Detailing the Pro-Rata Rule

For IRA distribution purposes, all IRAs (except Roth IRAs) are considered one big giant IRA. It doesn’t matter if you have one IRA that was rolled over from a former employer, and one SEP IRA with your current employer, and one contributory IRA where you put annual contributions, and one after-tax IRA where you put contributions for which you do not take a deduction. All four IRAs will be considered one IRA any time you take a distribution.

Since they are all one IRA for distribution purposes, you cannot separate out any one component of your IRAs. You cannot take out or convert only the after-tax funds in your IRA. All distributions or conversions will be treated pro-rata.

You track your after-tax IRA funds on IRS Form 8606. The form must be filed with your tax return in any year that you make an after-tax contribution (or rollover after-tax funds from an employer plan to your IRA), and it must be filed in any following year when you take a distribution from your IRA. The form will calculate the amount of your distribution that is taxable.

Put simply, the form takes the total year-end balance of all your IRAs and divides that into the total balance of all after-tax amounts in all IRAs. The resulting percentage is then applied to the distribution to determine the tax-free portion of the distribution. The remaining balance of the distribution is taxable. The tax-free amount of the distribution will reduce the total after-tax amount carried forward to your next Form 8606.

Example: John has a rollover IRA from a previous employer of $270,000 and an “after-tax” IRA account with $30,000 of total contributions in it. John takes a distribution of $30,000 from his after-tax account and converts it to a Roth IRA. His total account balance is $300,000 ($270,000 + $30,000 = $300,000). 10% of his distribution will be tax free ($30,000 / $300,000 = 10%). He will pay income tax on $27,000 ($30,000 X 10% = $3,000 tax free, balance $30,000 - $3,000 = $27,000 taxable). Even though he has closed his after-tax IRA, his rollover IRA balance will now include the remaining after-tax balance of $27,000 ($30,000 after-tax balance - $3,000 distributed = $27,000).

As you can see from the calculation, it won’t matter what IRA account you take the distribution from. Some of the distribution will be taxable and some will be tax-free. The overall totals of your pre-tax and after-tax amounts will be reduced without regard to the account the funds came from.

This is another installment in our weekly look at The Slott Report's "Best of 2013". New articles return next week!

-By Beverly DeVeny and Jared Trexler

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3 Surprising Ways Your Retirement Account Could COST You

When managing your retirement account, you should be aware of the unexpected ways those employer-sponsored or IRA accounts could actually COST you. Jeffrey Levine details 3 of those situations in the article below.

Student Aid
If you have a child who is already a college student or is quickly approaching that age, chances are you’ve noticed the extravagant costs that have come to be associated with post-secondary education. In today’s world, a four-year degree at even the most affordable of state-run colleges can easily run into the tens of thousands. It should come as little surprise then that students and parents alike go to great lengths to seek out any financial aid they qualify for to help with the cost. But can your IRAs impact your (or your child’s) ability to claim financial aid?

Well, thankfully there’s some good news here. Retirement accounts can generally be excluded from your assets when you’re filling out the free application for federal student aid (FAFSA). This includes your IRAs and Roth IRAs, as well as your company sponsored retirement accounts. It’s not all roses though. Although you can generally exclude these accounts from a FAFSA application, certain colleges and universities do look at these accounts when determining who qualifies for their own student aid programs. Plus, the FAFSA application includes questions on your income, which can be increased when you take distributions from your retirement accounts or make Roth conversions.

Medicare Premiums
What in the world does your IRA have to do with your Medicare premiums? Nothing, provided your money stays in an IRA. Start taking taxable distributions from your IRA or other tax-deferred retirement accounts though, and suddenly, your IRA can have a lot to do with your Medicare premiums.

That’s because Medicare Part B premiums are income based. For 2013, the “standard premium” is $104.90 per month. However, depending on your income, you could pay more than three times that amount! Those with the highest incomes must pay an additional $230.80 per month in 2013. Ouch! That income could be from continued employment, interest, dividends or other sources, including IRA distributions and Roth conversions.

Here’s the weird thing about the Medicare Part B premiums you need to know. They are generally based off of your tax return from two years prior. So that means that if you make Roth IRA conversion now, in 2013, you might not finish really paying for it until 2015! Some of you may be finding this out first hand this year, as Medicare Part B premiums for 2013 might be increased thanks to the additional income reported on your 2011 tax return from your 2010 Roth IRA conversion (remember, a special rule in 2010 allowed Roth converters to split income evenly over 2011 and 2012).

Taxation of Social Security
If you are currently receiving Social Security benefits, the amount of those benefits included in your gross income and subject to income tax depends on your “combined” - a.k.a. “provisional” - income. This calculation is a little complicated, but needless to say, it includes taxable income from your IRAs and other retirement accounts, as well as Roth conversions. If your income is low enough, you won’t pay tax on any of your Social Security benefits, but if your income is higher, you could pay tax on up to 85% of your benefits. If you’re planning on taking an IRA distribution or making a Roth conversion and receive Social Security benefits, you should factor in any impact it might have on the taxation of your Social Security benefits first.

This is another installment of The Slott Report's "Best of 2013" week. This article was first posted on June 5, 2013.

-By Jeffrey Levine and Jared Trexler

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IRA Rules to be THANKFUL For

With Thanksgiving just days away, let’s reflect on some of the IRA rules you should be thankful for this year.

Be thankful that the qualified charitable distribution (QCD) exists, at least through the end of this year (2013). If you are age 70 ½ or older, the QCD provision allows you to give up to $100,000 directly from your IRA to charity. Although you won't be able to take a charitable deduction for that amount, you won’t have to include it in your income for this year either. This helps keep your tax bill lower by preventing your IRA distribution from increasing your income and potentially phasing out personal exemptions or itemized deductions, or from increasing your exposure to the 3.8% healthcare surtax. Plus, the QCD can be used to satisfy all or a portion of your 2013 required minimum distribution.

Be thankful that there are still no restrictions for Roth IRA conversions. That’s right, no matter what your age, income, account value or any other factor, if you have an IRA or other eligible retirement account, you can convert that account to a Roth IRA today. You will, of course, have to pay the income tax on the amount converted now, but you’ll be creating an account that can grow tax-free for the remainder of your lifetime. As an added benefit, unlike a traditional IRA or company plan, you’ll never have to take distributions from your Roth IRA if you don’t want to.

Be thankful that if you decide to do a 2013 Roth conversion, you have the flexibility to change your mind all of the way until October 15, 2014. If you change your mind, you can do what’s called a Roth recharacterization, and remove all the tax from your Roth IRA conversion. There’s no specific reasoning required by the tax code to do so, but common reasons you might consider a Roth conversion include:

1) You don’t have the money to pay the tax
2) Your account value has dropped since you converted
3) You’ve simply had a change of heart

Be thankful that you can generally change your beneficiary form whenever you want. It’s amazing how much can change in a person’s life from one year to the next. From the celebration of a birth or marriage to the heartache of the loss of a loved one, there’s no shortage of life events that can change who you want to name as your IRA beneficiaries. Luckily, as these events occur, you can keep your plan up-to-date, and make sure your hard-earned retirement savings are left to the right people simply by filling out a new beneficiary form.

Thanksgivukkah wishes to everyone.

- By Jeffrey Levine and Jared Trexler

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Year-End Roth Conversion Question-And-Answer

It's that time of year. The leaves are falling. The holidays are coming. And retirement planning quickly turns to year-end conversion questions. To help the financial advisor-client team with your year-end Roth conversion planning, we have assembled a FAQ list below. Also, read through our latest articles on Roth conversion planning.

Q: What’s the last day I can make a 2013 Roth IRA conversion?
A: The answer to this question is a little tricky. A Roth IRA conversion will be treated as a 2013 Roth IRA conversion provided the funds leave the distributing account by December 31, 2013. If you make your Roth IRA conversion via a direct rollover or trustee-to-trustee transfer - which is generally the best way to convert - then the funds could go into your new Roth IRA the same day they leave your old account.

On the other hand, you can do a Roth IRA conversion via a 60-day rollover, though it’s generally not recommended. In such cases, money might not go into your Roth IRA until well into 2014, but could still be counted as a 2013 Roth IRA conversion. For instance, if you take a distribution from your IRA on December 31, 2013 and deposit the funds into a Roth IRA on February 28, 2014 (within 60 days), you’ve still made a 2013 Roth IRA conversion.

Q: What happens if I make a Roth conversion before the end of the year, but when I meet with my tax preparer to do my 2013 tax return, the tax bill is more than I thought?
A: No problem. A 2013 Roth IRA conversion can be recharacterized - a fancy tax word for undone - up until October 15, 2014. The recharacterization can be made for any reason, including that you simply changed your mind.

Q: If I make a Roth IRA conversion now, when do I have to pay the tax?
A: This depends on a number of factors. Depending on your specific circumstances, you may have to make an estimated tax payment in January 2014. Alternatively, you may be able to square up with IRS anytime before April 15, 2014. Since the answer to this question depends on many variables, it’s best to review this question with a knowledgeable financial advisor or tax professional.

Q: If I convert today, how soon can I access my Roth IRA?
A: Right away. As far as the tax code is concerned, there is no waiting period to be able to access your converted funds. If you are younger than age 59 ½, however, distributing converted funds within 5 years of your conversion generally results in a 10% penalty on those amounts. The real benefit of the Roth IRA conversion is in the long-term tax-free compounding, so if you think you will need to tap your Roth IRA funds relatively soon, it’s probably not a good idea to convert in the first place.

Q: I’ve made Roth IRA conversions in the past. Are there any new rules I need to be aware of for 2013?
A: The Roth IRA conversion rules haven’t changed much lately. However, there are always changes and new wrinkles in the tax law that can factor into whether or not a Roth conversion makes sense. For instance, beginning in 2013, there is an additional 3.8% surtax on any net investment income that exceeds your applicable threshold. Although IRA distributions are not considered net investment income, a Roth IRA conversion will increase your total income, and could result in the 3.8% surtax being assessed on greater amounts of other, net investment, income. 2013 Roth conversions could also result in the loss or reduction of your personal exemptions and itemized deductions. This was not the case in recent years.

Q: Can I put my new Roth IRA conversion in my existing Roth IRA account?
A: There is nothing in the tax code that stops you from doing this, but if there is any chance that you might recharacterize this conversion, you should consider putting it in a separate, new Roth IRA. That will make doing a recharacterization easier. Once you have passed the recharacterization deadline, you can combine your Roth IRA accounts with no worries.

- By Jeffrey Levine and Jared Trexler

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Contributing to an IRA When You Are Married Filing Separately

If you are married, you can choose between filing your federal income tax return as a joint return or as a separate return. In general, the married-filing separately (MFS) status typically gives you fewer tax benefits than filing jointly. That's because MFS taxpayers aren’t allowed to claim certain tax benefits such as the student loan interest and tuition deduction. You also have more of your Social Security benefits taxed. Additionally, there are certain IRA contribution and deduction rules that are generally less favorable when you file separately.

If you want to make an annual Roth IRA contribution for the year, your modified adjusted gross income (MAGI) has to be within a certain dollar range. If you’re MFS, those limits are $0 - $10,000 for 2013 and 2014. For example, if your MAGI is exactly $5,000, i.e., right in the middle of the $0 - $10,000 range, you can only contribute half of the maximum Roth IRA amount for the year. If your income is $10,000 or more, you’re not permitted to make an annual Roth IRA contribution for the year.

If you want to convert your IRA to a Roth IRA, there are no longer any income limits. Before 2010, conversions were limited to taxpayers that had less than $100,000 in adjusted gross income. Further, if you were MFS, you weren’t allowed to do a conversion regardless of your income. Fortunately, you can now do a Roth IRA conversion even if you’re MFS and even if you’re not allowed to make an annual Roth IRA contribution.

If you want to make a Traditional IRA contribution, all you need is to be younger than age 70 ½ and to have compensation from your job for the year. Even if you’re married filing separately, you can still make an IRA contribution regardless of how high your MAGI is. But, as far as taking a tax deduction for your IRA contribution, you have lower income phase-out ranges. For example, if either you or your spouse actively participates in an employer retirement plan for the year, then your ability to take a tax deduction on your IRA contribution is phased out between MAGI of $0 - $10,000. So, it is possible that you can make an IRA contribution, but you probably won’t get a tax deduction for doing so.

Filing your tax return as MFS can be tricky so it’s best that you work with a competent tax adviser.

- By Joe Cicchinelli and Jared Trexler

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3 Things You Should Do Right Away If You Missed Extended Tax Filing Deadline

Did you miss the October 15th extended tax filing deadline? Ed Slott and Company IRA Technical Consultant Jeffrey Levine details 3 things you should do right away if you missed this important tax date.

If you can't view the video below, click here to get the 3 things to do if you missed the deadline. And make sure you subscribe to our YouTube Channel, IRAtv, to get the latest IRA, tax and retirement planning videos sent straight to your email inbox.



By Jeffrey Levine and Jared Trexler

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Slott Report Mailbag: Can I Use Severance Pay as Compensation for a 401(k) Contribution?

This week's Slott Report Mailbag includes questions on using severance pay as compensation for 401(k) contributions, using non-cash distributions to satisfy RMDs (required minimum distributions, and rolling an after-tax 401(k) to a Roth IRA? As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Send questions to [email protected]

Ed,

As long as an employee’s total contributions to his 401(k) in a single year do not exceed $50,000 or 100% of your compensation, does the IRS prohibit an employee from putting his severance pay into his 401(k) when he retires as an after-tax contribution?

In other words, with respect to after-tax contributions to a 401(k), does the IRS preclude the use of severance pay to make after-tax contributions to a 401(k)?

Thanks.

Scott

Answer:
Generally, severance pay is made to employees after they leave the company they work for. True severance pay or “parachute payments” are not considered compensation for purposes of making 401(k) contributions.

2.

Are non-cash RMDs permitted for inherited IRAs that are already in distribution due to the age of the deceased? The beneficiary is age 60.

Answer:
Non-cash distributions can be made to a beneficiary of an inherited IRA to satisfy the RMD for the year regardless of when the decedent died or the age of the beneficiary.

3.

Can an after-tax 401(k) be rolled over to a Roth IRA ?

Answer:
Yes. All 401(k) funds can be converted to a Roth IRA. However, the pro-rata tax rule will generally apply.We looked at that situation in this article.

- By Joe Cicchinelli and Jared Trexler

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Think You Are Done Paying For Your 2010 Roth IRA Conversion? Think Again.

There were two key tax law changes in 2010 that encouraged people to convert their existing retirement accounts to Roth IRAs.

First, the restrictions that previously prevented Roth IRA conversions for those with high incomes or those filing married-separate returns were eliminated. This opened the Roth conversion door for millions of Americans who previously did not qualify to do conversions. Second, 2010 Roth IRA conversions were given special tax treatment. Instead of having conversion income included entirely in 2010 as would typically be the case, 2010 Roth IRA converters were able to split the income from their conversions equally over 2011 and 2012.

That being the case, many of those converters believe they have seen the end of the cost of their 2010 conversions, but that may not be so. There are two key ways in which you may still be affected by your 2010 Roth conversion.

One possibility is that you may be paying 2013 estimated tax payments that are artificially inflated. Here’s why… There are two safe harbor methods for paying estimated taxes that will definitely keep you from owing estimated tax penalties. One way is to pay in 90% of your current year tax liability through quarterly payments. While this is a perfectly acceptable method, it’s not as foolproof as its counterpart, because your current year tax liability isn’t known for sure until after the year is already over. The other safe harbor method requires you to pay in 100% of your previous year’s tax liability (110% for certain high-income filers) through quarterly installments. This is generally the preferred method because by the time your first estimated tax payment for the year is due (April 15th), you typically know, or at least have a pretty good idea, what your total tax bill was for the previous year.

Suppose however, that you made a large Roth conversion in 2010 - say $600,000 - and you split that income equally, $300,000 per year, over 2011 and 2012. If that’s the case, and you’re paying 2013 estimated taxes based on 2012’s tax liability (the generally preferable way), your 2013 estimated taxes will be artificially high, since 2013 won’t have any of that Roth conversion income. Overpaying your estimated taxes doesn’t technically hurt you, since you will get any overpayment back when you file your 2013 tax return, but giving an interest-free loan to the government isn’t exactly on the top of most people’s priority list.

Another way in which you may still be paying for a 2010 Roth conversion is if you are a Medicare participant. Medicare Part B premiums are income-based, so an increase in your income can increase your premiums. Here’s the thing though… the premiums are generally based on your income from your tax return of two years prior. That means that your 2014 Medicare Part B premiums will likely be based on your 2012 tax return. If that return includes Roth conversion income from 2010, your premiums might be higher than they otherwise would be based on your “real” income. Thankfully, however, those Part B premiums should drop back down in 2015, when they will generally be based on your 2013 tax return, which won’t have any 2010 Roth conversion income reported on it.

Then… maybe… finally… you might truly be done paying for your 2010 Roth IRA conversion.

- By Jeffrey Levine and Jared Trexler

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Distributions From a Roth IRA Conversion

Suppose you are one of the many retirement account owners who converted funds to a Roth IRA in 2010 when there was a special 2-year “deal” on paying the taxes. Now you are wondering when you can take a distribution of those funds. The simple answer is that you can always take a distribution of your converted funds. However, depending on what you withdraw, you may not be happy with the tax consequences. Here are the rules.

First of all, all of your Roth IRAs are considered one, big, giant Roth IRA for distribution purposes. Your Roth funds are divided into three “pots” for distribution purposes.

The first pot of Roth funds that you empty are your annual contributions. You can take these funds out at any time and at any age, tax and penalty-free. Any distribution you take from any Roth IRA will be considered to be your contributions until they are gone.

The next pot you empty are your conversions. They are distributed on a first in, first out basis. Your conversions will be always be distributed income tax free. However, if you are either under age 59 ½ and the conversion you are withdrawing from was done less than 5 years ago, the distribution will be subject to the 10% early distribution penalty - unless an exception to the penalty applies.

The last pot of Roth money you empty will be your earnings. Distributions of earnings can be subject to both income tax and the 10% early distribution penalty. To have a tax-free distribution of earnings, you must have established your first Roth IRA account more than 5 years ago AND the distribution must be made after you are either age 59 ½, or due to your death, disability, or the distribution is for the first-time purchase of a home (lifetime cap of $10,000 per person). If you don’t meet those criteria, your distribution will be taxable. If you are under age 59 ½ at the time of the distribution, it will also be subject to the 10% early distribution penalty unless an exception applies.

Now that you know the rules, can you take a distribution from your 2010 Roth conversion? Assuming that is the only Roth IRA you have, yes you can take a distribution from your 2010 conversion. If you are under the age of 59 ½, you will owe the 10% early distribution penalty on any part of the distribution that was taxable at the time of the conversion.

Need help with this or any other IRA question? You can find an Ed Slott-trained advisor in your area on our website, www.irahelp.com.

 - By Beverly DeVeny and Jared Trexler

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Slott Report Mailbag: Is a Conversion From an IRA to a Roth IRA Subject to the 10% Penalty?

This week's Slott Report Mailbag looks at the 10% early distribution penalty, which is in affect before age 59 1/2 in many cases. We also answer a tricky question about Roth recharacterizations. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Ed,

Send questions to [email protected]

My daughter is 47 years old. She wants to convert funds from her traditional IRA to fund her Roth IRA each year. Even though she is not age 59 ½, can she move these funds without the 10% penalty since the funds are moving from one IRA to another?

Thanks!

Scott Wheeler

Answer:
A conversion from an IRA to a Roth IRA is taxable, but not subject to the 10% early distribution penalty.

2.

I have always considered my contributions to my Roth IRA as part of my emergency fund, knowing I could take the contributions (but not the earnings) before I reach age 59 ½ with no penalty. I also contribute to a traditional IRA. There was one year when my income unexpectedly jumped up above the level allowed for a tax-deductible IRA, but I didn’t realize I wasn't eligible until months after I made my contribution. Come April when I did my taxes I had this contribution re-characterized as a Roth IRA and paid taxes on it. My question is this: can the money I re-characterized be included as the portion of my Roth IRA, which can be taken out before 59 1/2 without penalty?

Answer:
Yes. Your recharacterized IRA contribution is treated as a Roth IRA contribution that can be withdrawn tax-and-penalty free at any time.

3.

I made three conversions in 2010. I know that I will be able to make qualified withdrawals on January 2, 2015. I also made a conversion on 1/3/2012. Must this conversion be governed by its own 5-year rule, meaning, qualified withdrawals will begin on 1/3/2017?

Thanks.

Answer:
Assuming you are now age 59 ½ or older, there is no separate 5-year clock for purposes of the 10% penalty on the 2012 conversion because that penalty doesn’t apply any longer. But, if you’re under age 59 ½, the 2012 has its own separate 5-year clock with respect to the 10% penalty. With respect to a qualified withdrawal of interest, there is only one 5-year clock that expires on 1-1-15. All of your future Roth IRA withdrawals will be qualified (tax-free) from then on.

- By Joe Cicchinelli and Jared Trexler

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Slott Report Mailbag: Back to Basics with Key IRA Questions

We are going back to basics in this week's Slott Report Mailbag with questions revolving around the foundation of IRA planning. Converting and accessing funds and avoiding penalties are the fundamental keys you and your financial team grapple with each day. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Can I convert my employer plan or IRA to a Roth IRA?

Answer:

Send questions to [email protected]

All funds in traditional IRAs, SEP IRAs, and employer plans such as 401(k)s are eligible to be converted to a Roth IRA. Funds in a SIMPLE IRA can also be converted AFTER the SIMPLE account has been open for two years. A conversion before that date will be subject to a 25% penalty tax on the amount withdrawn AND the funds are not eligible for transfer to any other type of plan except another SIMPLE. To do a conversion of employer plan funds, you must be eligible to take a distribution from the plan.

2.

Who takes the year of death required distribution from an IRA?

Answer:
Any remaining amounts of the year of death required distribution MUST go to the beneficiary. The distribution never goes to the decedent or to the estate, unless the estate is the beneficiary. Any required distributions that are not taken will be subject to the 50% penalty and are reported on IRS Form 5498 by the beneficiary for the year the distribution was missed.

3.

I just found out I was not eligible to make a Roth contribution/conversion. What do I do now?

Answer:
 

First and foremost, you will have to remove the funds from the Roth IRA. You have three options.

1. Recharacterization - The funds can be recharacterized to a traditional IRA up to October 15th of the year after either the year of the conversion or the year for which the contribution is made. You must notify both the Roth IRA and the traditional IRA custodians that you are doing a recharacterization. A net amount is recharacterized. Gains or losses on the account for the time the funds are in the account that are attributable to the contribution/conversion must also be recharacterized. The funds must be moved in a trustee-to-trustee transfer back to an IRA. Once this is done, the funds are treated as though they had always been in the IRA.

2. Excess Contribution - This option can be used either before or after the October 15th date. If it is before October 15th of the year after either the year of the conversion or the year for which the contribution is made, then again a net amount must be withdrawn. The IRA custodian should be told this is a withdrawal of an excess contribution. The funds will go into your pocket and will no longer be in an IRA. Any earnings that are withdrawn will be taxable for the year of the contribution/conversion, not the year they are withdrawn.

If the October 15th date has passed, this will be your only option for removing the funds. However, you no longer have to calculate gains or losses. You only remove the amount of the contribution/conversion. This is good if you have gains in the account, bad if you have losses. You also will have to pay a 6% excess contribution penalty on the amount of the contribution/conversion that was in the account as of December 31st of the prior year. This penalty will also apply to a contribution made up to April 15th of the current year that was designated as a prior year contribution. The penalty is reported on IRS Form 5329 which is filed with your tax return. The penalty will apply for each year that the excess amount remains in the account (that is why you need to remove it as soon as possible).

3. Carry Forward - You can carry forward the excess amount and use it up in subsequent years as contributions for those years. This is generally only a good idea for contributions when you are fairly certain that you will be eligible to make a contribution in the next year. You will still owe the 6% excess contribution penalty for each year that you have excess funds in the account.

-By Joe Cicchinelli and Jared Trexler

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Slott Report Mailbag: Can I Convert My Non-Deductible IRA Contributions to a Roth IRA?

This week's Slott Report Mailbag discusses Roth IRA contributions, conversions and the availability of certain employer-sponsored retirement plans.  As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

For the last 15 years, I have been putting money in my traditional IRA. I have also been maxing out on my pension at work. Since I never took a deduction for my IRAs, I would like to transfer my traditional IRA to a Roth IRA. What difficulties will I have with the IRS?

John Di Paolo

Answer:

Send questions to [email protected]

You should have no problem converting your non-deductible IRA contributions to a Roth IRA as long as you have been filing IRS Form 8606 with your tax return in each year that you made a non-deductible contribution. The conversion of IRA funds to a Roth IRA is taxable. Because you have non-deductible contributions, those amounts aren’t taxed when they are converted but the earnings will be. There is a pro-rata rule that will apply at the time of your conversion. It can be found on Form 8606. All of your IRA accounts are looked at as one account and will be part of the pro-rata calculation. Your conversion to a Roth IRA will be partly taxable and partly after-tax based on the ratio of all of your after-tax amounts divided by the total balances in all your IRA accounts.

2.

Hello,

Can I contribute to my company 401(k), Health Savings Account (HSA), and a Roth IRA in the same tax year? If so, what are the income and contribution limits?

My wife and I are both in out middle 50s and have an AGI (adjusted gross income) of about $100,000 annually. For 2013: 8% of my paycheck is withheld for our company 401(k) (maximum % the company will match funds). I have $6,500 that will be funding a HSA and would also like to contribute to a Roth IRA (if tax code permits).

Michael in Mount Vernon

Answer:
There are no income limits to contribute to a 401(k), however, the income limits for contributing to a Roth IRA for 2013 are $178,000 - $188,000 if you file jointly. The tax code allows you to contribute to all three if you meet the requirements for all of them.

3.

If a company already has a SEP IRA, can they contribute to an IRA for certain employees as well?

Best regards,

Stacey

Answer:
Yes. An employer-sponsored IRA arrangement allows an employer to contribute to IRAs of any employees he or she chooses. The IRA contribution is treated as wages to the employees.

-By Joe Cicchinelli and Jared Trexler

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Roth Conversions and the 2013 Taxes

A Roth conversion could cost you more in 2013. That's because of several new and/or increased taxes in play for this year. The top income tax bracket is 39.6% for individuals married filing jointly with taxable income in excess of $450,000. A large Roth conversion could easily push an individual into the highest income tax bracket. When adjusted gross income for our married couple exceeds $300,000, personal exemptions and itemized deductions begin to phase out. And, when modified adjusted gross income exceeds $250,000, net investment income for our married couple becomes subject to the 3.8% surtax. So you can see how a Roth conversion could cost an individual more in taxes this year.

So, why do a Roth conversion? The above mentioned taxes are all “permanent,” at least until Congress changes the tax law again. When considering a Roth conversion, you do not want to look short term. Short term means all we are looking at is the taxes due today on the conversion. You want to look long term. Long term you are going to have to deal with these taxes each year. When you get to age 70 ½ you will have mandatory distributions from your retirement plans. Consider whether or not those required minimum distributions (RMDs) will push you up over any one or more of the limits described above. The only way to get out of RMDs is to get rid of your traditional IRA and similar retirement funds. One way to do that is to do a Roth conversion.

Doing nothing means you could feel the pain year, after year, after year. The taxes owed on a Roth conversion are a one-time hit - you only feel the pain once. Later on, when you would have to be taking those taxable RMDs, you can take income tax-free distributions from your Roth IRA instead, if you need money.

There are other considerations when doing a Roth conversion. You must have the funds to pay the income tax on the conversion - preferably non-retirement funds. Using non-retirement funds has the added benefit of reducing future net investment income that could potentially be subject to the 3.8% surtax. If you are going to need to spend your retirement funds in your retirement, a Roth conversion may not be the best thing for you to do. You might be better off spreading the tax out over a number of years.

You can do partial conversions of your IRA to a Roth IRA. Many individuals do this to “fill up a bracket” or to lessen the amount they have to pay in income tax each year. When using this bracket method, you convert only the amount that takes you to the top of your current income tax bracket.

Deciding to do a Roth conversion is a complicated process. This article only discusses a small number of the variables to be considered. You should consult with an advisor before making your final decision. You can find a list of Ed Slott trained advisors on our web site, www.irahelp.com.

A final note - Roth conversions are not an irrevocable decision. You can recharacterize (undo) a Roth conversion up to October 15th of the year after the conversion.

- By Beverly DeVeny and Jared Trexler

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Roth Conversions and the Pro-Rata Rule

For IRA distribution purposes, all IRAs (except Roth IRAs) are considered one big giant IRA. It doesn’t matter if you have one IRA that was rolled over from a former employer, and one SEP IRA with your current employer, and one contributory IRA where you put annual contributions, and one after-tax IRA where you put contributions for which you do not take a deduction. All four IRAs will be considered one IRA any time you take a distribution.

Since they are all one IRA for distribution purposes, you cannot separate out any one component of your IRAs. You cannot take out or convert only the after-tax funds in your IRA. All distributions or conversions will be treated pro-rata.

You track your after-tax IRA funds on IRS Form 8606. The form must be filed with your tax return in any year that you make an after-tax contribution (or rollover after-tax funds from an employer plan to your IRA), and it must be filed in any following year when you take a distribution from your IRA. The form will calculate the amount of your distribution that is taxable.

Put simply, the form takes the total year-end balance of all your IRAs and divides that into the total balance of all after-tax amounts in all IRAs. The resulting percentage is then applied to the distribution to determine the tax-free portion of the distribution. The remaining balance of the distribution is taxable. The tax-free amount of the distribution will reduce the total after-tax amount carried forward to your next Form 8606.

Example: John has a rollover IRA from a previous employer of $270,000 and an “after-tax” IRA account with $30,000 of total contributions in it. John takes a distribution of $30,000 from his after-tax account and converts it to a Roth IRA. His total account balance is $300,000 ($270,000 + $30,000 = $300,000). 10% of his distribution will be tax free ($30,000 / $300,000 = 10%). He will pay income tax on $27,000 ($30,000 X 10% = $3,000 tax free, balance $30,000 - $3,000 = $27,000 taxable). Even though he has closed his after-tax IRA, his rollover IRA balance will now include the remaining after-tax balance of $27,000 ($30,000 after-tax balance - $3,000 distributed = $27,000).

As you can see from the calculation, it won’t matter what IRA account you take the distribution from. Some of the distribution will be taxable and some will be tax-free. The overall totals of your pre-tax and after-tax amounts will be reduced without regard to the account the funds came from.

-By Beverly DeVeny and Jared Trexler

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Slott Report Mailbag: Can I Keep Doing Backdoor Roth IRA Conversions?

This week's Slott Report Mailbag includes questions about the rules involved intended yearly contribution dates (is it when the check was postmarked or when the custodian received it?) and the backdoor Roth IRA conversion. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Hi Guys,

Send questions to [email protected]

I have a question for you. I wrote a check out on 12/27/2011 for my IRA contribution for 2011. The receiving company did not open the mail until January 3, 2012 so they applied the deposit as a 2012 contribution. Because I did not write on the check memo ‘2011 contribution’ they ‘assumed it was for 2012.’ They accepted the deposit into my account. Then at the end of 2012, I deposited $6,000 for my 2012 IRA deposit, it wasn’t until I saw they funded the wrong account that they said, “oh you over funded your IRA for 2012.” I said, “no, that 2011 check was for my 2011 contribution.” They are stating because they did not receive it until 2012 they assume it’s for 2012. Taxes have been filed. Doesn’t the date of check mean something?

Please advise. I’m very upset.

Thank you so much.

Answer:
The IRS rules state that when filing a tax return or making IRA contributions, it’s the date of the postmark that matters. However, a custodian could have a policy that it’s the date they receive a check that matters to them.

2.

Can a new traditional IRA deposit for the 2012 tax year be deposited into an existing "rollover" IRA from previous years that was rolled out of a corporately sponsored plan? I am having a disagreement with a CPA friend of mine. Thanks

Answer:
Yes. In most cases, there is no longer a reason to keep rollover IRA funds separate from other IRA funds.

3.

Hello,

Every year, I need to wait until my taxes are calculated before I know if my income will allow me to contribute to a Roth IRA. If I am over the limit, I do the traditional IRA and immediately convert it to a Roth. I do not have any deductible IRAs. My question is - Is there any reason why I shouldn't just automatically do the traditional IRA and immediate conversion to Roth every year, instead of waiting to see I qualify for a straight Roth contribution? Are there any downsides to this for someone with no deductible IRAs?

Thanks in advance!

Jack Lam

Answer:
The difference is in how the distributed funds are treated. The advantage of making Roth IRA contributions directly versus a back-door conversion is that the Roth IRA contributions can be withdrawn at any time with no federal income tax or 10% early distribution penalty. Making a non-deductible IRA contribution that is then converted to a Roth IRA is a conversion. Roth conversion funds are subject to a five-year waiting period, for each conversion, for exemption from the 10% early distribution penalty if you are under age 59 ½. The ordering rules for Roth distributions state that the contributions will be deemed to be distributed first, then conversions - first in, first out.

-By Joe Cicchinelli and Jared Trexler

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Retirement Plan Income Tax Deadlines

We are down to the wire. Tax day is Monday, April 15th and it is coming up quickly. Following are some retirement plan deadlines you don't want to miss!

April 15th: This is the last day you have to make an IRA or Roth IRA contribution for 2012. There are exceptions for individuals in certain combat zones, and there may be extensions for individuals in certain federally declared disaster areas. The contribution limit for 2012 is $5,000 per person (those age 50 or older at any time in 2012 can add an additional $1,000 to their accounts for a total of $6,000). You must have earned income at least equal to the amount you contribute. You cannot make an IRA contribution if you were age 70 ½ or older in 2012. There are income limits for making a Roth contribution. Participation in an employer plan has NO impact on your ability to make IRA or Roth IRA contributions.

October 15th: This is the deadline for recharacterizing a contribution or a Roth conversion. You must have timely paid your taxes and filed your return or your return must be on extension to qualify for this date.

This is also the deadline for timely removing an excess contribution made for 2012. If the contribution is not removed in accordance with IRS guidelines, the 6% penalty will apply to the amount of the excess contribution.

This is also the deadline for making employer contributions to a SIMPLE IRA. The SIMPLE IRA must have been timely established in 2012.

December 31st: This is the deadline for taking a 2013 required distribution. If 2013 is your first distribution year, you can delay the first distribution until April 1, 2014. However, you would still have to take a second distribution for 2014 by the end of 2014.

This is the last date to do a Roth conversion for 2013. In order for a conversion to be a 2013 conversion, the funds must be out of the IRA or employer plan by December 31, 2013. You do not have until April 15, 2014 to do a 2013 Roth conversion.

SEP IRA Contribution Deadline: SEP IRAs can be established and funded up to the tax filing deadline plus extensions for the business. The business need not be on a calendar year.

You can find more information on these deadlines in IRS Publication 590 (for IRAs) or Publication 560 (for SEPs and SIMPLEs) on the IRS website at www.irs.gov.

Timing is everything. Don’t miss your deadline.

-By Beverly DeVeny and Jared Trexler

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Slott Report Mailbag: When Is a Spouse's Consent Required for IRA Beneficiary Exclusion?

This week's Slott Report Mailbag answers questions running the gambit of financial planning - from the 403(b) employer plan side to IRA beneficiary rules and the Roth conversion conversation. We also answer a question that is state-specific regarding IRA beneficiary exclusion. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Ed,

Send questions to [email protected]

If my company matches my Roth 403(b) contributions, do I have to track the employer (pre-tax) contributions separately from my Roth 403(b) contributions, or should my employer be contributing the matching contributions to my 403(b) plan? I’m concerned both might be going into the Roth 403(b), which would result in a pro-rata distribution when I start taking my distributions.

Thank you,

Jeff

Answer:
The plan must track the employer and employee contributions as well as the “regular” 403(b) portion and the Roth 403(b) portion. The match must be allocated to the regular portion of your 403(b) account. If you believe that there is a mistake on how the plan is allocating the contributions, you should ask the plan administrator.

2.

I have a question regarding distribution of an inherited IRA.

I am the executor of my mother’s will. She has an IRA, which she makes monthly withdrawals from. She has no other savings and just a checking account that depletes monthly.

Her IRA will be split amongst four children. As the executor, how do I have monies taken from the IRA to pay off her debts before it is distributed as per her IRA beneficiary form?

The only money that will be available to pay off the debts will have to come from the IRA.

Thanks,

Jay Lewis

Answer:
Assuming your mom has passed away, because the estate is not the IRA beneficiary, you do not control the IRA funds. Each of the four children as beneficiary controls their own portion of the IRA. If any child uses their portion to pay off mom’s debts, that child will still owe income tax on the inherited IRA distribution. The children may want to disclaim the IRA and then, if the funds go to your mother’s estate, there will be money to pay off her debts. You should speak to an estate planning attorney, CPA or financial advisor before taking a distribution.


3.

When is a subsequent spouse's consent required for exclusion as a beneficiary? Would the answer be affected by the fact that the IRA is fully funded prior to the marriage? For information purposes, the primary beneficiaries are children and grand children from a previous marriage.

Answer:
Under federal law, spousal consent is not necessary to name an IRA beneficiary. However, spouses have rights under state law. For example, if you live in a community or marital property state, spousal consent is generally required to name someone other than the spouse as the beneficiary of an IRA. Those states are Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

4.

Hi Ed,

Love your articles. I have a scenario-related question. I never considered the possibility of a Roth conversion due to my higher income years, but it may make sense as I wind things down.

I am 60 and contemplating full retirement. My wife (58) and I have about $1.3 million in traditional IRAs. We plan to collect Social Security at 66 or delay a bit. We have over $1 million in our brokerage account (all long-term positions earning qualified dividends).

Unless I starting draining IRAs, required minimum distributions (RMDs) on top of my social income will drive my tax bracket up considerably down the road.

I am in an "income trough" for the next 6 years. Conventional wisdom says to use taxable accounts first in retirement, but it would seem to make sense to convert $60-80k per year of IRA funds to Roth over the next 6-7 years while living off my taxable account. Our cash needs are low enough that I could do this and stay in the 15%-25% tax bracket during these years and cover the distribution taxes.

Down the road, I will have a tax-efficient taxable account and healthy Roth accounts that are post-tax.

Does this strategy make general sense?

Thanks,
"xcrider"

Answer:
Generally, moving funds from taxable IRAs to tax-free Roth IRAs can be beneficial. The Roth IRA benefits are tax-free income in retirement - keeping taxable income low, even when taxes increase. Also, there are no required distributions for Roth IRA owners. If you will not need the money soon or at all, the Roth conversion can be an excellent and effective estate-planning vehicle. However, you should discuss this with an advisor beforehand. The new taxes this year on net investment income, the return of phase-outs for deductions and exemptions, and the new higher income tax bracket could all be affected by a Roth conversion.

-By Joe Cicchinelli and Jared Trexler

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Reminder From IRS: Don't Forget Your 2010 Roth Conversion!

IRS recently issued a "friendly" reminder to taxpayers who did Roth conversions back in 2010 and took advantage of the two-year deal to split their conversion income equally between 2011 and 2012.

IRS wants to be sure that those taxpayers do not "forget" to include the second half of their conversion on their 2012 tax returns.

Normally, a conversion is taxable in the year the funds left the IRA or employer plan (you do not have until April 15th to do a conversion for the prior year like you do for a Roth contribution). In 2010, Congress needed to raise money so it encouraged us to do Roth conversions by allowing us to not include the income on our 2010 tax returns, but to instead include half of the converted amount on our 2011 return and the other half on our 2012 return. Now, it is time to pay the piper.

Don’t think that IRS has forgotten about your tax bill. In 2010, they made you tell them how much you needed to include on your 2012 return. It was done on IRS Form 8606 in Part II for an IRA conversion and Part III for a conversion from a plan. Since the ability to defer the income for two years was only available in 2010, you will only find that specific language on the 2010 version of Form 8606.

If you do not have the funds to pay the tax, you do not have too many options. It is too late to recharacterize the Roth conversion and get out from under the tax bill. A 2010 Roth conversion could be recharacterized up to October 15, 2011. IRS has the ability to allow a taxpayer additional time to do a recharacterization, but generally will only do so if the failure to do a recharacterization is due to advisor error. The extension of time can only be granted through a private letter ruling request and IRS charges a fee of $4,000 for those requests. You will have to pay professional fees for someone to prepare that ruling too. There is no guarantee that a taxpayer’s request will be granted.

So, make sure you include the last installment of income from those 2010 Roth conversions on your 2012 tax return. If you cannot pay the tax bill, seek the advice of a tax professional for your options on dealing with IRS.

Article Highlights:

• The last installment of income from a 2010 Roth conversion is due with 2012 income tax returns
• There is no ability to recharacterize a 2010 Roth conversion

- By Beverly DeVeny and Jared Trexler

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Slott Report Mailbag: Can I Contribute to a Roth IRA?

This week's Slott Report Mailbag includes some of the more popular questions we receive each week. Can I contribute to a Roth IRA? What happens to my deceased parent's required minimum distribution (RMD)? We answer those questions and more in the question-and-answer below.  As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

Send questions to [email protected]

1.

I made a Roth contribution for this year, but my accountant says I will make too much money to be eligible to make a contribution. What are the rules for making Roth contributions? I thought everyone could make a Roth contribution now.

Answer:
As of 2010, everyone can do a Roth conversion, but the rules for Roth contributions did not change. So, even though you can convert millions in your IRA accounts to a Roth IRA, you may not be able to contribute a mere $5,000.

First of all, you must have earned income or compensation in order to make a Roth contribution. Social Security, pension payments, rental income, interest and dividends are NOT earned income - even if you worked hard to get them.

You can make Roth contributions even after you are 70 ½, as long as you have earned income.

There are income limits for making Roth contributions. For 2013, if you are married filing jointly and your income is more than $188,000 you cannot make a Roth contribution. The ability to make a contribution phases out for income between $178,000 to $188,000. If you file your return as single or head of household, the ability to contribute phases out between $112,000 and $127,000. If you are married, filing separate, the phase-out range is $0 to $10,000. The formula for calculating the amount of your contribution when you are in the phase-out range can be found in IRS Publication 590.You can find that on the IRS website, www.irs.gov. On the left hand side of the screen, click on Forms and Publications.

The numbers for the phase-out ranges are not your gross income; they are your modified adjusted gross income (MAGI).

2.

My mother died this year before taking the full amount of her required minimum distribution (RMD) from her IRA. What happens now?

Answer:
The full amount of the required distribution must be taken in the year of death. The beneficiary named on the beneficiary form for the IRA must take any distribution not taken. It does not go to the decedent or on their return. It does not go to the estate unless the estate is named on the beneficiary form. When there are multiple beneficiaries, generally the RMD amount will be split between them according to the percentages of the account that they inherit. But if one beneficiary wants to take out their share in full, that distribution can be used to satisfy any remaining RMD. The general rule is that the first funds out of the IRA account (that are payable to an individual), will satisfy the RMD.

3.

I have an irrevocable trust named as my IRA beneficiary. Does that mean I can't change my beneficiary?

Answer:
No, you can still change the beneficiary. The trust may be irrevocable, but chances are your beneficiary form is not. So if you are no longer happy with the irrevocable trust as your beneficiary, simply contact your IRA custodian and/or advisor and name a new beneficiary. You can even name a new irrevocable trust.

- By Joe Cicchinelli and Jared Trexler

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Slott Report Mailbag: Can I Deposit This Check In My IRA After 60 Days?

This week's Slott Report Mailbag talks about the act of "moving money" from one retirement account (yours or an inherited account) to another. There are many tax and penalty pitfalls at play, and we dissect the right way to go through these procedures in the question-and-answer below. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

I retired and asked to do a direct rollover from my former employer's 401(k) plan to my IRA. The check was mailed to my house but made payable to my IRA custodian. I just realized I didn't deposit that check right away. It's now past 60 days since I received it. Can I deposit that check now or is it too late?

Send questions to [email protected]

Answer:
You're in luck. You can deposit that check even though it's after 60 days from when you received it. The 60-day rule does not apply to a direct rollover. A direct rollover is when you don't have control of the money. In this case the check was made payable to your IRA custodian, not you. Therefore, you can deposit that direct rollover check after 60 days.

2.

My Aunt died and I directly rolled over the pension money she left me to an inherited Roth IRA. Is this a tax-free rollover?

Answer:
No. This is a taxable rollover because the money was rolled into an inherited Roth IRA. If you had directly rolled over the money to an inherited regular (Traditional) IRA, it would have been a tax-free rollover. The good news is that when you later take the money out of the Roth IRA, it will generally be tax-free.

3.

I took out $20,000 from my IRA last month in one withdrawal. I'd like to complete the rollover of $20,000 with multiple deposits to my IRA during the 60-day rollover time frame. Will the IRS allow me to do that or must I roll over the entire $20,000 in one deposit?

Answer:
It's your choice. You can roll over the $20,000 in one deposit or you can do multiple deposits totaling $20,000 on separate days, as long as the deposits are made within 60 days.

-By Joe Cicchinelli and Jared Trexler

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