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Roth IRA

Don’t Forget to Pay Tax on Your 2010 Roth Conversion

Feb 27th, 2013
by jblankenship.
2 comments
Forget-me-not

Remember back in those heady days in 2010, when you finally had carte blanche eligibility to convert your IRA funds to a Roth IRA regardless of your income?  And then there was a special provision that the IRS made available: you could convert money to your Roth IRA in 2010, and delay recognizing the income and paying the tax over the next two years… remember that?  That was so cool.

However.

(Ever notice how there’s always a “however” in life?)

Here we are, two years later, and NOW you have to pay tax on the Roth conversion that happened way back then.  You might have forgotten it altogether, but you can bet the IRS hasn’t forgotten.

Hopefully you didn’t forget this on your 2011 tax return that you filed in 2012 as well.  At that time, you should have recognized half of the deferred Roth IRA conversion from 2010 on your 2011 return, and paid tax on that half.  Now, in 2012, you’re up to the point where you can finish this off.  On your 2012 return you will recognize the remaining half of the 2010 conversion, and pay the tax on it.

The good news is that the tax rates haven’t gone wild like a lot of folks projected – as long as your income didn’t dramatically increase your rates should be roughly the same as they were in 2010.  In addition, if you decided to do your Roth Conversion as soon as possible in 2010 and you invested in the S&P 500 (for example), you would have experienced an increase of more than 33.3% to this writing (February, 2013).  That should help take the sting out of the tax cost.

Just don’t forget to finish paying the taxes on your conversion this year. The penalties and interest on the unpaid tax could take all of the benefit out of your conversion/delay strategy.

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Pros and Cons of the Roth 401(k)

Feb 13th, 2013
by jblankenship.
6 comments
Christine Roth

The Roth 401(k) first became available in January 2006, is an option available for employers to provide as a part of “normal” 401(k) plans, either existing or new.  The Roth provision allows the employee to choose to direct all or part of his or her salary deferrals into the 401(k) plan to a separate account, called a Designated Roth Account, or DRAC.

The DRAC account is segregated from the regular 401(k) account, because of the way the funds are treated.  When you direct a portion of your salary into a DRAC, you pay tax on the deferred salary just the same as if you had received it in cash.  This deferred salary is subject to ordinary income tax, Medicare withholding, and Social Security withholding if applicable.

The unique thing about your DRAC funds is that, upon withdrawal for a qualified purpose (e.g., after you have reached age 59½, among other purposes) the growth that has occurred in the account is not subject to tax.  If this sounds familiar, it’s because this is the same type of tax treatment that is applied to a Roth IRA.  Conversely, the regular 401(k) growth and contributions are subject to ordinary income tax upon withdrawal – just the same as a regular (non-Roth) IRA.

Pros of a Roth 401(k)

Among the positive aspects of a Roth 401(k) versus a regular 401(k) are:

  • Future taxation is eliminated (for qualified purposes).  Growth and contributions are tax-free when withdrawn after age 59½.
  • Concerns over future tax rates are eliminated since you’ve already paid the tax on your contributions. If the future tax rates are greater you’d pay the higher rates on regular 401(k) distributions – no tax is due on qualified Roth 401(k) distributions.
  • Contributions could be withdrawn tax-free, with restrictions, prior to age 59½ – after you have left the employer.
  • Early distribution options for education, home down payment, or medical expenses are not available for a DRAC as they are from a regular 401(k).

Benefits of a Roth 401(k) versus a Roth IRA:

  • Higher contribution amounts for the Roth 401(k) – up to $23,000 in 2013, versus $6,500 for a Roth IRA (catch-up contributions have been included, the maximums are $17,500 and $5,500 if under age 50).
  • Employer matching contributions are available, although these must be directed to a “regular” 401(k) account, not the DRAC.
  • Income restrictions that are applied to Roth IRA contributions are more-or-less eliminated with the DRAC.
  • Contributions can be made to the account after reaching age 70½ if still employed and not a 5% or greater owner of the employer.
  • Loans may be available against the balance in the Roth 401(k) account while still employed, if allowed by the plan administrator.

Cons of a Roth 401(k)

Negative aspects of a Roth 401(k) compared to a regular 401(k):

  • You must pay tax on the salary deferred into the DRAC, whereas deferrals to a regular 401(k) are not subject to ordinary income tax.
  • If tax rates are lower for you in retirement, you have paid a higher rate on the contributions to the account, although the growth is still tax free for qualified withdrawals.

When comparing a Roth 401(k) to a Roth IRA, the following downsides are evident:

  • Upon reaching age 70½ your DRAC account will be subject to Required Minimum Distributions, just like a regular 401(k) or IRA.  This can be mitigated by rolling over the Roth 401(k) to a Roth IRA upon leaving the employer.
  • You can’t access the contributions to the DRAC before you leave employment, while you can always have access to the contributions to a Roth IRA account.

Decision-point

The decision of whether to participate in a Roth 401(k) if your employer provides one is primarily the same as the decision-point of contributing to a Roth IRA versus a regular IRA.  Actually, the decision between the two types of IRA is a bit more complicated due to restrictions on income levels and deductibility, which don’t apply here.  The primary questions that need to be asked are:

  1. Can you afford the tax on the maximum contribution to a Roth 401(k) account?
  2. Do you think the tax rates will be higher or lower when you reach retirement age?

Affordability

If you can’t afford to pay the additional tax on the deferred salary (as compared to when you place the money in a regular 401(k)), then it would probably be better to choose the regular 401(k).

For example, if you’re in the 25% tax bracket deferring the maximum $23,000 into a regular 401(k) will reduce your taxes by $5,750 – and so if you chose the DRAC instead, you’d have to pay that much more in tax.  If this kind of additional tax will have a negative impact on being able to pay your day-to-day expenses, the Roth 401(k) is probably not a good option for you.

Keep in mind that the decision isn’t all-or-nothing: you could choose to direct a portion of your deferral to Roth 401(k) and the remainder to the regular 401(k), which would allow you to manage the amount of extra tax that you pay.

Future Tax Rates

If you believe that the future tax rates will be greater than they are for you now, it will be to your advantage to use the Roth 401(k) – so that you pay tax at the lower rate now and avoid the future higher rate.  On the other hand, if you believe that the rates will be lower for you in the future, deferring tax on regular (non-Roth) 401(k) contributions will be more to your advantage.

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Receive a Tax Credit For Saving

Dec 19th, 2012
by jblankenship.
No comments yet
Life Saver's & Tent, Atlantic City, N. J.

Starting (or staying with) a savings plan can be difficult to do.  After all, it’s often difficult enough to just get by on your earnings day-to-day, week-to-week, before reducing the take-home pay that you’ve worked so hard for by putting it into a savings plan.  The thing is though, once you start a savings plan, you’ll be surprised at how little it “hurts” to start putting small amounts aside.  After a while, you won’t even miss it.

In addition, the IRS has a way to help you get started – it’s called the Saver’s Credit.  This is a credit that you receive on your tax return, simply for putting money aside in a savings plan.  Pretty sweet deal, if you asked me!

The IRS recently released their Newswire IR-2012-101, which details how the plan works and how you can take advantage of it.  The full text of IR-2012-101 is below:

Plan Now to Get Full Benefit of Saver’s Credit; Tax Credit Helps Low- and Moderate-Income Workers Save for Retirement

WASHINGTON – Low- and moderate-income workers can take steps now to save for retirement and earn a special tax credit in 2012 and the years ahead, according to the Internal Revenue Service.

The saver’s credit helps offset part of the first $2,000 workers voluntarily contribute to IRAs and to 401(k) plans and similar workplace retirement programs.  Also known as the retirement savings contributions credit, the saver’s credit is available in addition to any other tax savings that apply.

Eligible workers still have time to make qualifying retirement contributions and get the saver’s credit on their 2012 tax return.  People have until April 15, 2013 to set up a new individual retirement arrangement or add money to an existing IRA and still get credit for 2012.  However, elective deferrals (contributions) must be made by the end of the year to a 401(k) plan or similar workplace program, such as a 403(b) plan for employees of public schools and certain tax-exempt organizations, a governmental 457 plan for state or local government employees, and the Thrift Savings Plan for federal employees.  Employees who are unable to set aside money for this year may want to schedule their 2013 contributions soon so their employer can begin withholding them in January.

The saver’s credit can be claimed by:

  • Married couples filing jointly with incomes up to $57,500 in 2012 or $59,000 in 2013;
  • Heads of Household with incomes up to $43,125 in 2012 or $44,250 in 2013; and
  • Married individuals filing separately and singles with incomes up to $28,750 in 2012 or $29,500 in 2013.

Like other tax credits, the saver’s credit can increase a taxpayer’s refund or reduce the tax owed.  Though the maximum saver’s credit is $1,000, $2,000 for married couples, the IRS cautioned that it is often much less and, due in part to the impact of other deductions and credits, may, in fact, be zero for some taxpayers.

A taxpayer’s credit amount is based on his or her filing status, adjusted gross income, tax liability and amount contributed to qualifying retirement programs.  Form 8880 is used to claim the saver’s credit, and its instructions have details on figuring the credit correctly.

In tax-year 2010, the most recent year for which complete figures are available, saver’s credits totaling just over $1 billion were claimed on more than 6.1 million individual income tax returns.  Saver’s credits claimed on these returns averaged $204 for joint filers, $165 for heads of household and $122 for single filers.

The saver’s credit supplements other tax benefits available to people who set money aside for retirement.  For example, most workers may deduct their contributions to a traditional IRA.  Though Roth IRA contributions are not tax deductible, qualifying withdrawals, usually after retirement, are tax-free.  Normally, contributions to 401(k) and similar workplace plans are not taxed until withdrawn.

Other special rules that apply to the saver’s credit include the following:

  • Eligible taxpayers must be at least 18 years of age.
  • Anyone claimed as a dependent on someone else’s return cannot take the credit.
  • A student cannot take the credit.  A person enrolled as a full-time student during any part of 5 calendar months during the year is considered a student.

Certain retirement plan distributions reduce the contribution amount used to figure the credit.  For 2012, this rule applies to distributions received after 2009 and before the due date, including extensions, of the 2012 return.  Form 8880 and its instructions have details on making this computation.

Begun in 2002 as a temporary provision, the saver’s credit was made a permanent part of the tax code in legislation enacted in 2006.  To help preserve the value of the credit, income limits are now adjusted annually to keep pace with inflation.  More information about the credit is on IRS.gov.

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Retirement Plan Contribution Limits for 2013

Oct 31st, 2012
by jblankenship.
No comments yet
Employee of the Month Reserved Parking Sign

The IRS recently published the new contribution limits for various retirement plans for 2013.  These limits are indexed to inflation, and as such sometimes they do not increase much year over year, and sometimes they don’t increase at all.

This year we saw across-the-board increases for most all contribution amounts, and as usual the income limits increased as well.  This provides increased opportunity for savings via these tax-preferred vehicles.

IRAs

The annual contribution limit for IRAs (both traditional and Roth) increased from $5,000 in 2012 to $5,500 in 2013.  The “catch up” amount, for folks age 50 or over, remains at $1,000.

The income limits for traditional (deductible) IRAs increased slightly from last year: for singles covered by a retirement plan, your Adjusted Gross Income (AGI) must be less than $59,000 for a full deduction; phased deduction is allowed up to an AGI of $69,000.  This is an increase of $1,000 over the limits for last year.  For married folks filing jointly who are covered by a retirement plan by his or her employer, the AGI limit is increased to $95,000, phased out at $115,000, which is a $3,000 increase over last year’s limits.  For married folks filing jointly who are not covered by a workplace retirement plan but are married to someone who is covered, the AGI limit for deduction is $178,000, phased out at $188,000; this is an increase of $5,000 over 2012’s limits.

The income limits for Roth IRA contributions also increased: single folks with an AGI less than $112,000 can make a full contribution, and this is phased out up to an AGI of $127,000.  For married folks filing jointly, the AGI limits are $178,000 to $188,000 for Roth contributions, up by $5,000 over 2012.

401(k), 403(b), 457 and SARSEP plans

For the traditional employer-based retirement plans, the amount of deferred income allowed has increased as well. For 2013, employees are allowed to defer up to $17,500 (up from $17,000) with a catch up amount of $5,500 for those over age 50 (unchanged from 2012).  If you happen to work for a governmental agency that offers a 457 plan in addition to a 401(k) or 403(b) plan, you can double up and defer as much as $35,000 plus catch-ups.

The limits for contributions to Roth 401(k) and Roth 403(b) are the same as traditional plans – the limit is for all plans of that type in total.  You are allowed to contribute up to the limit for either a Roth plan or a traditional plan, or a combination of the two.

SIMPLE

Savings Incentive Match Plans for Employees (SIMPLE) deferral limits also increased, from $11,500 to $12,000 for 2013.  The catch up amount remains the same as 2012 at $2,500, for folks at or older than age 50.

Saver’s Credit

The income limits for receiving the Saver’s Credit for contributing to a retirement plan increased for 2013.  The AGI limit for married filing jointly increased from $57,500 to $59,000; for singles the new limit is $29,500 (up from $28,750); and for heads of household, the AGI limit is $44,250, an increase from $43,125.  The saver’s credit rewards low and moderate income taxpayers who are working hard and need more help saving for retirement.  The table below provides more details on how the saver’s credit works:

Filing Status/Adjusted Gross Income for 2013
Amount of Credit Married Filing Jointly Head of Household Single/Others
50% of first $2,000 deferred $0 to $35,500 $0 to $26,625 $0 to $17,750
20% of first $2,000 deferred $35,501 to $38,500 $26,626 to $28,875 $17,751 to $19,250
10% of first $2,000 deferred $38,501 to $55,500 $28,876 to $44,250 $19,251 to $29,500
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The Roth 401(k) Plan

Aug 20th, 2012
by sraskie.
2 comments
David Lee Roth

Many hard working Americans have access to a defined contribution retirement plan called a 401(k). Essentially, a 401(k) is a retirement savings vehicle provided by employers to their employees as a means for the employee to save for retirement, often with the employer providing a “match” of the employee’s contributions up to a certain percentage.

As of January of 2006 (a result of EGTRRA 2001), employers can now offer employees the Roth 401(k) as part of their 401(k) plan. Before we get into the advantages of the Roth 401(k), let’s briefly look at how the regular 401(k) works. Employees that have access to a 401(k) are generally allowed to contribute up to $17,000 (2012 figures, indexed annually) per year to their 401(k). Employees aged 50 and over are allowed an additional $5,500 (again, 2012 figures, indexed annually). Employee salary deferrals are taken from the employee’s earnings on a pre-tax basis – meaning the amounts going to the 401(k) are not taxed and thus allowed to grow tax deferred in the 401(k) until needed or required to be withdrawn at 70½ (RMDs). When withdrawn, they are then taxed at ordinary income tax rates.

Enter the Roth 401(k).

With a Roth 401(k), an employee’s salary deferrals are taken after the paycheck has been taxed – meaning after tax money goes into the Roth 401(k) account and is allowed to grow tax-deferred and qualified withdrawals are income tax free. Like its regular 401(k) counterpart, the Roth 401(k) requires RMDs to be taken at age 70½.

The Roth 401(k) offers an employee many advantages. The first is that an employee may make more money than would allow him or her to contribute to a Roth IRA. There are no such income restrictions or phase-outs in a Roth 401(k). Additionally, an employee can choose to save money to their Roth 401(k) if they feel they may be in a higher tax bracket at retirement or if they feel tax rates will increase in the future. Also, the maximum contribution to a Roth 401(k) is $17,000 annually versus $5,000 annually for a Roth IRA. Those age 50 or over are allowed to put in an additional $5,500 into their Roth 401(k), whereas those same people are only allowed an additional $1,000 for their Roth IRA. Finally, when an employee retires, they are allowed to roll their Roth 401(k) to a Roth IRA – without taxation or penalty, and avoid RMDs (remember Roth IRAs do not have RMDs).

The first place to check to see if you can take advantage of the Roth 401(k) is with your HR representative. Should you have access to this option, see if your employer will match your contributions to the Roth 401(k). The Roth 401(k) can make a lot of sense for those wanting to save even more money on a tax-advantaged basis.

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The Difference Between IRA Contributions and Rollovers

Jul 18th, 2012
by jblankenship.
2 comments
Contribution Box

Often there is confusion about what constitutes a “contribution” and a “rollover” into an IRA.  This post is intended to clear up the difference.

While both activities are technically contributions, there’s a major difference between the two.  The most significant of the differences is that with a regular annual contribution there are several limits imposed that can be quite restrictive.

Annual Contribution Limits

For an annual contribution to a traditional IRA or a Roth IRA, you are limited to the lesser of $5,000 or your actual earned income for the year.  If you have no earned income, you’re not allowed to make an annual contribution to an IRA.  Above that amount, if you happen to be 50 years old or better, you can add $1,000 more to your annual contribution (2012 figures).

Astute readers will point out that there is the option for a spouse to make a spousal IRA contribution in the event that one member of the couple has low or no income for the year.  As long as the other spouse has earned income, IRA contributions are allowed on behalf of the other spouse up to the limits mentioned above.

In addition, if the taxpayer has a retirement plan available in his or her job, there are further income limits that impact deductibility of traditional IRA contributions.  For 2012, the limit is Modified Adjusted Gross Income above $92,000 (for married filing jointly) or $58,000 for single filers.  Above these limits, deductibility is gradually reduced to zero when the Modified Adjusted Gross Income (MAGI) is at $112,000 (or $68,000 for singles).

For Roth IRA contributions, if the MAGI is greater than $183,000, contributions are not allowed for those who are married filing jointly.  For Single filers, the limit is $125,000.

Rollovers

Rollover contributions don’t have an annual limit.  You can rollover literally as much as you like from a qualified retirement plan (QRP) or IRA into another IRA.  In addition, there is no requirement to have had earned income for the year when making a rollover.

In addition, rollovers have no impact on your annual contribution amounts and vice versa.  You can rollover any amount without having to worry about annual limits, and then you can make regular annual IRA contributions up to the limits mentioned above.

Conversions

You are further allowed to convert any amount that you wish from a traditional IRA or QRP into a Roth IRA without limits and without impact to annual contributions.  The problem is that you have to pay tax on pre-taxed amounts that you convert, and this can amount to a sizable tax burden – all pre-tax amounts converted to Roth IRA are subject to ordinary income tax.

Conclusion

So the major difference between annual contributions and rollover or conversion distributions is that annual contributions represent “new money” being contributed into the IRA or Roth IRA account.  Rollovers are simply the transfer of money that was already in a tax-deferred account, into another tax-deferred account.  Or in the case of a Conversion, this is the transfer of existing tax-deferred funds into a tax-free Roth IRA.

Limits on contributions do not apply to rollovers or conversions; the two types of money are not related in any way.

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Tips for Summer Jobs From the IRS

Jul 16th, 2012
by jblankenship.
1 comment
Reel lawn mower

With summer in full swing, many young folks are working in temporary jobs for the summer.  There are a few things that you need to know about these temporary jobs that the IRS (and I!) would like you to know.  Recently the IRS produced their Summertime Tax Tip 2012-13, which provides important information for students working in summer jobs.  I have added an extra couple of tips after the original IRS text that may be useful to you as well.

The original text of the Tip is below:

A Lesson from the IRS for Students Starting a Summer Job

School’s out, but the IRS has another lesson for students who will be starting summer jobs.  Summer jobs represent an opportunity for students to learn about the tax system.

Not all of the money they earn will be included in their paychecks because their employer must withhold taxes.

Here are six things the IRS wants students to be aware of when they start a summer job.

1.  When you first start a new job you must fill out a Form @-4, Employee’s Withholding Allowance Certificate.  This form is used by employers to determine the amount of tax that will be withheld from your paycheck.  If you have multiple summer jobs, make sure all your employers are withholding an adequate amount of taxes to cover your total income tax liability.

2.  Whether you are working as a waiter or a camp counselor, you may receive tips as part of your summer income.  All tips you receive are taxable income and are therefore subject to federal income tax.

3.  Many students do odd jobs over the summer to make extra cash.  Earnings you receive from self-employment – including jobs like baby-sitting and lawn mowing – are subject to income tax.

4.  Even if you do not earn enough money to owe income tax, you will probably have to pay employment taxes.  Your employer will withhold these taxes from your paycheck.  If you earn $400 or more from self-employment, you will have to pay self-employment tax.  This payes for benefits under the Social Security system that are available for self-employed individuals the same as they are for employees that have taxes withheld from their wages.  The self-employment tax is figured on Form 1040, Schedule SE, Self-Employment Tax.

5.  Food and lodging allowances paid to ROTC students in advanced training are not taxable.  However, active duty pay – such as pay received during summer camp – is taxable.

6.  Special rules apply to services you perform as a newspaper carrier or distributor.  You are treated as self-employed for federal tax purposes regardless of your age if you meet the following conditions:

  • You are in the business of delivering newspapers.
  • All your pay for these services directly relates to sales rather than to the number of hours worked.
  • You perform the delivery services under a written contract which states that you will not be treated as an employee for federal tax purposes.

If you do not meet these conditions and you are under age 18, then you are generally exempt from Social Security and Medicare tax.

My Additional Tips

In addition to the tips that the IRS has given above, I have two more tips to add to the list:

7.  If your income is going to be rather low, enough that you will not owe income tax for the year, you can use the special exemption provision, by writing “EXEMPT” in the box on line 7.  This is allowable if you had a right to a refund of all tax withheld last year (if applicable) and you expect a refund of all tax withheld this year (if any is withheld).  Using the exemption provision, your income will only be subject to withholding for Social Security and Medicare tax.

8.  Since most of the time summer jobs pay relatively low amounts, it can be especially advantageous to utilize a Roth IRA for saving some (or all) of your earnings.  You’re allowed to contribute the greater of your total income or $5,000 to a Roth IRA each year.  Since your tax rate on this summer income is low or possibly zero, this represents a very low cost way to fund a Roth IRA.  An added benefit is that funds in a retirement plan (such as a Roth IRA) are not counted toward federal financial aid calculations.  This can help out when you’re applying for financial aid for college.  See Roth IRA for Youngsters for more details.

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