This week Gail answers your questions on retirement, IRAs and Roth IRAs.

Dear Gail-

I am a retired federal employee. I was told that I could not make tax-deductible contributions to an IRA. Is this true?

Thank you,
Bill

Dear Bill,

Assuming that all of your income consists solely of pension checks or another form of payout from a retirement plan, you are not eligible to contribute to any type of IRA .

IRA contributions can only be made to the extent you receive “taxable compensation.” Essentially, this means income you are paid as a result of a job, such as wages, salary and commissions. It also includes self-employment income and payments you receive as alimony or separate maintenance.

Admittedly, this is a little confusing because, clearly, your retirement income is “taxable.” However, this is specifically excluded. For purposes of making an IRA contribution, IRS Publication 590 states that the following is not considered compensation:

*Earnings and profits from property, such as rental income, interest income, and dividend income

*Pension or annuity income

*Deferred compensation received (compensation payments postponed from a past year)

*Income from a partnership for which you do not provide services that are a material income-producing factor

*Any amounts you exclude from income, such as foreign earned income and housing costs

What if, like many retirees, you return to work part-time? In that case, you would have “taxable compensation” and could potentially contribute to an IRA. This year, the maximum you can contribute is the smaller of either:

- $4,000 ($5,000 if you are over age 50), or
- your total taxable compensation (see above)

Caution! If you are also receiving Social Security benefits, it’s possible that only a portion of your IRA contribution will be deductible. Publication 590 can be found at www.irs.gov. There’s a worksheet (p. 77) that walks you through the math. However, this is required only if all four of the following conditions are true :
1. You receive Social Security benefits, AND
2. You have taxable compensation, AND
3. You contribute to your traditional (tax-deductible) IRA, AND
4. You or you spouse are covered by an employer retirement plan

The phrase “covered by an employer retirement plan” does not mean you receive benefits from that plan! It means you are an active participant, which means that either you or your employer or both of you are currently making contributions to the plan on your behalf.

The easiest way to tell if you are covered by a retirement plan through your job is to look at your pay stub or simply ask your human resources department. You can also check Form W-2 that you receive at the end of the year. If you were covered by an employer-sponsored plan, there should be a check mark or “X” in the “Retirement Plan” box.

Whether you are working or not, once you reach age 70½ you are no longer eligible to contribute to a “traditional” (tax-deductible) IRA. However, there is no age limit on a Roth IRA. Although your contributions are not tax-deductible, all of the earnings your Roth IRA accrues can be withdrawn by you or your beneficiaries income tax-free .

Hope this helps!

-Gail

Dear Gail-

My wife and I receive Social Security. We also have a military retirement and the VA pays me a 60 percentdisability benefit.

Is there much advantage to converting regular IRA accounts to Roth IRAs before reach 70 ½? We have bout $45,000 in them and do not need the income at this time. I would like to maximize the principal as much as possible. Plus, I’ve had no really clear explanation of how the mandatory withdrawal system works.

Thanks,
Mark
Rtd. Major, US Army

Dear Mark,

As you’re probably aware, in order to convert traditional IRA assets to Roth IRA assets, your Modified Adjusted Gross Income cannot exceed $100,000. This income limit disappears in 2010, thanks to the tax act just signed by President Bush.

There’s no simple answer to the question about when it makes sense to convert a traditional IRA to a Roth IRA because of the number of issues involved. Such as, do you expect your income tax rate to be higher or lower in the years ahead? How long will you leave the money in the Roth IRA before you start withdrawals? What rate of return will your account earn? Etc.

But at your age, in my opinion the make-or-break factor is relatively easy to decide: how do you intend to pay the income tax you’ll need to come up with when you make the conversion?

Unless you plan to pay this with non-IRA money, it’s probably not worth it. That’s because if you subtract the taxes you owe from the amount of money you’re converting, you’re doing two things:
1. prematurely paying the taxes you’ll eventually owe when you do start withdrawals, and
2. reducing the amount of money that is available to benefit from the tax-free potential a Roth offers

Let’s say you’re in the 15 percentile tax bracket. If you and your wife convert all of your IRAs ($45,000), you’ll pay an additional $6,750 in income tax this year. Unless you expect your income tax rate to go up by the time you reach age 70½, it makes no sense to give the government its money any earlier than necessary!

In terms of point No. 2, if you use the money in your traditional IRAs to pay this tax bill, you’ve reduced the amount in your Roths to $38,250. This means, depending upon the investments you choose, it will take years before your accounts are worth what they used to be. If you were younger and had more time for the magic of compounding to work, I’d be less hesitant.

Frankly, it sounds as if your main reason for converting your IRAs is to simply avoid the confusion about taking your Required Minimum Distributions (RMDs) once you reach age 70½! As you’re clearly aware, there is no such requirement with a Roth IRA.

Calculating your RMD really isn’t that daunting. You simply divide the value of your IRA as of the end of the previous year (which you find on the year-end statement sent by your IRA custodian) by your “Distribution Period”: 12/31 IRA Balance/Distribution Period.

Your "Distribution Period" corresponds to your age and can be found in Publication 590 on the IRS website, www.irs.gov. Assuming you and your wife are not more than 10 years apart in age and have named each other as beneficiaries, you will calculate your RMDs based on Table III, “Uniform Lifetime”(p. 100).

For instance, say your IRA was worth $20,000 on December 31, 2005 and you turn 74 this year, your 2006 Required Minimum Distribution would be:

I think what often confuses folks is the rule surrounding the first Required Minimum Distribution. Technically, you have to start RMDs in the year you turn 70. However, you’re allowed to take this first withdrawal as late as April 1st of the year after you turn 70½.

The key is to remember that if you postpone your first withdrawal until the April 1st deadline, you must take two distributions that year — one for the year in which you turned 70 and another for the current year (in which you turn 71).

However, there’s a very simple way to avoid this complexity: just take your first RMD in the year you actually celebrate your 70th birthday! The next year, your RMD will be based on being age 71, and so forth.

Hope this clears things up. Thanks for the sacrifice you made for our country.

Best wishes,
-Gail

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.