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

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

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

Mary would like to know: My husband and I have both been contibuting to Roth’s - 1600.00 combined per year. This past year, because he left a job, had a vacation buy out, and started a new job, we are over the salary limit for the Roth, among other things. We are stymied by what to do. Next year our income will not be over the limt. Do we have to take out everything? Only the amount contibuted this past year? What if we did nothing? We have continued contibuting, but are wondering about converting to a traditional IRA - all of the investment or only the amount from last year?. Any suggestions would appreciated? In addition, we have lost the tuition deduction for the 2 college kids and the 2 other children under 17 because of this income this year. Thanks!

My response: Dear Mary,

The law provides a way to fix an excess contribution that was made to a Roth IRA. If you do not fix the excess contribution (or you do not fix it properly) you are required to pay a 6% penalty tax EACH YEAR the excess contribution remains in error.

You can avoid the 6% penalty tax by taking the excess contribution and any earnings attributed to the excess contribution out as a distribution on or before the due date (including extensions) for filing your return for the year of the excess contribution. You are required to report and pay tax on the net income attributable to the excess contribution in the year of the excess contribution, even if you take it out during the following year. The earnings will be taxed like any other taxable distribution of earnings from a Roth IRA, and will be subject to the early distribution penalty if you’re under 59-1/2 unless an exception applies.

Another potential way to correct the excess contribution is to have the trustee of your Roth IRA make a direct transfer to a trustee for a regular IRA (the IRS refers to this as a “recharacterization”). To avoid penalties, the transfer must occur on or before the due date (including extensions) for filing your return for the year of the excess contribution. This transfer must include the amount of the excess contribution and the earnings that are attributed to it. If this is done properly the contribution will be treated as if it went to the regular IRA in the first place and you don’t have to pay tax on the earnings that are transferred from one IRA to another. As you can see, by recharacterizing the excess contribution and it’s earnings you can eliminate the 6% penalty tax and you’re allowed to keep the earnings in an IRA, instead of taking the earnings out and paying tax on them. Of course you’ll benefit from a recharacterization only if you’re permitted to contribute to a regular IRA. If your excess contribution to the Roth IRA would also be an excess contribution in a regular IRA you can’t use this method to avoid a penalty. If you’d like to research this further you can start with IRS Publication 590: Individual Retirement Arrangements and for various worksheets, calculators and other articles on the Roth IRA you may wish to visit http://rothira.com

I hope I satisfactorily answered your question.

Best wishes, Gina

Sharon asks:I have a Roth IRA and was considering to use it instead of my regular account for purposes of trading stocks, mind you I am not a day trader, when I refer to trading stocks, it may be after holding it a couple months to possibly a year to two. I will do that with seasonal stocks or cyclical. I have been for the most part long-term buy and hold in my Roth IRA, but figure i would be able to get a tax benefit if I traded within the Roth, is my reasoning sound? Thanks in advance for any comments. Sharon

My reply:

Without suggesting what is or is not an appropriate investment or way for you to invest (since I do not know what your total portfolio or personal financial statement looks like), I can say, that from a tax standpoint you are correct.

It is generally true that keeping investments that yield, or may yield, gains taxed as ordinary income in an IRA makes good sense. The most obvious exception that I can think of is foreign stocks, as the foreign tax that is withheld will be permanently lost.

You should also keep in mind that there are no tax benefits to losses incurred by trading in an IRA account.

And most important, it is rarely wise to change your basic investment strategy due to taxes.

Best wishes, Gina

Kelly asks:Is it true that I will never have to pay capital gains taxes on my Roth IRA? If I do well in the market and my Roth has a million dollars in it and $50,000 of that is contributions, I can take money out and won’t have to pay any taxes? No short term or long term capital gains? And no additional income taxes later when I retire and take even more money out? And my withdrawals won’t bump me up into a higher bracket? Right now, I’m not concerned with mandatory withdrawals, but I’m trying to figure out which account will be most beneficial to withdraw from first, my Roth or my 401K, or to withdraw a balance between the two accounts. There’s lots of years for things to change, I’d just like to get a general idea. Thanks a bunch!

My response: Hello Kelly!

Until Congress changes the law, all qualified distributions from a Roth IRA are not included in gross income and no taxes (or penalties) are due on the contributions you make or their earnings.

In general, a qualified distribution is a withdrawal from a Roth IRA made 5-taxable-years after the year of your initial Roth IRA contribution when you have reached age 59-1/2.

Most taxpayers who have both a Roth IRA and a 401(k) find that it is beneficial to withdrawal from both of their plans at the same time. Some taxpayers choose to withdrawal enough from their 401(k) such that they use up their personal exemptions and standard or itemized deductions and withdrawal the remainder that they need to live on from their Roth. Other taxpayers, withdraw more from their Roth IRA such that they do not make their Social Security benefits taxable. You should ask your tax professional to run some projections for you, such that you’ll know what makes the most sense for your situation.

Before anyone asks, no I cannot see into the future and I am not sure that Congress will change the law, but I wouldn’t put it past them. Many of us can remember when Social Security benefits were completely tax-free. Then they capped the taxable part of Social Security at 50%, and now up to 85% of Social Security benefits are taxable. It’s not hard to imagine that someday Congress will do the same to Roth IRAs. It would be very easy for them to change the Roth IRA into the equivalent of a non-deductible traditional IRA (no income tax on the amounts previously taxed, but taxes due on earnings, etc.).

Best wishes, Gina

Chris ponders: I’m so glad I found your blog! I’m still eligible for contributing to a Roth IRA. I’m married, but due to my household income I can only deduct $3500. Can I put the remaining $500 into a non-deductible traditional IRA? Also, assuming I could put the remaining $500 into a traditional IRA, would I really want to? Thanks.

I respond: Hello Chris! I’m glad you found my blog too! You can’t “deduct” any contribution to a Roth IRA, but you can “make” a $3,500 Roth contribution. If this is your situation, then yes, you could put the remaining $500 in a (non-deductible) Traditional IRA. As far as whether or not you would want to, that’s totally up to you. In order to help you make this decision I will provide you with the following information:

• Future taxable distributions from a traditional IRA will be taxed as ordinary income.
• In future years you may be able to transfer that money into a Roth IRA from a Traditional IRA.
• IRA assets are better protected from creditors than other assets.
• The IRS is constantly changing the “rules of the game”. Someday, all (or a larger portion) ROTH distributions may be taxable.

Best wishes, Gina

Francine from Houston: Hi Gina! I have a SIMPLE IRA through my employer. I having been making regular contributions to this plan for three years. I would like to do a SIMPLE to ROTH conversion before the end of this year. In the past, I did a ROTH conversion of my employer account just after I left my employer. However I plan on still being employed by this employer well into next year. Can I still convert my current SIMPLE IRA to a ROTH even though I’m still going to be employed? That is if my employer and current custodian (Fidelity) will allow it? Yes, I am otherwise eligible to do a SIMPLE to Traditional to ROTH conversion. Thanks, Francine

My response:Hello Francine! Thanks for visiting. Once a SIMPLE plan has been in existence for 2 years, your account behaves just like a traditional IRA. Thus, you can convert to Roth with no interference from the plan. For more information please see IRS Publication 590.