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IRA

Be Careful When Converting

Conversion of St Paul

Conversion of St Paul (Photo credit: Lawrence OP)

When converting from a 401(k), traditional IRA, 403(b), SIMPLE IRA, SEP or 457(b) to a Roth IRA there are some important tax considerations to keep in mind.

First, converting from a tax deferred plan to a tax free plan it’s not always the best idea. Generally, it’s going to make sense to convert if the tax payer believes that he or she will be in a higher income tax bracket in retirement. For example, John, age 28 has a 401(k) and recently left his employer. He’s currently in the 15% bracket but expects to be in the 28% bracket or higher in retirement. It may make sense for John to convert his 401(k) to his Roth IRA.

This makes sense for John because when he converts from a pre-tax, employer sponsored plan like the 401(k) it’s money that has not yet been taxed. If he converts while in the 15% bracket, that money is now subject to tax at the 15% rate, and arguably a lower amount of money being taxed since he’s still young. If he decided to wait until retirement to convert (let’s assume he’s in the 28% bracket) then that money is going to be taxed at 28%, or almost twice the rate if he had converted when he was in the 15% bracket. John has also eliminated future RMDs as Roth IRAs have no such requirement.

Generally, it may make sense to not convert if you expect to be in a lower tax bracket at retirement. The reason is you’d convert at a higher tax bracket today, only to be in a lower bracket in retirement. Thus, you’ve paid a higher than necessary amount of tax on your money.

Second, when converting, pay close attention to you your age and how you choose to “pay” the tax. Let’s look at two examples.

Let’s say John in the example above decides to convert when he leaves his employer at age 28. He’s saved a nice sum of $100,000 in his 401(k). He decides to convert to a Roth IRA at the 15% bracket. He elects to pay the tax himself from outside of the 401(k), that is, he elects to not have any tax withheld from the conversion. He decides he’ll pay the tax from another source when tax time comes around. All is being equal, John owes $15,000 at tax time.

This turns out to be a very wise decision for John. Here’s why.

Let’s assume the same scenario above except that John decides to have the $15,000 withheld from his 401(k) to pay the taxes on the conversion. Remember how old John was? 28. He’s under age 59 1/2 and the $15,000 withheld for taxes is considered an early distribution, and, you guessed it, subject to the 10% early withdrawal penalty. So instead of paying $15,000 in taxes, John pays an additional $1,500 due to the 10% penalty or a total of $16,500.

It pays (either you or the IRS) to consider the tax ramifications of converting to a Roth IRA. Talk to an experienced financial planner and or tax advisor for help.

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Further Guidance on the One-Rollover-Per-Year Rule for IRAs


As a follow-up to the recent post on this blog The One-Rollover-Per-Year Rule: Revised, the IRS has recently released some additional guidance on the subject, via Announcement 2014-15.

As previously mentioned, the IRS has determined to begin using the one-rollover-per-year rule applied to ALL IRAs that the taxpayer owns, rather than only the affected IRAs that have been involved in a rollover.

According to the Announcement, the IRS fully acknowledges that the previous understanding of the rule was that it applied on an IRA-by-IRA basis.  In fact, there was a Proposed Regulation § 1.408-4(b)(4)(ii) on the books that was to further define the rule as applied only to the involved IRAs.  Ever since the Tax Court decided otherwise in the case Bobrow v. Commissioner (TC Memo 2014-21), the rule has been changed.

According to the recent announcement though, this will not take affect across the board until January 1, 2015.  Prior to that date, presumably, the old interpretation will be used, except, apparently, for Mr. Bobrow’s case (and any further cases that might be tried by the Tax Court).

How Does an Early Withdrawal from a Retirement Plan Affect My Taxes?

Image courtesy of adamr at FreeDigitalPhotos.net

Image courtesy of adamr at FreeDigitalPhotos.net

Oftentimes we are faced with difficult situations in life – where we need extra money to pay for a major car repair, a new roof for the house, or just day-to-day living expenses – and our emergency funds are all tapped out.  Now your options become poor: should I go to a payday loan place, put more on my credit card?  My mortgage is upside-down so there’s no home equity loan in my future, and I can’t ask my folks for a loan, I’ve asked them for too much.  Hey, what about my retirement plan?  I’ve got some money socked away in an IRA that’s just sitting there, why don’t I take that money?

It’s really tough to be in a situation like this, but you need to understand the impacts that you’ll face if you decide to go the route of the IRA withdrawal, especially if you’re under age 59½.

Any money that you take out of a retirement plan as a withdrawal will be taxed as ordinary income – just like wages, salaries, and tips.  So if you’re in the 25% marginal tax bracket, every dollar that you withdraw from your IRA or 401(k) plan (if allowed) will cost you 25 cents right off the top.

In addition to the ordinary income tax, if you’re less than 59½ years of age you’ll also be hit with an additional 10% penalty for an early withdrawal (unless your withdrawal meets one of these 19 exceptions). So now every dollar that you withdraw costs an extra 10 cents on top of the ordinary income tax.  If you’re in the 25% bracket, that $10,000 withdrawal from your IRA can cost you as much as $3,500 in extra taxes and penalties.

Bear in mind that you may be able to take a temporary loan from your 401(k) or other qualified retirement plan (QRP) if you’re still employed by that employer.  Naturally you’ll need to repay the loan, but it might be a better option cost-wise than the other choices.  Plus, if you have an outstanding loan from your QRP and you leave the employer you’ll be required to either recognize the balance of the loan as a withdrawal or pay it back to the plan immediately.

Armed with this information makes your decision points much more clear: review all of the available options mentioned above (loans from family and friends, home equity loans, payday loans, and the like) against the cost of the taxes for taking an early withdrawal from your retirement plan.  The best option may be to see about a formal loan from family, paying them a reasonable rate of interest.  But of course, your circumstances are going to dictate the best option for you.  Just go into it with your eyes wide open.

2014 IRA MAGI Limits – Married Filing Separately

Separated Strawberry

Separated Strawberry (Photo credit: bthomso)

Note: for the purposes of IRA MAGI qualification, a person filing as Married Filing Separately, who did not live with his or her spouse during the tax year, is considered Single and will use the information on that page to determine eligibility.

For a Traditional IRA (Filing Status Married Filing Separately):

If you are not covered by a retirement plan at your job and your spouse is not covered by a retirement plan, there is no MAGI limitation on your deductible contributions.

If you are covered by a retirement plan at your job and your MAGI is less than $10,000, you are entitled to a partial deduction, reduced by 55% for every dollar (or 65% if over age 50), and rounded up to the nearest $10.  If the amount works out to less than $200, you are allowed to contribute at least $200.

If you are covered by a retirement plan at your job and your MAGI is more than $10,000, you are not entitled to deduct any of your traditional IRA contributions for tax year 2014.  You are eligible to make non-deductible contributions, up the annual limit, and those contributions can benefit from the tax-free growth inherent in the IRA account.

If you are not covered by a retirement plan but your spouse is, and your MAGI is less than $10,000, you are entitled to a partial deduction, reduced by 55% for every dollar over the lower limit (or 65% if over age 50), and rounded up to the nearest $10.  If the amount works out to less than $200, you are allowed to contribute at least $200.

Finally, if you are not covered by a retirement plan but your spouse is, and your MAGI is greater than $10,000, you are not entitled to deduct any of your traditional IRA contributions for tax year 2014.  You are eligible to make non-deductible contributions, up the annual limit, and those contributions can benefit from the tax-free growth inherent in the IRA account.

For a Roth IRA (Filing Status of Married Filing Separately):

If your MAGI is less than $10,000, your contribution to a Roth IRA is reduced ratably by every dollar, rounded up to the nearest $10.  If the amount works out to less than $200, you are allowed to contribute at least $200.

If your MAGI is $10,000 or more, you can not contribute to a Roth IRA.

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2014 MAGI Limits for IRAs – Married Filing Jointly or Qualifying Widow(er)

rendered universal joint animation. Español: M...

rendered universal joint animation. (Photo credit: Wikipedia)

Note: for the purposes of IRA MAGI qualification, a person filing as Married Filing Separately, who did not live with his or her spouse during the tax year, is considered Single and will use the information on that page to determine eligibility.

For a Traditional IRA (Filing Status Married Filing Jointly or Qualifying Widow(er)):

If you are not covered by a retirement plan at your job and your spouse is not covered by a retirement plan, there is no MAGI limitation on your deductible contributions.

If you are covered by a retirement plan at work, and your MAGI is $96,000 or less, there is also no limitation on your deductible contributions to a traditional IRA.

If you are covered by a retirement plan at your job and your MAGI is more than $96,000 but less than $116,000, you are entitled to a partial deduction, reduced by 27.5% for every dollar over the lower limit (or 32.5% if over age 50), and rounded up to the nearest $10. If the amount works out to less than $200, you are allowed to contribute at least $200.

If you are covered by a retirement plan at your job and your MAGI is more than $116,000, you are not entitled to deduct any of your traditional IRA contributions for tax year 2014. You are eligible to make non-deductible contributions, up the annual limit, and those contributions can benefit from the tax-free growth inherent in the IRA account.

If you are not covered by a retirement plan at your job, but your spouse IS covered by a retirement plan, and your MAGI is less than $181,000, you can deduct the full amount of your IRA contributions.

If you are not covered by a retirement plan but your spouse is, and your MAGI is greater than $181,000 but less than $191,000, you are entitled to a partial deduction, reduced by 55% for every dollar over the lower limit (or 65% if over age 50), and rounded up to the nearest $10. If the amount works out to less than $200, you are allowed to contribute at least $200.

Finally, if you are not covered by a retirement plan but your spouse is, and your MAGI is greater than $191,000, you are not entitled to deduct any of your traditional IRA contributions for tax year 2014. You are eligible to make non-deductible contributions, up the annual limit, and those contributions can benefit from the tax-free growth inherent in the IRA account.

For a Roth IRA (Filing Status of Married Filing Jointly or Qualifying Widow(er)):

If your MAGI is less than $181,000, you are eligible to contribute the entire amount to a Roth IRA.

If your MAGI is between $181,000 and $191,000, your contribution to a Roth IRA is reduced ratably by every dollar above the lower end of the range, rounded up to the nearest $10. If the amount works out to less than $200, you are allowed to contribute at least $200.

If your MAGI is $191,000 or more, you cannot contribute to a Roth IRA.

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2014 MAGI Limits – Single or Head of Household

David Lee Roth IRA ruins my perfect shot

David Lee Roth IRA ruins my perfect shot (Photo credit: nickfarr)

Note: for the purposes of IRA MAGI qualification, a person filing as Married Filing Separately who did not live with his or her spouse during the tax year, is considered Single and will use the information on this page to determine eligibility.

For a Traditional IRA (Filing Status Single or Head of Household):

If you are not covered by a retirement plan at your job, there is no MAGI limitation on your deductible contributions.

If you are covered by a retirement plan at work, if your MAGI is $60,000 or less, there is also no limitation on your deductible contributions to a traditional IRA.

If you are covered by a retirement plan at your job and your MAGI is more than $60,000 but less than $70,000, you are entitled to a partial deduction, reduced by 55% for every dollar over the lower limit (or 65% if over age 50), and rounded up to the nearest $10. If the amount works out to less than $200, you are allowed to contribute at least $200.

If you are covered by a retirement plan at your job and your MAGI is more than $70,000, you are not entitled to deduct any of your traditional IRA contributions for tax year 2014. You are eligible to make non-deductible contributions, up the annual limit, and those contributions can benefit from the tax-free growth inherent in the IRA account.

For a Roth IRA (Filing Status Single or Head of Household):

If your MAGI is less than $114,000, you are eligible to contribute the entire amount to a Roth IRA.

If your MAGI is between $114,000 and $129,000, your contribution to a Roth IRA is reduced ratably by every dollar above the lower end of the range, rounded up to the nearest $10. If the amount works out to less than $200, you are allowed to contribute at least $200. If your MAGI is $129,000 or more, you cannot contribute to a Roth IRA.

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