Tax Tips Blog

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

Edwards writes:

I took approx $5000 out of a Roth Ira that I funded in 2005. I took the money out in 2006 to invest in a startup business (which is going along fairly well). This Roth was funded with a one time contribution.

I miscalculated the amount of funds that would be needed to get this off the ground so I had to hit the Roth.

I received a letter from the IRS asking for me to pay them. I replied to the letter that this IRA was a Roth IRA and because I used after tax dollars AND I had no earnings, that I owed them nothing. I received another IRS letter today that asks me to sign a consent but does not specify what they want. I am not going to sign this.

Question: Did a taxable event occur when I took money out of the roth Ira?

My reply:
Hello Edward.

In general, distributions from Roth IRAs are tax-free until you’ve withdrawn all your regular contributions. After that you’ll withdraw your conversion contributions, if any. When you’ve withdrawn all your contributions (regular and conversion), any subsequent withdrawals come from earnings.

Withdrawals of earnings are tax-free if you’re over age 59½ and at least five years have expired since you established your Roth IRA. Otherwise (with limited exceptions) they’re taxable and potentially subject to the early withdrawal penalty.

You didn’t tell me how old you were when you made the withdrawal or the amount of the withdrawal, just that you “funded” it with $5,000 and had “no earnings”. My guess is that you were under age 59-1/2 when you withdrew the money, prior to it being in the Roth for 5 years, and you did not properly disclose on your tax return the reason for your withdrawal.

If my guess is correct then a taxable event did occur. However, you may not owe any tax if you can satisfy one of the exceptions and/or properly inform the IRS that you had no earnings. It sounds like you did this with your first response to the letter they sent you.

As to their request for “consent” without seeing all the notices that they sent you and your return I would have no idea what they are requesting consent for. It would make sense to me that they wish to verify that you did not have any earnings in your Roth and that is what their content is for, but it’s just a guess and may be incorrect.

I wish you success in your business!

Best wishes,
Gina

Lucille writes:
Dear Mrs. Gina,

I hope that you can give me some advice. I have a Roth IRA (not converted from a traditional) and it has slowly been losing value. What I would like to know if there is a penalty if I withdraw the funds and reinvest funds into an Roth IRA certificate at my local credit union.

Sincerely,
Lucille

My reply:
Lucille,

Hello! Thanks for visiting.

If I’m understanding you correctly, what you’re really asking is if you can change the location of your Roth IRA from wherever it is to your local credit union AND change what you are invested in, both without penalty.

If so, the answer is YES. You can do what is called a “trustee-to-trustee” transfer to transfer your IRA from wherever it is now to your local credit union. Once it has been transfer you can change your investment.

Simply tell your local credit union trustee what you would like to accomplish and they should be very familiar with the rules.

I hope this answers your question.

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

Mark writes: I have a side business with no employees. My understanding of the solo 401k is that you can contribute 15k initially and then 25% of your income. My side business nets 12k-15k. Would I be able to, after paying self employment taxes, contribute the remaining amount in into the solo 401k. Also, I contribute to a 401k through my other job as well. Would I be able to max it out as well?

Thanks for your help,
Mark

My reply: Hi, Mark thanks for visiting! Employee elective deferrals to a solo 401(K) plan are limited to $15,500 for 2008. This means that all of your employee elective deferral contributions for your 401k from all of your employers including your solo 401k from your sideline C business are limited to $15, 500.

However, there are two contribution parts with a solo 401(k). First, you can contribute up to 100% of the first $15,500 of your 2008 compensation or self-employment income ($20,500 if you’ll be 50 or older at year-end). Second, you can contribute and deduct an additional amount of up to 25% of your compensation income, or 20% of your self-employment income.

Because of these two parts you could make employee elective contributions of $15,500 to your 401k at your regular job (assuming your compensation is high enough) and then contribute based on the profits of your sideline business.

But I think you should look into the SEP for your sideline business because you can accomplish the same thing with less paperwork.

Best wishes,

Gina

Tom writes:

My dad is age 57, and will be retiring in 3 months. He will be eligible to take a lump sum distribution from his company’s pension plan. If he does a direct rollover of the pension plan moneys into an IRA, will he be able to make withdraws from the IRA without the 10% penalty, i.e., separating from service after age 55? Or does he have to take withdraws from the IRA subject to Section 72(t) rules to avoid the 10% penalty?

My reply:

Hello Tom!  Congratulations to your father!

As you know if he were to take the lump sum distribution from a qualified retirement plan upon retirement, since he is 57 that distribution would avoid the 10% penalty.

In general, if he were to rollover his pension, instead of taking a distribution, then he would have to abide by the rules of the rollover.  If after he has established an IRA from his pension he wanted to take a distribution, in order to avoid the 10% early withdrawal penalty he would have to find another exception.  Some of those exceptions include:

• Distributions made as part of a series of substantially equal periodic payments for life (as you referred to)
• Distributions made to unemployed individuals for health insurance premiums
• Distributions due to total and permanent disability

Since I have not seen your father’s past tax returns or retirement plan options, the advice given above may not be accurate or complete for his specific situation; thus, I advise your father to consult with a qualified tax professional before making a final decision.

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

Rob asks:Hello Gina. I’ve been trying to figure out what my income and taxes will be in retirement and was hoping to get some help. If a married couple does not work after the age of 65, and we receive money from pensions/social security/401k/Traditional IRA/Roth IRA annually and/or monthly, do we have to pay Social Security & Medicare (7.65%) taxes on any of the income we receive from these payments? I’m aware that we will have to pay federal income tax on the 401k and traditional ira distributions, and i don’t believe we have to pay any federal income tax on the pensions/social security/roth ira distributions, but i have no knowledge of whether or not they have to pay the 7.65% on any of this. Thanks for the help. Rob

My reply:Hello Rob! I think it’s great that you’re thinking about this before your retire, as it may not be as straight forward as you imagined.

First, you paid Social Security & Medicare taxes on the income that was used to make your contributions into your pension / 401(k) / IRA, so they’re not owed again when money comes out. Assuming that you do not have any after-tax contributions in your 401(k)’s and traditional IRAs, then you are correct that you will have to pay Federal tax on those distributions.

If you have any after-tax contributions in these accounts then you already paid Federal tax on the amount of those contributions and do not owe it again.

As for your Roth, you are correct that you will not owe Federal tax (because Roth Contributions are made with money you already paid Federal tax on) as long as you make a “qualified” distribution.

Your pension distributions will be at least partially taxable, perhaps completely taxable.

Whether or not your Social Security benefits are taxed, and how much of them is taxed, depends on what other income you have at that time. In the scenario you describe, at least after your mandatory distributions from your 401(k) and traditional IRA begin at age 70 1/2, at least a portion of your Social Security will probably be taxed.

A qualified tax professionally will gladly help you with this calculation. Short of that, you may wish to spend some time on the IRS website and read up on Publication 590 (Individual Retirement Arrangements), Publication 575 (Pension and Annuity Income) and Publication 17, (Your Federal Income Tax).

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

Jeremy asks:My financial planner told me that I can make withdrawals from my 403(b) account at any time without early withdrawal penalties or federal income tax consequences because I obtained this particular 403(b) account as the result of a Qualified Domestic Relations Order (QDRO). Then as I was leaving his office he handed me a pamphlet that states that I cannot rely on any tax advice he provides. Did he give me correct tax advice? Jeremy

My response:  Hello Jeremy, thanks for visiting.

It sounds to me like your financial planner was confused by the fact that your ex was not taxed and did not have to pay a penalty because of the transfer under the QDRO. Now that it’s your retirement account it behaves exactly like an account you had funded on your own. You can read more about this in IRS Pub 575.

Best wishes,

Gina