Taxes 101: IRA Conversions

Taxes 101

IRAs are all the rage during tax season. In fact, 82 percent of taxpayers qualify for tax-deductible IRA. To understand the Roth IRA, we need to take a tiny step back and first get to know the Traditional IRA. The Traditional IRA allowed you to reduce your taxable income by making a deposit to your IRA and taking that amount as a deduction off your income for tax purposes. For those in the 25% tax bracket this means that a deposit of $5000 is only $3750 out of your pocket this year. If you have a 401(k) or similar retirement plan at work, your ability to deduct you IRA deposit may be limited depending on your income. This phase-out begins at $55,000 for singles, $89,000 for married. Here’s a short video and post about boosting your refund with IRAs.

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 You get no tax deduction for deposits, but the money can grow and is withdrawn tax-free. The money you deposit can be withdrawn at any time without penalty, but the growth within the account is not taxed if withdrawn after 59-1/2.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.