This week's topics: Roth IRA conversions, a December cliffhanger, making too much money and spousal IRAs.

 

Hi Gail,

I have a traditional IRA that we converted to a Roth IRA last year. It came time to do taxes this year and our AGI is over $100,000. The tax forms said that you cannot convert your IRA if you make over $100,000. Now, it would have been good to know this before the conversion, but we were not aware of this.

We have converted the IRA back to a traditional IRA. Its value at the conversion back to traditional IRA is lower than when we converted it to a Roth last year due to the current stock market state. Note the reconversion was during this year, 2001.

My question is this: will we have to pay any kind of penalty to the IRS for doing that conversion? We did not touch the money. Will there be any kind of weirdness because the conversions happened in different years?

Sincerely,

Kim

P.S. Why is there a limitation of 100,000 for your AGI? I feel like we are being "punished" because we are wise with our money.

 

Dear Kim —

You're correct: in order to convert your traditional IRA to a Roth IRA, your income cannot exceed $100,000. However, this figure is not the number which appears in the line of your tax form for "Adjusted Gross Income", or AGI. (Figures the IRS would add a twist.) Instead, the "income" which determines whether you qualify for a conversion is your "Modified Adjusted Gross Income" — MAGI, for short.

Don't bother to look on your tax form for this number. MAGI isn't there. You or your tax professional need to do some additional calculations.

Here's how it works: Start with your AGI. To this you have to add back a number of deductions. These include:

— Deduction or exclusion taken for foreign housing

— Deduction for foreign earned income (e.g. from international mutual funds)

— Deduction for student loan interest

— Exclusion taken for qualified bond interest

— Exclusion taken for employer-paid adoption expenses

— Deduction for a contribution to a traditional IRA

Now subtract the amount of money you're converting from your traditional IRA to a Roth. Finally, you've reached the magic number that needs to come in under $100,000.

If this were still 2000, your tax professional might have been able to suggest some ways to reduce this number and bring your income in under $100,000. But any moves would have had to be made before the end of last year. The government recognizes that well-intentioned individuals might convert their traditional IRA to a Roth believing they meet the income requirements and then later find out their income is too high. So they created a procedure which allows people to correct the situation, that is, to re-deposit the money back into their traditional IRA. This is called "re-characterizing."

Re-characterizing involves transferring your entire Roth IRA balance- the original amount plus any earnings —  back into a traditional IRA via a "trustee-to-trustee transfer." You must not take possession of the money.

Of course, the easiest way to do this is if the custodian is the same on both IRAs. You've got to let the custodian know that you are re-characterizing this money as a "traditional IRA" instead of a Roth. The deadline to complete this is the same as the deadline to file your 2000 tax return, including extensions. Every mutual fund and major brokerage firm is familiar with this issue and ought to have the forms and procedures in place to handle things smoothly. As long as you followed the rules, there is no penalty.

However, you probably have to file Form 5498 along with your tax return. This is a new form for this year. Regardless of the change in value, the IRS looks at this whole thing as if the conversion never happened and the money was in your traditional IRA the whole time. It would have been terrific if you hadn't made so much darn money last year!

Gail

P.S. Blame Congress for the $100,000 income ceiling on conversions. There is talk of doubling this amount, but I wouldn't hold my breath.

 

Dear Gail

I converted my conventional IRA to a Roth IRA. I mailed it overnight on Dec. 27 so that it could be completed "as of" the end of 2000. The company, an online discount brokerage, failed to process the conversion "as of" Dec. 29 and so I had to call and get that straightened out as I needed to pay my taxes by Apr. 15 on the amount converted!

Finally, they got me the 1099R but what they did NOT do was to make the AMOUNT converted retroactive to Dec. 29! In January I was fortunate enough to add $5,000 to my account and so it looks like I'll need to pay taxes on an additional $5,000. My question is: if my conversion was made retroactive to Dec. 29, shouldn't I be allowed to pay taxes on the amount that was converted as of Dec. 29 and not the amount I had at the time they got around to processing my paperwork? I am struggling with the company to get them to do this.

Thank you

Shannon

 

Dear Shannon —

You really cut this close. If your IRA conversion paperwork arrived at the brokerage firm on Thursday, Dec. 28, there is no guarantee they would process it that day. However, that still left two additional working days for them to handle this before the end of the year.

What confuses me is that you say you got the date "straightened out," yet in the next sentence you seem to contradict this. All I can suggest that is you again contact this company (always note the date, time and name of the person you speak with) and explain the situation. If you have a copy of the overnight delivery receipt you could fax them a copy to prove when you sent in the paperwork. The delivery company (FedEx, UPS, U.S. Postal Service) can trace when the package was delivered. The IRS is going to base your conversion on the date noted on your 1099R. Your taxes will be based on the amount on that form, as well.

I'm not going to guarantee this can never happen when you use a full service firm, but if it did, your broker — not you — would be the one doing the legwork and making the phone calls. Something to think about. Let me know what happens.

Gail

 

Dear Gail,

The first year Roth IRAs became available, I converted my IRA and my wife's spousal IRA under the program that allowed you to spread out the taxes on this for four years.

When I did the conversion several years ago, our joint income was under the $100,000 limit. However, I'm now making more money and it's over that amount. Am I going to get in trouble for this?

Also, I've been adding $2,000 to each of our Roth IRAs every year. Am I prohibited from doing this now that my income is a little over $100,000?

Charlie

 

Dear Charlie —

You're fine on both counts. The only thing that matters is your joint income (see 'MAGI" above) in the year in which you made the conversions. Since it was below the $100,000 limit back then, no problem.

The income requirements for "new" contributions to a Roth IRA are different than those on a conversion. (Again, thank Congress for this.) If you are married, filing jointly, you can each make an annual contribution of $2,000 to your respective Roth, provided your joint income is under $150,000.

By the way, you bring up an excellent point: a lot of folks miss the opportunity to open an IRA in their spouse's name because they think she/he has to be working. (I'm not immune to this myself — see below!) However a non-working spouse is entitled to their own IRA — either the traditional, deductible kind or a Roth.

Best wishes,

Gail

 

Dear Gail,

In your answer to Jean Swanson, which appeared in your March 30 column on the internet, you said that her husband could not contribute to any kind of IRA because he didn't have any earned income. What about spousal IRAs? I though that a spouse could contribute to an IRA as long as the other spouse had enough earned income.

Thanks

Leonard

 

Dear Leonard —

You're right, thanks for catching that. The case involved Jean, who is still working, and her retired (lucky!) husband. A $2,000 IRA contribution could be made for him as a non-working spouse of someone who is employed.

However, Jean's question concerned whether they would be able to reduce their taxable income if he put $2,000 into a Roth IRA. The answer is still "no." Contributions to a Roth can only be made with after-tax dollars.

However, she could contribute $2,000 into a traditional IRA in his name. This would be fully deductible.

Because Jean is covered by a retirement plan at work, she could not deduct the full $2,000 contribution to a traditional IRA in her own name unless their Adjusted Gross Income last year was under $52,000.

Thanks —

Gail

 

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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.