IRA, Roth IRA Tax Traps
If you have or plan to have an IRA or a Roth IRA, check out Senior Correspondent Mike Causey\'s column today before you make any moves. His expert guest says th...
While I am taking a break, we’re running some of the best-of-the-best articles on financial planning for feds and retirees. Today’s is courtesy of the Federal Employees News Digest by tax expert Ed Zurndorfer, EA, CFP, CLU, ChFC, RHU, REBC, from July. He talks about what you can, can’t and shouldn’t do with your IRA or Roth IRA:
On Jan. 1, 2010, a change of law took effect allowing any traditional IRA owner to convert their traditional IRAs to Roth IRAs. Financial journals have encouraged many traditional IRA owners to consider the long term benefits of a Roth IRA conversion. But a Roth IRA conversion can unfortunately trigger unintentional tax traps to the unwary IRA owner. This column discusses some of these tax traps.
Naming a Beneficiary
For both traditional and Roth IRAs, the beneficiary form is a most important estate planning document. This is because without formally being named as a beneficiary, an individual who inherits an IRA – for example, through a Will – will not be considered a beneficiary. As such, if the IRA owner died before age 70.5 – the beginning date for making minimum required distributions – then the individual who inherits the deceased’s traditional IRA via the will must withdraw the entire IRA within five years of the IRA owner’s death. Had the individual been instead named as a beneficiary, the individual could “stretch out” the IRA payouts over the individual’s life expectancy. If the IRA owner died after age 70.5, then the individual inheriting the IRA via the will may withdraw the IRA over the deceased IRA owner’s remaining single life expectancy, had he or she lived.
With a Roth IRA in which qualified withdrawals are tax-free, the individual who inherits a Roth IRA would also have to withdraw the entire Roth IRA within five years of the owner’s death. But if the individual was instead named as the Roth IRA beneficiary, then the individual could withdraw the account over his or her life expectancy, possibly resulting in a lifetime stream of tax-free payments.
Partial Roth IRA Conversions
If an individual owns both deductible (before-taxed) traditional and nondeductible (after-taxed) traditional IRAs, then the individual cannot “pick and choose” which IRA to convert and to not pay tax on the conversion. Rather, when there is a conversion of a nondeductible IRA, a pro-rated amount of after-taxed money is included with each dollar converted. The following is the “pro-rata” formula for calculating the tax-free portion of each dollar converted to a Roth IRA:
(total cost basis in all IRAs/total value of all IRAs) times amount converted
The following example illustrates:
Elliot has three deductible IRAs that have a total fair market value of $30,000. He has also one nondeductible IRA with a fair market value of $30,000 consisting of which $25,000 are after-taxed contributions. If on 4/16/2010 Elliot converted his nondeductible IRA to a Roth IRA, then the tax-free portion of the $30,000 nondeductible IRA being converted is equal to:
($25,000/$60,000) times $30,000, or
$12,500 (tax-free)
This means that Elliot will have to pay federal (and state, if applicable) income tax on $12,500 in the year he converts his nondeductible IRA to a Roth IRA.
Where is the tax trap? Unless Elliot did the conversion on December 31, he will not be able to perform an exact calculation. This is because the total value of all traditional IRAs used in the pro-rata calculation comes from the total balance on December 31 of the year of conversion. In the above example, suppose the $30,000 that remained in Elliot’s traditional deductible IRA grew to $50,000 as of Dec. 31, 2010. Now the total value of Elliot’s IRAs – which includes the $30,000 converted amount – is now $80,000. The tax-free percentage is now $25,000 basis/ $80,000 total value. That means the tax-free portion of the conversion is $25,000/$80,000 times $30,000 or $9,375 rather than $12,500.
TSP Rollovers
Another potential tax trap for federal employees can occur when a retiring employee directly rolls over (aka “transfers”) monies from the TSP to a traditional IRA in the same year that the retiring employee makes a Roth IRA conversion. Note that only IRA assets fall under the ‘pro-rata” rule. Retirement plan assets- this includes the TSP – have no effect. To illustrate, consider this example:
Joan retired from federal service on Feb. 29, 2010. On March 10, 2010, Joan converted her only IRA – a nondeductible traditional IRA worth $50,000 of which $30,000 was nondeductible contribution and $20,000 was earnings. If Joan converts the traditional IRA to a Roth IRA, she will owe tax on $20,000 of earnings. This is the case even though Joan has $250,000 in her TSP account. But on June 15, Joan rolls over her TSP account to a traditional rollover IRA. As of Dec. 31, 2010, the new balance in Joan’s traditional IRA will be $300,000 (the $50,000 of IRA funds plus $250,000 of TSP rolled into an IRA).
The total value of Joan’s traditional IRAs now changes from $50,000 to $300,000, thereby making the $30,000 of non-deductible IRA contributions a lower percentage of the total IRA balance. That results in the tax-free percentage of the $50,000 conversion, going from $30,000/$50,000, or 60 percent, to $30,000/$300,000, or 10 percent. This means that of the $50,000 IRA converted, only 10 percent or $5,000 is tax-free. If the TSP rollover not occurred during 2010, 60 percent or $30,000 would have been tax-free.
Joan could have avoided this mistake by waiting until after Jan. 1, 2011 to rollover her TSP.
Finally, distributions made prior to age 59.5 from a converted Roth IRA may be subject to a federal income tax penalty.”
From Federal Employees News Digest. To see more, go to: www.federaldaily.com.
Used with permission of 1105 Media Inc.; © Copyright 2010 by 1105 Media Inc..
Edward A. Zurndorfer is a Certified Financial Planner and Enrolled Agent in Silver Spring, MD. He is an employee benefits, financial planning and tax planning speaker for NITP, Inc. He is also the owner of EZ Accounting and Financial Services and a registered representative with FSC Securities Corporation located in Silver Spring, MD 20902.
To reach me: mcausey@federalnewsradio.com
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