iras

The Roth IRA

Mar 20th, 2013

Once you’ve established your emergency fund, it’s time to continue to pay yourself first but for a sunny day in the future – your retirement. For most people (this includes you) the Roth IRA is going to be a great option to save money for retirement and have a tax-free source of income once they hit their golden years. The Roth IRA was named after its namesake, Senator William Roth of Delaware. The IRA part simply means Individual Retirement Arrangement.

Roth IRAs work like this: You save money into your Roth IRA on an after-tax basis. What this means is that when you get paid from your job and you’ve already paid Uncle Sam his share in taxes – you get what’s left over. Of those leftovers (couldn’t help the food reference) you can take some of that money and put it into a Roth IRA. This money then goes into an account of your choosing. This could be into mutual funds, stocks, bonds, ETFs, or even a simple savings account at your bank. There are a few things that are not allowed in IRAs such as life insurance and collectibles like art and antiques.

Over time your contributions, depending on how they’re invested, will grow tax-deferred into a nice little nest egg ready for you to hatch at retirement. The magic of the Roth IRA really begins here. Remember when I said that after-tax money was going into the account? Well, since you’ve gone through the pain of having been taxed on that money already, any qualified withdrawals from your Roth IRA are now…wait for it…TAX FREE! Imagine an income source in retirement that cannot be taxed.

There are some great calculators online that can be used to show you how much you can have saved in 10, 20 or 30 years. I’ve included some websites you can visit at the end of the book.

As of this writing in 2013 you are allowed to contribute $5,500 annually to your Roth IRA and if you’re age 50 or older, another $1,000 as a “catch-up” contribution. These numbers will generally increase periodically as inflation increases and as time goes on.

To see if a Roth IRA is an option for you to consider, talk with your financial professional and explore your options. Some good rules of thumb when looking at your options for funding a Roth IRA are to avoid mutual funds with high fees and expenses, insurance products (annuities) with high fees and surrender charges and complex products that are difficult for you (and your advisor) to understand and explain.

IRAs and Medicaid

Feb 1st, 2013

by sraskie.

4 comments

When it comes to IRAs and Medicaid eligibility the question that gets asked is, “How does my IRA affect my eligibility for Medicaid?”

Many states share similar guidelines when it comes to exempt and non-exempt assets in IRAs. Essentially, it boils down to this: if the IRA is not in payout status (the IRA owner is not taking required minimum distributions) then the assets in the IRA are included (non-exempt) in the determination of eligibility. However, if the IRA is in payout status and the owner is now taking required minimum distributions (RMDs) the total amount of the IRA is not included, but the annual income from the RMDs is.The same would be true regarding 401(k)s, 403(b), and other qualified plans that may require RMDs after age 70 ½.

There are some states (Illinois for example) that treat IRAs, a 401(k), and pensions as exempt. Check your state’s laws to see where you fit in.

Another asset that works similarly is an annuity. Like the IRA, if an individual owns and annuity and it is not in payout status (it hasn’t been annuitized), the entire account balance is deemed non-exempt and it is considered an includible asset. If the annuity has been annuitized and is now rendering a steady stream of guaranteed payments, then the annuity balance is not included, but the annual income from the annuity payments is.

Determining Your MAGI

by jblankenship.

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There are income limits for contributing to an IRA (traditional and Roth), and below are links by filing status to illustrate the income limits in the situation where you are or are not covered by an employer-provided retirement plan, given your filing status. This, along with your filing status and your Modified Adjusted Gross Income (MAGI) is an important factor in setting the limits for TIRAs, as there is the issue of deductibility at stake.

In order to fully understand the limitations, you also need to understand what makes up your Modified AGI (MAGI). The MAGI is calculated as follows:

1.    Start with your Adjusted Gross Income (line 22, Form 1040A, or line 38, Form 1040).
2.    Add back in your IRA deduction amount (line 17 on Form 1040A or line 32 on Form 1040)
3.    Add back in your student loan interest (line 18 on Form 1040A or line 33 on Form 1040)
4.    Add back in any tuition and fees deductions from line 34 on Form 1040 (or line 19 on Form 1040A)
5.    Add any domestic production activities from line 35 on Form 1040 (there is no line for this on 1040A)
6.    Add back any foreign earned income exclusions from line 18 of Form 2555EZ or line 45 of Form 2555.
7.    Add back any foreign housing deduction from line 50 of Form 2555
8.    Add back any excluded qualified savings bond interest shown on line 3, Schedule 1, Form 1040A, or line 3, Schedule B, Form 1040 (from line 14, Form 8815)
9.    Add back in any excluded employer-provided adoption benefits shown on line 30, Form 8839.

The total of these nine items listed above make up your Modified Adjusted Gross Income, or MAGI.

For the IRA MAGI limitations where your income tax filing status is Single or Head of Household, click here. Note: if a taxpayer files Married Filing Separately and did not live with his or her spouse during the tax year, for the purposes of IRA eligibility that taxpayer is considered Single and would use this table. (click here for 2012 limits)

If your income tax filing status is Married Filing Jointly or Qualifying Widow(er), click here for the IRA MAGI limitations. (click here for 2012 limits)

For a tax filing status of Married Filing Separately, and you have lived with your spouse at any time during the tax year, click here for IRA MAGI limitations. (click here for 2012 limits)

UBTI in an IRA

Aug 3rd, 2011

by jblankenship.

2 comments

Erythronium hendersonii, Henderson's Fawn-Lily

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I’ve mentioned before about various types of transactions that are not allowed in your IRA, but we’ve not actually covered the topic of Unrelated Business Taxable Income (UBTI) in your IRA. UBTI isn’t prohibited within an IRA, but it does pose problems and adds a great deal of complexity to your account.

Unrelated Business Taxable Income

So, what is UBTI anyway? The concept of UBTI pre-dates IRAs – it was originally developed in relation to charitable organizations, trusts, and other tax-exempt entities. The IRS developed this concept to ensure that tax-exempt organizations didn’t have a competitive advantage over taxable organizations, such as for-profit corporations. The way that income is determined to be “unrelated” is by checking these two tests:

Is the income from a trade or business that is regularly carried on?
Is the trade or business unrelated to the tax-exempt entity’s exercise of the entity’s tax-exempt purpose?

If these two tests are met, then the income may be UBTI. Here’s an example that may help you to better understand the concept of UBTI (taken from IRS Publication 598:

An exempt vocational school operates a handicraft shop that sells articles made by students in their regular courses of instruction. The students are paid a percentage of the sales price. In addition, the shop sells products made by local residents who make articles at home according to the shop’s specifications. The shop manager periodically inspects the articles during their manufacture to ensure that they meet desired standards of style and quality. Although many local participants are former students of the school, any qualified person may participate in the program. The sale of articles made by students does not constitute an unrelated trade or business, but the sale of products made by local residents is an unrelated trade or business and is subject to unrelated business income tax.

The concept of UBTI covers many more situations, and you can find out much more about other types of activities that can generate UBTI by going to IRS Publication 598.

IRAs

Since IRAs are, until distribution, exempt from tax, UBTI applies to certain types of income received within an IRA account as well (all of this applies to Roth IRAs as well as traditional IRAs). The IRS Code defines any active trade or business as unrelated to the IRA’s tax-exempt purpose.

There are exceptions as well (of course there are!). The exceptions for tax-exempt organizations are numerous and complicated. The following is a partial list exceptions specifically for IRAs:

dividends
interest (includes “points”)
royalties
rent from real property (real estate)
sales proceeds from real property, as long as the property is not held as inventory or held in the normal course of a business (e.g., flipping)

This is nowhere near an exhaustive list – see Publication 598 for more details.

Examples of ways that an IRA investment could generate UBTI include: full ownership of a pass-through business, such as a limited partnership or S-Corporation; use of IRA funds to loan to a business – and the terms of the loan include participation in the profits of the business (as opposed to simple loan payments); and use of IRA funds to flip properties (via a partnership or LLC, for example), since the property is considered inventory and not investments.

Another way that UBTI is generated is through debt-financed income (also known as UDFI). UDFI occurs in a case like this: An IRA purchases a piece of real estate to be held for rental property. In the purchase of the property, the IRA put 50% down in cash and financed the remaining 50% through the seller. Even though rental income is considered to be exempt (see the list above), since debt was used to acquire the property, half of the rental income (reducing as the debt is paid off) would be considered UDFI, and therefore subject to taxation. The good news is that the proportional part of the expenses associated with the debt-financed income would offset the income.

Okay, so my IRA has UBTI. Now what?

If your IRA generates UBTI, it doesn’t disqualify the IRA (like prohibited transactions would). No, what UBTI does is requires your IRA to file an income tax return. This is unusual since an IRA is supposed to be tax-exempt, but since the UBTI is generated, income tax will be owed on the income if it reaches certain levels.

If the IRA generates gross income of $1,000 or more during the tax year, the IRA must file Form 990-T by April 15 of the following year, just like individual tax returns. The issues that arise with this include:

The IRA must have a federal tax id (EIN).
The custodian is considered responsible for filing Form 990-T, but most self-directed IRA custodians transfer this responsibility to the account owner.
The IRA custodian may not have all of the information required to file the return, as much of the information in these privately-held investments is given directly to the account owner.
The account owner ultimately has the final responsibility to file the Form 990-T, and lack of understanding of the rules can cause major issues for the account owner.
The account owner also will be required to file quarterly estimated tax payments as long as the investment is in place. Every three months, a tax payment must be made to the IRS if the total tax for the year is expected to be greater than $500.

Form 990-T is a four-page form, and filling it out can be a fairly complex undertaking – one that you’re not likely to enjoy filling out (as I’m sure you do most tax forms).

Lastly, UBTI is one of those cases where income within an IRA is actually destined to be double-taxed. Even though you pay tax on the UBTI as it is earned within the IRA (at trust rates, not individual rates, which are more compressed), when you take the money out of the IRA you’ll be taxed again. Paying tax on UBTI doesn’t create non-taxable basis in the IRA, in other words.

With so many other eligible investment options, why not stick with the simple, non-UBTI investments for your IRA? If you must invest in one of these investments that could trigger UBTI if it were in an IRA, just go ahead and invest your taxable monies in the endeavor – you’ll save yourself a lot of grief.

Avoid the Overweight Retirement Plan

Mar 30th, 2011

by jblankenship.

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While it’s generally a good idea to defer as much income as possible into your available IRAs, 401(k)s and Roth accounts, as with everything else in life, too much of a good thing can be a problem as well.

When you have the bulk of your financial assets in retirement plans, you might accidentally expose yourself to some risks that you haven’t thought about… since retirement plan assets are much more likely to be impacted by changes to legislation – as we have seen in the past.

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In these days when Congress is looking for money just about everywhere, it’s not a stretch to imagine new legislation coming down the pike to tax retirement plan assets (like the 15% “excess” plan accumulations that was enacted in 1986 and later repealed). Other possibilities include accelerating required minimum distributions to achieve a faster payout taxation of the plan; eliminate the “stretch” provisions; or even nationalization (yikes!) as suggested to Congress by experts as recently as 2008.

Assets held outside of retirement plans enjoy capital gains tax treatment (under current law) that is generally much more favorable than the ordinary income tax rate. Plus, these assets also can receive a step-up in basis when passed to your heirs, removing the capital gains on a lifetime’s appreciation in the account, whereas retirement plan assets do not receive this treatment.

This is not to say that you want to eliminate your retirement plans altogether, but rather to balance your assets by tax treatment. It makes good sense to diversify by tax treatment, as a hedge against the various things that could occur to the retirement accounts.

There is no perfect formula for determining what is the appropriate amount to maintain in tax-deferred retirement plan accounts versus taxable versus Roth accounts – this is determined by the individual, along with his or her trusted advisors.

Sometimes it makes sense for the individual to have the lion’s share of his or her savings in deferred accounts, such as when we’re very young. At other stages in life (early retirement before age 70½, for example) it could make a lot of sense to start eliminating the deferred accounts in favor of Roth or taxable accounts.

The idea is to weigh the tax impacts of moving money about against the potentialities that are out there for massive changes to the tax treatment rules on those accounts.

Required Minimum Distributions for IRAs and 401(k)s

Mar 23rd, 2011

by jblankenship.

1 comment

This is one of those subjects that can be a bit confusing – and it’s based on the rules that apply to the different kinds of plans. You are aware that you’re required* to begin taking Required Minimum Distributions (RMDs) once you reach age 70½ – but did you know that specifically which account you take the RMD from has some flexibility? Well – not just flexibility, also some rigidity…

You Alone amongst all the Thousands....... m...

Image by -RejiK via Flickr

There is a Difference Between IRA and 401(k)

Starting off, we need to understand that, in the IRS’s eyes, there is a big difference between an IRA and a 401(k). For brevity, we’re referring to all sorts of Qualified Retirement Plans, such as 403(b) or 457 plans, as 401(k) plans. You may consider the two things to be more or less equal, but if you think about it, there are considerable differences between the two – amounts you can fund the account with each year, catch-up arrangements, who can defer funds into each kind of plan, and the list goes on.

A 401(k) plan, being an employer-provided retirement plan, has a completely different set of rules governing it – including provisions that go all the way back to the original ERISA legislation. Among those rules are the rules about RMDs.

On the other hand, the IRA is not covered by ERISA, and as such there are other rules that apply to these arrangements – including the RMDs.

We don’t have nearly enough space here to go over everything that is different between these two types of plans, but we’ll cover the RMD treatment fairly well.

Required Minimum Distributions (RMD)

Each and every 401(k) plan that you own is treated as a separate account in the eyes of the IRS. As such, if you have four old 401(k) plans when you reach age 70½, you will have to calculate and take a separate RMD from each 401(k) plan that you have. In other words, you couldn’t aggregate all the plans together and take one RMD from one of the accounts that is large enough to cover all the RMDs. In addition, you have to consider each account separately and figure out how much of each RMD is taxable, if you have post-tax dollars in the account(s).

However, no matter how many IRAs that you have, since the IRS looks at these plans as one single plan, you are allowed to pool all of the account balances together, calculate the RMD amount, and then withdraw that amount any single IRA account or any combination of accounts. Your tax basis is aggregated as well, so the tax treatment is a consideration for the entire pool of your IRAs in total (rather than account by account as is the case with 401(k) plans).

Example

You have two old 401(k) plans and three IRAs. This is your year, you’ve reached age 70½, so you have to start taking RMDs. How do you do it for these five accounts?

Each 401(k) plan has to be calculated separately – and a RMD taken directly from each account. But you can pool the IRA account balances together and take one RMD from one of the accounts that is large enough to cover all three accounts’ minimum distribution.

This is another reason why it can be helpful (from a paperwork standpoint, if nothing else) to rollover your old 401(k) plans into IRAs. By doing this, you don’t have to take a distribution from, in the case of the example above, three different accounts at a minimum.

* One final note: if you are still working at and after age 70½ and your 401(k) plan allows it, you may not be required to take RMDs from the account. This is yet another difference between IRAs and 401(k)s with regard to distributions.

Dealing With the Lump-Sum Inherited Qualified Plan

Mar 9th, 2011

by jblankenship.

2 comments

While most of the time an inheritance of a Qualified Retirement Plan (QRP) such as a 401(k) or 403(b) can be distributed over the lifespan of the heir, such a stretch distribution is not required by the IRS. The only thing that the IRS requires of these plans is that they do not prescribe a benefit payout to an heir that is slower than the stretchout over the lifetime of the heir. This could sometimes mean that the plan requires a lump-sum payout of the plan benefits.

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Prior to 2006, this could really cause a problem, especially if you don’t need the funds at the time. In a good situation the plan might require a 5-year payout; for a rough go of it, they might push you to take the entire amount in a lump sum. Since PPA in 2006, there has been a direct rollover option available to beneficiaries of QRPs. You can set up an inherited IRA account (using the name of the decedent in the title, such as “John Jones, deceased, FBO Jane Jones”) and then perform a direct, trustee-to-trustee rollover into the IRA from the QRP.

This will satisfy the plan’s requirement for the lump-sum payout, while at the same time giving you the option of stretchout of the distributions over your lifetime. It is important to note that this rollover must be a direct, trustee-to-trustee rollover – the 60-day rollover cannot be used in this case!

Roth it!

One additional way to deal with such a payout requirement is to convert the QRP directly to an inherited Roth IRA account. Again, you need to ensure that the account is titled appropriately as mentioned above. But then you can convert the QRP to the Roth account.

This may be another good reason for leaving your retirement account in a 401(k) plan – since there is still no way that an inherited IRA may be converted to a Roth IRA account. In this case the heir has the flexibility to convert the funds rather than rolling them over.

A downside to this is that the inherited Roth IRA is required to distribute its funds to the heir over the heir’s lifetime – which is different from your normal Roth IRA. A standard, owned Roth IRA account does not have to distribute the account’s funds during the lifetime of the owner, but any inherited Roth IRA does. This is true whether the original account that was inherited was already a Roth IRA, or if it was converted from a QRP into the Roth.

Contingent Beneficiary Designation

Mar 2nd, 2011

by jblankenship.

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contingent glasses by verityatthedisco Often overlooked in filling out forms for your IRA or 401(k) is the Contingent Beneficiary. We usually do a good job of determining who is to be the Primary Beneficiary(s) – this is often the Spouse or significant other to the account owner (although others may be designated, more on that below).

The idea is that your Spouse would take ownership of the account, and then designate a new Primary Beneficiary(s). This way your spouse will get the benefit of the account and he or she can choose whomever he or she wishes to be the Primary Beneficiary(s) of the account – possibly a new spouse, or the couple’s children, or a favorite charity.

But what happens if the Spouse predeceases the account owner, or they die simultaneously? Without a contingent beneficiary designation, the estate will determine how the account will be distributed, and this can cause some problems if there is no will specifically naming beneficiaries for such situations. For one thing, without specific beneficiaries named, it is likely that the entire account would have to be distributed within 5 years – rather than allowing for a stretch distribution.

Naming a contingent beneficiary (or class of beneficiaries) can help to resolve this situation. For example, you could name your children specifically as contingent beneficiaries and define the percentage each child should receive. Another way to do this would be to name the class – “All my children” – as contingent beneficiaries, this way all the children would share equally. (This could also be a way to name a Primary Beneficiary class as well.)

Comparison of per stirpes and per capita inher...

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But what if one of your children pre-deceases you? How do you want that situation to be handled: to have the remainder of your children split the benefit equally, or for the deceased child’s family to receive that child’s share? In order to do this, you need to specifically denote that the beneficiary is “All my children, per stirpes”. This phrase will cause the account to be divided equally among your children, living or dead, with the share for each deceased child going to his or her children.

Multiple Primary Beneficiaries

If you have designated a class of beneficiaries (as described above) as your Primary Beneficiary – you may have other plans that you’d like to have enacted in the event of one or more of the class pre-deceasing you.

Instead of your spouse or your children, what if you’re not married and have no children? In this case, you might wish to leave a portion of your account to your sibling(s), and perhaps a portion of the account to a charity.

For a complex example, let’s say you have a favorite charity that you wish to designate to receive 1/2 of your IRA at your passing, and the other half you’d like to go to your brother. In the event that your brother should happen to pass away before your own demise, unless you’ve designated a contingent beneficiary, his estate will receive the half designated to him.

But what if you really wanted it all to go to the charity in the event your brother pre-deceased you? Properly designating the charity as the contingent beneficiary in the event of the brother’s early death would take care of this.

Disclaiming, Too

One more thing: in designating your contingent beneficiaries, you should also make provision for the contingent(s) to take claim in the event that the Primary Beneficiary disclaims the inheritance. In this case, the Primary could determine that he or she prefers to have the account in the hands of the contingent(s), and so disclaims the inherited account.

Without specifically addressing this in your beneficiary designation, your estate could become the beneficiary of the account, negating the wishes of the disclaimer. This is especially important for ERISA-controlled plans (401(k) or 403(b), for example) due to the rules ERISA has for distribution.

You may need to work closely with your custodian to properly make this contingent beneficiary designation, as the forms they give you are purposely simple. And sometimes the custodian will refuse to give you the option of drafting your own letter of instruction for beneficiary designation. In that case, the only way you can get your designation corrected would be to change custodians – and this might be a problem if it’s an employer-sponsored plan.

Just keep this in mind as you consider your beneficiary designations – but do what you can to make sure that your wishes are going to be carried out the way you hoped.

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Roth Conversion and the Pro-Rata Rule

Jan 20th, 2011

by jblankenship.

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good question by e-magic I recently received the following question from a reader. It’s a unique situation that you may find interesting, so I thought I’d share the interaction with you:

Here’s my situation, in 2010, I started with the following:

(A) Rollover IRA (from rollover funds back in 2007 with no new funded added since. $157K was rolled over in 2007, but account is now valued at ~$146K).
(B) Roth IRA (that was opened years ago with minimal amount, but no new funds added in the past decade due to income limitation)
(C) Non-deductible (separate) traditional IRA account opened in 2006 with max allowable IRA amount deposited in each year, but have only been depositing NON-DEDUCTIBLE dollars ($4K each in 2006 & 2007, and $5K each in 2008, 2009, 2010 for a total of $23K invested). However, the account was only worth ~$17K/$18K at the time I went to convert)

In early 2010, after making the 2010 contributions, I converted the entire value of the non-deductible traditional IRA account to a Roth IRA.

My question is: since I’ve kept my non-deductible contributions in a separate account and converted to the Roth IRA, am I subjected to the pro-rata rule for taxes due in 2010 even though I have no other IRA account other than the Rollover IRA? I had thought that since I had a “loss” with my non-deductible account, and that I kept the funds separate, I would not, but not sure.

This was my response:

It seems like this would be pretty complex, but it really isn’t too bad if you keep two things in mind:

1) the IRS looks at all of your traditional IRAs (includes rollovers, deductible contributory and non-deductible contributory) as one single balance

2) given #1, you cannot separate deductible and non-deductible amounts when taking distributions

Since a Roth conversion is a distribution, and knowing what we know from #1 & #2 above, part of your conversion would be taxed and part of it would be tax-free – and the amounts would be pro-rated, based upon a calculation factoring your end-of-year balances in all of your IRA accounts, plus any amount that was distributed during the year.

So, if you take the balance of all of your IRAs at the end of the year ($146k) and add the amount of your distribution for conversion ($18k), you come up with a total of $164k (assuming there were no other distributions in 2010). Of that, you indicated that there was $23k from non-deductible contributions. Dividing that non-deducted amount by the total we come up with ~14.02% (23k / 164k = .14024). Of the $18k that you converted, 14.02% or $2,523.60 would be considered tax-free distribution, and the remaining $15,476.40 would be taxable. (This calculation was done with the very round figures that you provided. Actual end-of-year 2010 figures must be used to calculate the true pro-rata amounts.)

The good news is that, if you choose, you can spread the tax on your conversion onto your 2011 and 2012 returns. Or you can just pay the piper on your 2010 return – it’s your call.

And then there was a follow-up from the reader:

Just a few additional follow-up questions for you:

(1) If only a percentage of my distribution is tax-exempt this year, am I not being “double-taxed” (so-to-speak) on the $15,476.40, since this is after-tax dollars that funded the non-deductible traditional IRA? If I make NO additional conversions or distribution until I reach of age, 59 1/2 (by the way, I’m currently married and in my mid-forties), what amount is tax-exempt when I make the next distributions? Can I expect $15,476.40 ($18K – $2,523.60) + $15,476.40 (taxes due this year) = $30,952.80 now considered as non-deductible because taxes have already been paid (50% was non-deductible conversion, the other 50%, taxes paid in 2010)? Assuming NO new non-deductible funds moving forward, is my “new” non-deductible amount now stand at $30,952.80?

(2) Since my current Roth IRA is UNDER $30,952.80, how can I now correctly earmarked my Rollover account with taxes already paid to $15K so that when it’s time for me to take distribution from that account, I’m not going to be taxed again (!)? In other word, for argument sake, let’s just say my Rollover IRA does not grow beyond $146K until I’m 59 1/2, can I then use $15,476.40 as non-deductible dollars of my $146K, thereby, only ~$130K is taxable? Additionally, I would assume that my Roth would now grow tax-free from here-on-in, so any gains is not subjected to taxes.

(3) Finally, is there any way that I can undo what was converted to my Roth IRA in 2010 before I file my taxes on April 15? I did the non-deductible to Roth IRA conversion back in Jan 2010. I did A LOT of research back in 2009 and there was a lot of advice (Suze Orman, Kiplinger, Money Magazine, etc) that stated that if one had non-deductible funds in a separate traditional IRA, that one would be able to make a Roth conversion in 2010 TAX-FREE. It was touted as a way for those of us who had not been able to make Roth IRA conversions because of income limits to now be able to take advantage of the Roth. There was not any mention of the Pro-Rata. It appears that somewhere in 2010, the pro-rata rule came into play, and now those conversions are not only NOT tax-free, but potentially can be double-taxed! I can’t quite understand how this can be done so that I’m not being double-taxed on my non-deductible funds.

… and here is my response to the follow-up:

Back to my #1 and #2 – you had total basis of $23k (the non-deductible amount) in all of your IRAs. With the distribution and the pro-rata taxation, you will have used up $2,523.60 of the $23k. As you distribute funds from your IRA, each year the rate will adjust to match the new figures. YOU MUST KEEP TRACK OF YOUR BASIS ON YOUR OWN – no one else will track this for you, unless you have your tax guy do it and then I’d keep my own record anyhow if I were you.

The amount in your Roth account is not considered non-taxable basis for your Traditional IRA. The balance of your Roth IRA is classified as: amounts you’ve contributed, amounts you’ve converted, and growth on the value of the first two amounts. The only figure that’s important to track is the total of the amount you contributed or converted, since if you begin taking distributions before age 59½ you’ll need to know how much has already been taxed. Early distributions from the Roth account are not subject to a pro-rata rule – your taxed contributions and conversions come out first, then growth last.

You can re-characterize the Roth conversion at any time before October 15 – but it would be simplest if you did this before April 15. This will essentially put your money back into the traditional IRA and the IRS treats the situation as if nothing happened.

After my response, the reader replied:

I’ve been researching the re-characterization, but have a couple more questions:

(1) The Roth conversion without income limit, can that be conducted in 2011 and onward, or was this just for 2010 only?

(2) If answer to #1 above is yes, can I roll all the deductible portion, $130K of my Rollover IRA (i.e. $146K – ~$16K = $130K) to my current Employer’s 401K, and then convert the $16K tax-free to my Roth IRA this year since I would have paid taxes on this on 4/15/11? Tracking the non-deductible versus deductible seems too complicated — can I just do it this way? That way, outside of the company’s 401K plan, I’d only have a Roth IRA and zero balance in a non-deductible IRA?

To which I responded as follows:

1 – yes, the income limit was eliminated beginning in 2010 and will remain so for the foreseeable future

2 –As I read the code it seems to me that such a move would work. This would be one way of getting around the problem with your conversion/taxation – re-characterize your conversion from 2010, rollover the monies from the deductible account to your 401(k), and then convert the monies from the non-deducted account to Roth. The biggest problem with this is getting the 401(k) plan to accept the roll-in of your IRA.

Photo by e-magic

Order of Roth IRA Account Distributions

Sep 29th, 2010

by jblankenship.

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522px-Grissom_waits_for_launch_orders_61-MR4-60 You may never have thought about this, but when you start to take money out of your Roth IRA account(s), there is a specific order to which the distributions are attributed. You might not think it makes any difference, but in some cases it does – specifically as it applies to any distributions that are not qualified.

Of course, by qualified, the IRS means any distributions that are made after the account has been established for 5 years and one of the following: 1) when you are at least age 59½ years of age; 2) if the distribution falls under the exception for a first time home purchase; 3) the distribution occurs due to the account owner’s complete disability; or 4) the distribution occurs after the death of the account owner. There are other exceptions, which you can read about in the article – Exceptions to the IRA Early Withdrawal Penalty.

Otherwise, your distribution could be subject to the 10% early withdrawal penalty – but this is where the ordering rules come in. As you know, commonly your Roth IRA distributions are considered to be tax-free – but this is only when they are qualified distributions (as mentioned above). When you take money out of your Roth IRA account in a non-qualified fashion (e.g., prior to age 59½), a portion of the distribution may be subject to penalty.

Ordering Rules

You may recall that, since there is no special tax treatment (i.e., no deduction) for your regular Roth IRA contributions, you can withdraw these contributions at any time for any reason. This is the first part of the IRS’ special ordering rules. Withdrawals from your Roth IRA account are attributed as follows:

Excess contributions
Regular contributions
Conversion and rollover contributions, on a first-in first-out basis (generally, total conversions and rollovers from the earliest year first). See Aggregation (grouping and adding) rules, below. Take these conversion and rollover contributions into account as follows:
1. Taxable portion (the amount required to be included in gross income because of the conversion or rollover) first, and then the
2. Nontaxable portion.
Earnings on contributions.

Disregard rollover contributions from other Roth IRAs for this purpose.

Aggregation (grouping and adding) rules. Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.

Add all distributions from all your Roth IRAs during the year together.
Add all regular contributions made for the year (including contributions made after the close of the year, but before the due date of your return) together. Add this total to the total undistributed regular contributions made in prior years.
Add all conversion and rollover contributions made during the year together. For purposes of the ordering rules, for example, in the case of any conversion or rollover in which the conversion or rollover distribution is made in 2010 and the conversion or rollover contribution is made in 2011, treat the conversion or rollover contribution as contributed before any other conversion or rollover contributions made in 2011.

Add any recharacterized contributions that end up in a Roth IRA to the appropriate contribution group for the year that the original contribution would have been taken into account if it had been made directly to the Roth IRA.

Disregard any recharacterized contribution that ends up in an IRA other than a Roth IRA for the purpose of grouping (aggregating) both contributions and distributions. Also disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.

Penalty

So, with the above ordering rules in mind, as you take money out of your Roth IRA, only the part that represents the growth in the account, plus any amount that was converted less than five years prior, will be subject to the 10% penalty. These funds are the last in the ordering process, you won’t be charged the penalty until you get to those amounts in your account.

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iras

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