the “Rich.”  As stated in Part I, under current law, distributions under Roth IRA’s are to be tax free since the tax was paid at the time of the contribution.  The key word there is “current law.”  We have no way of knowing what Congress will do in the future as it becomes more and more desperate to raise tax revenues for its never ending laundry list of government programs and agencies.  There is a possibility that at some point in the future Congress will find it “necessary” to tax a portion of Roth IRA distributions for “wealthy” Americans.   While most politicians will say this will not happen, keep in mind that they also told us that no portion of Social Security benefits would be taxable since it had already been taxed once.  

When our country was formed, our founding fathers were vehemently opposed to the income tax.  It wasn’t until the ratification of the 17th amendment in 1913 that the income tax was Constitutional.  At that time, we were assured by our politicians that it would never need to go above one to two percent, and that it would only apply to the wealthiest Americans.  Well, we have all seen how that promise played out.  My point is that most of the publications and articles I read on the Roth IRA assume that all distributions will always be tax free.  Keep in mind that they may not be.

Fair Tax.  Another possibility that we must be aware of is what happens if the Fair Tax or something similar ever becomes law?  What if there is a total transformation of our tax system in which the income tax is eliminated and replaced with a transaction oriented tax?  Would the people who converted their traditional IRA’s to Roth IRA’s and paid in hefty sums in taxes to do so get the shaft?  I am willing to bet they would.  It is unlikely that this is going to happen in the next few years, but some people are planning 20, 30 or 40 years out.  There is no telling what the political landscape or the tax system will look like at that time.  (See Tax Diversification on Part IV)