Tax Tips Blog

Charles writes: I was wondering if a traditional IRA is rolled over to a ROTH IRA, is that considered income or a capital gain? The reason why I am asking this is if I lost $20,000 in the stock market, I have a loss toward any capital gains. So, If I rolled over $20,000 from my IRA to a ROTH IRA, then I would have a wash gain. That way, I don’t have to write off $3000 per year for the next 6 1/2 years. I don’t want to have to wait that long to write it off.

I hope this makes sense?

Charles

My reply:Hello Charles, thanks for visiting.
Your question makes perfect sense, but sadly it won’t fly.
If all of your contributions to all of your traditional IRAs have been deductible, then the full amount of your rollover would be taxable as ordinary income, even if some or all of the income produced by your traditional IRA was from capital gains.
If you’ve made nondeductible contributions to one or more of your traditional IRAs, then the conversion will be at least partly nontaxable.

Best wishes,
Gina

Steve writes:
I’m sure this question has been covered, but I can’t seem to find the answer I’m looking for….

My spouse does not work. I participate in a 401K. Our modified AGI likely will be 160+. As far as I can tell, we cannot contribute to a Roth IRA. I can contribute fully to a traditional IRA, and to a spousal IRA, up to a combined total of 8K. But no portion of any contribution that I make to either is deductible. Am I right thus far?

With this in mind, does it make sense to contribute to traditional/spousal IRAs, even though contributions are not deductible?

Thanks,
Steve

My reply:
Hello Steve! I have written a lot about retirement plans, including using a non-deductible IRA, and if those posts didn’t help you, I hope this one will…

First, your thinking is correct. Now to try to help you decide if contributing to a non-deductible IRA is right for you, please consider the following:

If you decide to make the non-deductible IRA contribution then you’re free to invest in whatever you like (that’s allowable for an IRA, of course) and you won’t have to worry about current taxes. You can change from one investment to another without incurring capital gains taxes. And when you do eventually withdraw the money from the IRA, you will recover your contributions tax free, so there is no double taxation. The taxable portion of the withdrawals will be taxed as ordinary income. So this would be a good place to invest in things that generate ordinary income anyway, such as corporate bonds, REITs and stock trading on a short-term basis.

And, if the law doesn’t change between now and 2010, starting in 2010, you’ll be able to convert your traditional IRAs to Roth IRAs, notwithstanding your income. You’ll pay tax (at ordinary income rates) on the appreciation between now and the time of conversion, of course, but from then on all further appreciation will be tax-free. If you already had substantial assets in a low-basis IRA, it probably wouldn’t make sense to consider this route, but it sounds like this will be your first traditional IRA.

Or, instead of contributing to a non-deductible IRA you could save for retirement outside of a retirement account, in an after tax account. The goal would be to try and take advantage of the current low tax rates on long-term capital gains and qualified dividends. To accomplish this you could purchase stocks that pay qualified dividends and plan on holding the stocks for at least a year. If you were able to accomplish this, then the maximum tax rate on these items would be 15%; thus you’ve limited your tax exposure. Another option would be to invest in tax-free bonds. With the possible exception of AMT, you would not pay taxes on the tax free bonds. Investments in real estate would be another option. Real estate investments can generate current tax free cash flow and long term gains.

There really isn’t a right or wrong way to go - it’s up to you and your preferences.

Best wishes,
Gina

Mike writes:
This question is in regards to a traditional IRA account for a married couple. If both spouses have compensation income and both spouses don’t have employer sponsored 401Ks, I understand that each spouse can make a deductible $4,000 contribution.

But do they each need their own individual IRA account or can they have a joint IRA account to which they contribute $8,000.

Thanks in advance.

My reply:
Hello Mike, thanks for stopping by.

First, you are allowed to make a deductible contribution to an IRA account if you are not covered by any pension plan, not just a 401(k) plan.

Second, if you are covered by a pension plan or 401(k) plan and your joint income is less than $100,000 then your IRA contribution is at least partially deductible. The amount you can deduct begins to phase out at $80,000 for joint taxpayers.

Third, only one spouse needs to have earned income. The non-working spouse can base their IRA contribution on the working spouse’s income. In this situation their IRA is called a “spousal IRA”.

Fourth, in 2008 you are allowed to contribute up to $5,000 per individual if you’re 49 or younger and $6,000 for each individual 50 or older.

And finally, last, but not least….each individual must have their own IRA account. IRA stands for “Individual” Retirement Arrangements.

Best wishes,
Gina

Vince writes:
I was checking my IRA yesterday and couldn’t find where my broker had taken out the RMD for 2007. I called them today, and they said I did not signed up for automatic distribution. I find this hard to believe, but they are very unfeeling about the matter. The question is, is there anything I can do to avoid the 50% penalty? I think it will be something like $6,000!

Another question is, if I have to pay the penalty, is there any point in taking out now the sum that should have been taken out in 2007?

In any event, I think I will transfer my account to another broker.

Thank you,
Vince

My reply:
Hello Vince, thanks for visiting.

You can petition the IRS to refund the penalty. There’s no guarantee it will work, but it is worth the effort.

Also, do you have more than one IRA? If so, the RMD doesn’t have to be taken from each IRA. You just have to be sure that the distributions are larger than the total RMDs.

Best wishes,
Gina

Emily writes:My financial adviser suggested that I open a Roth IRA as a way of providing for my childrens’ educations, since I can take early distributions from my Roth IRA without penalty for qualified educational expenses. I thought that the same kind of distributions can be made from regular IRA’s (i.e. traditional, rollover, SEP, etc)? If so, is there something particularly appealing about using Roth IRA’s for this purpose, besides the fact that the distributions won’t be taxed? Thank you in advance, Emily

My response: Hello Emily, thanks for writing.

Time to jump up on to my soapbox before I get directly to your question….. I have clients who have spent all, or most, of their retirement assets in order to provide a “better education” for their children. They spared no expense when it came to their children’s education - extra years in school while the child “found themselves”; several colleges and trade schools because the child couldn’t decide on a “career”; and then there’s graduate school, law school, medical school, not to mention their child’s living expenses while in college.

You’re not doing yourself of them any favors if you find yourself without enough retirement funds because you spent it all on their college education. Unless of course you and your children have an understanding that what you’re actually purchasing is a better retirement - they understand and realize that they will be paying for your retirement - living costs, health care costs, vacations, whatever you need.

I’ve never seen a family work this way. Instead I’ve seen successful children who are too busy to realize their parents are now financially destitute and too blind to realize they are the cause. I’ve seen children with over 5 years of post high school education still living with their parents because they couldn’t find a job in their chosen field of study.

I know many bankers and not one of them will loan any money to a retired couple who can’t pay their medical bills, can’t afford their prescription drugs, has fallen behind on their second mortgage they took out for little “Jimmy” to get his Harvard degree, etc. How many times have you heard someone say, “I locked in a great rate on my retirement loan”? You can’t get a loan for retirement.

On the other side of that coin, your children can get low cost, tax deductible loans for education. What I’m trying to say is, it’s my personal opinion that you should have a plan that enables you to fully fund your own retirement BEFORE you even consider funding your child’s education. Now, I’ll jump off this box and try to answer the question I believe you were asking….

First, as you wrote, you can withdrawal funds “without penalty” from all IRAs. This does NOT mean “without paying taxes” - you may owe taxes on your withdrawals made for college education expenses. Even though taxes feel like a penalty, then aren’t.

Roth withdrawals are considered to be taken in the following order:

1. contributions,
2. then conversions,
3. then earnings.

The taxation of each kind of withdrawal is as follows:

• Contributions These are the annual contributions, currently limited to $4000 ($5000 for those 50 and older). These can be withdrawn at any time without tax or penalty.
• Conversions This is money converted from a traditional IRA. (And soon to be money going from a 401k directly to a Roth.) Conversions can be withdrawn any time free of income tax. Remember that the tax was paid at the time of conversion. But they will be penalized unless the money has been in the account for 5 years OR the IRA owner is over 59 1/2 (or is disabled or deceased). Each conversion has a separate 5 year holding period in the Roth IRA.
• Earnings Once contributions and conversions are withdrawn, what is left in the IRA is earnings. Earnings are subject to tax AND penalty unless the Roth has been open for 5 years AND the IRA owner is over 59 1/2 (or is disabled or deceased). The Roth IRA is considered to be opened as of Jan 1 of the year for which the first contribution (or conversion) is made. So if the first contribution to the Roth IRA happened on April 15, 2008 as a contribution for tax year 2007, the IRA is considered to be opened as of January 1, 2007.

In a Traditional IRA, it depends on whether the contributions are deductible or non-deductible. Contributions that are deductible are the same as gains on the account and must meet one of the early withdrawal provisions to be penalty free. If the contributions are non-deductible that portion of the withdrawal is considered a return of basis and not taxed again at withdrawal.

Please don’t rule out your other options of saving for your children’s education. It depends on your family situation and finances, but if you’re certain your children will be attending college a Section 529 plan may be a good option. Yes, you will be penalized if you do not use these funds for college education, but if you have multiple children, you can re-designate it from one child to another and you can even use it yourself.

That said, if you don’t feel a Section 529 plan (or even a Coverdell ESA), is the right option for your family, you may want to consider the risks that the tax rules for retirement savings accounts may change before it’s time to use the money.

Best wishes,

Gina

Ron asks: Under current law, what is the maximum contribution allowable to a traditional IRA for 2007? (Even with the indexing, I expect to make too much to be eligible for a Roth contribution.) We are married, filing jointly, have plenty of earned income to support an IRA contribution, and neither my wife nor I will reach 50 years of age in 2007. Thanks for any help.

My reply: Hello Ron! The maximum contribution allowed is the same as it was last year, $4,000.

Anyone who has earned income (and their spouse) can make nondeductible contributions to an IRA.

As for deductible IRA contributions, eligibility phases out for married couples with Modified Adjusted Gross Income (MAGI) between $83,000 and $103,000. There isn’t an income cap for married couples when neither participates in an employer-sponsored retirement plan. If only one spouse participates in an employer-sponsored plan, deductible IRA eligibility for 2007 phases out between MAGI of $156,000 and $166,000 for the uncovered spouse and between $83,000 and $103,000 for the covered spouse.

Best wishes,

Gina

Rich asks:I’m thinking about opening a SEP-IRA this year. I believe the contribution limit is 25% of profits up to $44,000. If I have two different sole proprietorships, would I have to open two different SEP-IRAs or could I contribute 25% of total profits to just one IRA? TIA.

My reply: First if you already have a traditional IRA account you do not need to open any new accounts, but some custodians may make you open a new one anyway.

Second, because of the adjustment for 1/2 of your self-employment tax, your maximum contribution usually works out to 20% of the sum of your net taxable profit reported on your Schedules Cs up to $45,000 this year.

You may want to read IRS Publication 560.

Best wishes,

Gina

Karen writes:I know this is an easy stupid question and I need an answer really fast. I’m trying to do my 2006 taxes. I’m filing joint. I have maxed out my 401K and will not be making any additional IRA contributions. I’m not yet 50. I had a business for a part of the year this year. My income from my job for part of the year barely makes it above the $76,000 mark for Social Security, so I shouldn’t have to pay any self-employment SS taxes. However, I know that Medicare is not capped. Can you please tell me what the tax rate is for Medicare (I can’t seem to locate it,) so I can figure my SEP-IRA contribution correctly? Thanks.

My reply: I hate to be the bearer of bad news, but the social security tax limit goes up every year and in 2006 that limit was $94,600, not the $76,000 you thought it was (that was correct in 2000). You can find these limits and the rates on the Social Security Adminstration’s website. This means you will probably have to pay self-employment taxes. The rates for 2006 are as follows:

• SS (OASDI) employee 6.20% (capped at $94,600)
• SS (OASDI) employer 6.20% (capped at $94,600)
• Medicare employee 1.45% (no limit)
• Medicare employer 1.45% (no limit)

So if you made exactly $76,000 from your part time job, you’ll be paying 7.65% in Social Security and Medicare taxes on those wages. Then you’ll be paying 15.3% on $up to 18,400 from your self-employment income and paying 2.9% on your self employment earnings above $18,400, if any. You are entitled to an adjustment for one-half of the self-employment taxes that you will be paying.

401(k) and IRA deductions do not affect Social Security or Medicare taxes - only income taxes, so if your part year job was $76,000 after your $15,000 401(k) deduction, you won’t have to pay social security taxes on quite so much of your self-employment income, but you would still be a little under the limit at $91,000.

You’ll need to compute your self-employment tax, which is not affected by the SEP deduction, before you can figure your maximum SEP contribution. You may want to read IRS Publication 560 and then find a qualified tax professional to help you finish your return.

Best wishes,

Gina

www.GLGcpa.com

Dan asks:I’m debating if I should start an IRA or not. The problem is that all contributions would not be deductible. As far as I understand this, it means that any capital gains sells would not be taxed until I was ready to withdraw. My question is about withdrawing money from this account. Are the contributions I made post-tax taxed again upon withdrawal or only the earnings? It would make sense if it were only the earnings, however other than making one lump sum withdrawal, how would you determine what taxes to pay? Thanks in advance for answers to my ignorant question Dan

My reply: Hello Dan, thanks for writing.  Only the earnings are taxed upon your withdrawal.

As you make non-deductible contributions you report them on Form 8606, Part I, which you file with your individual tax return. This establishes your after-tax “basis” in your traditional IRA.

When you take distributions it is treated as if it came from both your nondeductible contributions and your earnings, in the proper proportion.

For example, if your basis is $20,000 and the year-end value of your IRA is $200,000, then your IRA is 1/10th contributions and 9/10ths earnings. If you then withdraw $10,000, $1,000 is tax free, $9,000 is taxable.

Best wishes, Gina www.GLGcpa.com

Jeff writes:I over contributed to my Roth IRA and was required to removed the excess contribution and associated earnings which was done last year. Rather than selling shares of stock and moving cash out of the account, the brokerage let me transfer shares of stock from my Roth account into a taxable account. Is the cost basis for the shares in my taxable account, the value of the stock on the day it was transferred to the taxable account? I had held the stock for over a year in my Roth account, but it has been in my taxable account for less than a year. If I were to sell the shares tomorrow would it be considered a short term taxable gain since they have been in the taxable account for less than a year? Thank you in advance, Jeff

My reply:Hello Jeff! You are correct on both accounts. Shares distributed from any IRA have a basis of their value when distributed and an acquisition date of the date of distribution. For more information please see IRS Publication 590.

Best wishes, Gina www.GLGcpa.com