What’s an IRA?

An IRA is an Individual Retirement Account. A regular IRA (contrasted with a Roth IRA, below), allows you to save money on a tax-deferred basis. Consequently, your account grows without an annual tax on its growth and income. Only upon distribution, ideally in retirement, do you pay tax on your regular IRA. Depending on your income, marital status, and ability to contribute to a workplace retirement plan, you might also be eligible to deduct your IRA contribution. (Here are the 2010 and 2011 IRA tax deduction rules.)

What is a Roth IRA?

A Roth IRA is an individual retirement account which creates the opportunity to save on a tax-free basis. While no Roth IRA contribution is ever tax-deductible, the growth of a Roth IRA, subject to fairly minimal requirements, is never taxed – not even during retirement when you might begin your money out. Unfortunately, not everyone can contribute to a Roth IRA, as there are certain maximum income limits (Here are the 2010 and 2011 Roth IRA contribution limits.)

Why Contribute to an IRA?

The tax benefits alone provide an enormous incentive to save for retirement by using a regular or Roth IRA. In addition, because the money is not easily available without income tax implications (and possible penalties), you are less likely to spend the IRA money than you would if the money were in your checking account. Numerous investment options – from mutual funds (including low-cost index funds) to stocks, bonds and CDs – are available via an IRA. As of 2010, you can even reverse a Roth IRA conversion.

Maximum IRA Contributions Limits

In 2010 and 2011, the maximum amount anyone can contribute to their IRA(s) is $5,000. For people who will be 50 or older by the end of the calendar year in question, an additional $1,000 “catch-up” contribution is permitted.

Earned Income Requirement

In order to contribute to either type of IRA, you must have earned income. For this purpose, earned income is defined as money earned via employment or self-employment. The only exception to the requirement you have earned income is if your spouse has sufficient earned income instead. If, for example, you do not work for pay but your spouse makes $30,000, both of you can make the maximum $5,000 contribution to your respective IRAs, since $30,000 exceeds the $10,000 ($5,000 x 2 IRAs –one for each spouse) earned income requirement.

Mixing and Matching Permitted

If you are otherwise eligible for both accounts, you may contribute to both a regular and a Roth IRA. However, the total annual limit of $5,000 ($6,000 if 50 or older), is a combined limit. Therefore, if a 45 year old contributes $3,000 to a Roth IRA, the most he may contribute to a regular IRA is $2,000.

When Can You Contribute to an IRA?

The deadline for an IRA contribution is the tax filing deadline for the year in question. Therefore, you can contribute for your 2010 IRA until April 15, 2011. Note that if you extend your tax return, you do not get an extension of time to make your IRA contribution.

Still, you can contribute to an IRA at anytime. Right now — in January 2011 —you can contribute to both a 2010 and a 2011 IRA. In fact, you can contribute to your 2011 IRA at any time from January 1, 2011 to April 16, 2012 (you get an extra day because April 15, 2012 is a Sunday).

What if You Want to Make a Deductible IRA Contribution But Don’t Have the Money?

Here’s one “trick” to consider. If your IRA deduction would be deductible but you don’t have the money, you can file your tax return indicating your intention to make the contribution by the deadline of the return. (Simply take the deduction as though you have already made the contribution). For example, you can file in February indicating a $2,500 IRA contribution. Let’s say your refund (due, in part, to this tax deduction) will be $2,500 and you receive it in March. As long as you move the money to the IRA before April 15, you’re in business—you’ve found a way to save for retirement without laying out the cash to do so. Want to report your IRA in TurboTax? It’s easy.

Why Re-characterize?

There are a variety of reasons why you might what to re-characterize a Roth IRA conversion. While this doesn’t apply in 2010, in past years you might have done it for income reasons (in years past, there were income restrictions on who could convert a Traditional IRA to a Roth IRA). More commonly, you may realize that you can’t or don’t want to pay the taxes on the conversion for a variety of reasons (job loss, divorce, changing priorities). It could be that you misunderstood what you were doing or that after the conversion your account lost money (so you would pay less in tax if you converted today).

Whatever the reason, a re-characterization lets you undo the conversion as if it never happened.

Re-characterization Rules

The best way to understand this is that you can usually undo a conversion from a Traditional IRA to a Roth IRA. There are a few exceptions, such as if you contributed directly (regular contribution) to a Roth IRA and meant to contribute to a Traditional IRA, you can make that change as well. You can’t re-characterize rollovers or employer contributions that were made into a Traditional IRA into a contribution to a Roth IRA.

Re-characterizing

In general, the due date to undo your conversion or contribution is the due date of your tax return for that year, including extensions. So if you made the change for 2010, you have until April 15th, 2011 to re-characterize.

To re-characterize, talk with your broker, the one that manages your IRA, to find out what the procedure is to re-characterize your Roth IRA. They will have specific procedures and more advice on what other considerations you may need to think about during the re-characterization.

Jim writes about personal finance at Bargaineering.com.

In 2010, the government lifted this income restriction and is letting everyone convert their Traditional IRAs to Roth IRAs. They are also extending the time period in which you have to pay the taxes due on this conversion. Instead of all the taxes being due in the year of the conversion (2010), you can elect to pay your taxes 50% / 50% in 2011 and 2012. For many people, these new Roth conversion rules are a welcomed site.

So why would anyone want to make this conversion? Well, the main point that I know you’ll need to consider is how you feel about taxes. With a Traditional IRA you can avoid taxes on money contributed, but you pay taxes on that money and the earnings when you withdraw it in retirement. With a Roth IRA, the money you contribute is already taxed, but when it’s time to retire, you can withdraw the funds and earnings without paying taxes.

It’s really a personal preference here, and everyone’s situation is different. Do you think taxes will be higher or lower for you in retirement? If you think taxes will be higher in the future, then a Roth IRA might look more attractive to you. Thus, converting would be worth the hassle.

Of course, taxes aren’t the only factor. You should consider:

Other differences between Traditional and Roth IRAs. These two accounts differ in more than just how they are taxed. For instance, the Roth IRA qualifications set income restrictions on who can make regular contributions annually. Make sure you learn the difference between the two before moving all your money over.

Your ability to pay the taxes. When you convert, you’ll need to pay the taxes on your Traditional IRA funds and earnings. This may be a big cash outlay. Can you handle that kind of payment? Also consider that the extra income may bump you up into a higher tax bracket.

How close you are to retirement. It can take a while before the differences in tax treatment (Traditional vs Roth) can have enough effect to make the initial cash outlay a good deal. It may just be too late for this to be worthwhile for you.

Your take on the Bush tax cuts. As it stands now, the Bush tax cuts will expire and taxes will go up in 2011 and 2012. If you plan on deferring your tax payment on the conversion until then (i.e. because that’s the only way you can afford it), it will cost you more in taxes if the Bush tax cuts expire.

As with any tax-related retirement issue, you need to consult the source to be fully informed. I encourage you to read through the conversion section of IRS Publication 590. And it’s probably a good idea to consult with a tax professional about your situation before you make the move.

On the withdrawal side, you may not withdraw funds prior to 59-1/2 (with limited exceptions) and at age 70-1/2 you are required to start taking withdrawals based on your life expectancy, otherwise known as RMDs, required minimum distributions. The withdrawals are taxed as regular income and subject to whatever marginal rate you’re in when you take that money. The benefit of this is that many people expect to be in a lower tax bracket upon retiring than when they were working.

Now, let’s look at the Roth IRA. In a sense, it’s the opposite of the Traditional IRA. You get no tax deduction for deposits, but the money can grow and is withdrawn tax-free. The money you deposit can be withdrawn at any time without penalty, but the growth within the account is not taxed if withdrawn after 59-1/2.

There are no required distributions at any age. The Roth IRA has its own income limits if you are covered by a plan at work, the phase-out begins at $105,000 for single, $167,000 for married.

So far, we’ve reviewed how to deposit to either account. One other possibility is to convert money from your Traditional to your Roth IRA. You would be required to pay the tax on the converted amount, but that money, as part of the Roth IRAs would not be subject to tax again. Until this year, the conversion was only allowed for people whose adjusted gross income (AGI) was under $100,000. Starting this year, anyone is permitted to convert. A special rule is in place for conversions made in 2010. You are permitted to take the converted amount and pay the tax on half the conversion in each of tax years 2011 and 2012, adding no income to the 2010 return. The current law also permits a conversion from your 401(k) directly to a Roth account, no need to first move it to a Traditional IRA.

These are the basics for what these accounts are and the tax implications for each, but how do you decide which one is right for you and whether or not a conversion from you Traditional IRA or 401(k) to a Roth IRA is the right move? First, you must know your marginal tax rate which is the tax paid as a percent of the very next dollar of taxable income. Unless you are near retirement or already there, your marginal rate at retirement is a bit of a long term forecast. Keep in mind, however, in today’s dollars a single retiree can have $43,300 in gross income (with exemption and standard deduction totaling $9,350 this is $33,950 taxable) to be at the top of the 15% bracket. It would take over a million dollars in pre tax accounts to create income this high. So, as a first step, it’s not a bad idea for someone in the 10% or 15% bracket to choose Roth knowing that as their income increases, they may wish to move to the pre tax 401(k) or IRA to avoid taxation at 25%.

An older wage earner may find that their pension will provide such high replacement income that when combined with their own retirement account withdrawals, they will be in a higher bracket at retirement. Using Roths and starting to convert their pre tax accounts a bit at a time can be a good idea. If you decide to convert, remember, it’s wise to do this only if you can pay the tax, when due, from other funds, not from the IRA money.

As with any financial issue, your specific situation will differ from those of others, so an understanding of the tax consequences of any decision you make is important. If you have questions after reading this, feel free to ask here, there are many who are happy to help. Hopefully now you see why 85 percent of IRAs are opened during tax season.

Why not take the last 2 weeks of January and commit to getting your personal finances in order? With cold weather in many parts of the country it’s a great time of year to hunker down for an afternoon and get your financial house in order.  I call it my yearly checkup, like spring cleaning for my finances.

One of the benefits of getting things organized is that I’m prepared and ready to file my tax return as soon as I have all the necessary tax documents. We usually end up with refund despite efforts to maximize our paychecks, and by filing early we get our refund that much faster. Another benefit is that if you end up owing money on your taxes, you will know sooner, and be able to plan ahead. Here are 5 tips to help you get organized and get a larger refund, or reduce the amount you owe.

5 tips to help you maximize your tax dollars

• Get Organized: Look through receipts, bank statements, and bills to find expenses that are tax-deductible. Expenses like college or professional courses, gas mileage if you use your car for work, and many others are deductible.
• To itemize or not to itemize?: Don’t assume you have too few deductions and take the standard deduction, make sure to run your numbers to see if you would be taxed less by itemizing. If you are itemizing, make sure you read through the instructions, you may miss something that could save you (or cost you) a lot.
• Open a Traditional IRA: Even though your calendar may say it’s 2010, you can still contribute to a Traditional IRA for 2009. This is a fantastic way to avoid owing money on your taxes. Maximum contributions for Traditional IRAs are $5,000 for those under 50, and $6,00 if you are over 50.
• Track Charitable Contributions: Make sure you are valuing your charitable contributions of goods properly. Many people undervalue clothing, and other household goods. To keep track of chartible deductions use It’s Deductible, a FREE product created by TurboTax that you can use online all year long. No more remembering what was in that bag you sent to Goodwill.
• Look for Extra Credit: Credits are more valuable than deductions because they reduce your tax $1:$1. Make sure you thoroughly read and understand all the credits available. You may qualify for a credit that you didn’t know about, such as the American Opportunity (formally the Hope) and Lifetime Learning credit that offset the cost of college tuition.

A bonus tip: Prepare for next year by keeping track of tax related expenses like medical co-pays, dependent care expenses, or capital losses in a simple spreadsheet. Have a folder or envelope in a handy spot to put all your relevant receipts and come 2011 you’ll be ready to file in January.

NOTE: If you make a contribution in 2010 before the April 15th deadline, be sure to tell your broker that you want the contribution to be for the 2009 tax year. By default, they will put it towards 2010 unless you tell them otherwise.

Roth IRA vs Traditional IRA

When it comes to IRAs, there are two major flavors – the Roth IRA and the Traditional IRA. With a Roth IRA, your contributions are not tax deductible but the account balance grows tax free. When you begin withdrawing money in retirement, you are not taxed on the disbursements. With a Traditional IRA, your contributions are tax deductible but you are taxed when you begin withdrawing money in retirement. You either pay the tax today, with a Roth, or you pay a tax in retirement, with a Traditional IRA.

The general idea is that a Roth IRA is valuable if you believe your income tax rate in retirement will be higher than your current rate. If you believe the reverse is true, then you would prefer a Traditional IRA because you get tax benefits immediately. Another school of thought argues that since it’s impossible to determine where the tax brackets will shift, it’s most important to diversify your tax profile. Finally, given the contribution limits on Roth IRAs, it might make more sense to take advantage of it today because you might not be able to tomorrow.

IRA Contribution Limits

IRA contribution limits are the same for Traditional and Roth IRAs. For 2009, you can contribute up to $5,000 total. If you are age 50 and above, you can contribute a maximum of $6,000. This amount is shared between the two types of accounts, so if you want to contribute to both then the sum can’t be greater than your limit.

Roth IRAs have an additional income restriction. If you are single filer, you can contribute the maximum as long as your adjusted gross income is under $105,000. If you earn between $105,000 and $120,000, your contribution maximum will be adjusted based on how much above the lower limit you earn. If you earn over $120,000, then you cannot contribute to a Roth IRA.

For example, if you have an AGI of $110,000, or 33.3% into the phaseout, then you can only contribute 66.7% of the $5,000 limit – or $3,340. (it is always rounded up to the next higher $10 increment, or $200 if the amount is less than $200)

For married filing jointly, the two limits are $159,000 and $169,000.

2010 Roth IRA Conversion Loophole

Starting next year, anyone will be able to convert a Traditional IRA to a Roth IRA. Today, that conversion is only permitted for individuals earning less than $100,000. This is a big deal for people who can’t contribute to a Roth IRA because of the income restriction. If you are one of those individuals, read up on the Roth IRA conversion rules to be prepared.

Jim writes about money at his personal finance blog Bargaineering.com.

What’s the difference between a tax deduction and a tax credit? You might think the two are interchangeable but they aren’t. A tax deduction is something that reduces how much taxable income you claim. A tax credit is something that directly reduces how much tax you owe.

Tax Deduction: Mortgage Interest Deduction

Let’s take an example of a popular tax credit – the mortgage interest deduction. If you own a home and have a mortgage, you are making monthly payments towards the loan. Part of your payment is towards principal and part of it is towards the interest on the mortgage loan. In general, your mortgage interest will be tax deductible. Let’s say you make $5,000 in mortgage interest payments for 2009 and you earn $50,000 a year. You are able to deduct $5,000 from your income so that it appears, for tax purposes, that you only made $45,000 a year.

Since you are in the 15% marginal tax bracket, according to the 2009 Federal income tax bracket, your actual savings is 15% on the $5,000 – or $750. You can measure the financial benefit of a deduction by multiplying it by your marginal tax rate.

Tax Credit: Hope Credit

Let’s compare the mortgage interest deduction to the Hope credit. The Hope credit is an education credit that allows you to claim 100% of the first $1,2000 of qualified education expenses and 50% of the next $1,200, for a total of $1,800. A credit is a straight reduction of your taxes owed, rather than a reduction of your taxable income, so the $1,800 credit means you pay $1,800 less on your taxes.

For refundable tax credits, if you would otherwise owe less than $1,800, you get the difference back as a refund! Unfortunately, the Hope credit isn’t a refundable tax credit (there are only five: the Additional Child Tax Credit, the Earned Income Credit, the Excess Social Security and RRTA Tax Withheld Credit, the First-time Homebuyer credit, and the Health Coverage Tax Credit).

For an intents and purposes, the financial benefit of a tax credit is the value of the tax credit.

Which Is Better?

It’s really not a question of which one is better because you don’t get to choose what a particular expense is. Something that is a tax deduction can’t be a tax credit, so you never really have a choice in the matter! If you’re starting to think that tax deductions are bad, because they only reduce your income, and tax credits are always better, there are some cases where it’s a little better if something is a tax deduction.

The Roth IRA account is a great retirement account only available to those who earn under a certain income limit. For single filers, if you earn more than $120,000, then you won’t be able to contribute to a Roth IRA. You can use tax deductions, such as contributions to a qualified 401(k), to reduce your adjusted gross income so that you would be eligible for the Roth IRA. Tax deductions, unlike tax credits, can be used in this way to open up some opportunities otherwise unavailable to you.

It’s not uncommon for people to mistake the two because IRS terminology was never designed to be clear and easy to understand. It’s usually only important for you to understand it when you’re making year end tax decisions because you won’t be able to mix up the two when you prepare your taxes, especially if you use a tool like TurboTax.