IRAs: Contributions, Taxes and Conversions

Hi, Gail.

My husband is retired, collecting a company pension and his Social Security. I am still working and now contributing the max to my 401k plan. Because I took a new job in the middle of last year with a substantial increase, we find that we will owe the IRS money in April.

Can my husband still open a Roth IRA for $2,000 and is this a legitimate deduction that can help reduce our 2000 tax bill?

Thanks for your help, Jean Swanson

Dear Jean,

Unfortunately, you must have "earned" income $#151; which is defined as income from employment $#151; in order to contribute to any type of IRA. The money your husband receives from his pension and Social Security does not qualify.

Sorry.

Hi, Gail. Your information is very interesting and useful. Please keep up the good work.

I am 54 and have a traditional IRA that I would rather not convert or otherwise disturb, as the yearly deduction is still useful in my situation. However, the ROTH looks like a good bet as well. The question is, is it possible to open a ROTH and channel contributions to it which are in excess of the deductible amount now going to the traditional IRA?

Thanks.

Stephen Skaggs

Dear Stephen,

You bring up an interesting strategy. Under current law, the total amount you can contribute to any combination of IRAs in a single year is $2,000. The question is, to what extent is this tax-deductible?

If you are not covered by a retirement plan at work, the full $2,000 IRA contribution is always tax deductible, no matter how much you make.

If you participate in a company retirement plan, then the deductibility of your IRA contribution depends upon your salary. Assuming your IRA contribution is for the year 2000, a single person with an adjusted gross income of $32,000 or less can deduct the entire $2,000. If your income is more than $32,000, but less than $42,000, then a portion of your contribution is deductible. In fact, for every $1,000 over $32,000, the amount that's deductible drops by $200. If your income exceeds $42,000, then you cannot deduct your IRA contribution at all.

Based on your question, I'm assuming you fall in the middle: income greater than $32,000 but less than $42,000. In this case, since part of the $2,000 would not be tax deductible, you might as well put that amount into a Roth IRA where it will grow tax-free.

Let's walk through some hypothetical numbers. I'm going to assume you are single and your adjusted gross income (AGI) is $36,500, meaning your IRA contribution will be only partly deductible. The question is, how much will NOT be deductible?

It's actually pretty easy to figure. Start with the AGI figure. Subtract the income limit for a fully deductible IRA ($32,000 for the 2000 tax year), then divide the result by $10,000. Multiply the resulting fraction by $2,000. That's the amount of IRA contribution you CANNOT deduct.

Since you could not deduct $900 worth of your IRA contribution, you could put this into a non-deductible Roth IRA and invest the balance — $1,100 — in your traditional IRA. Thus, you would be eligible to deduct $1,100 from your taxable income for the year 2000.

For married persons filing a joint return, each partner can make a tax-deductible contribution to an IRA provided their combined AGI is under $52,000. There is a similar phase-out to $62,000.

Again, these are the numbers for the year 2000. For 2001, the limits are $33,000 (single) and $53,000 (married, filing jointly).

One more thing to keep in mind. Not everyone can contribute to a Roth IRA. There are limits on that, too. (You're not surprised, are you?) Please click on "Archive" and scroll down to my article titled, "IRAs! Roth Withdrawals and Estate Taxes"

Thanks for bringing this up, Stephen!
Gail

Hi, Gail —
I am 66 and retired. I have about $75,000 in a regular IRA. Should I transfer to a Roth? If so how and when?

Deano

Dear Deano,

Maybe, maybe not. There's a lot more to this than you realize.

Moving money from a traditional IRA to the newer Roth IRA is called a "conversion." You are literally converting your IRA from one type of IRA into another. You cannot even contemplate this move unless your Adjusted Gross Income is under $100,000. Question number one: What is your AGI?

Assuming it is under $100,000, there's the issue of paying the taxes which are due. The contributions you made to your traditional IRA were tax-deductible, and the earnings have grown tax-deferred — meaning you have not yet paid income tax on any of the $75,000. In order to convert your traditional IRA account into a Roth IRA, you've first got to ante up to Uncle Sam. In other words, you must pay the income tax which has so far been deferred.

Assuming you're in the 28 percent tax bracket, that means you need to write the IRS a check for $21,000. And in order to get the biggest bang for your conversion, the money to pay the taxes should not come out of the IRA itself, but from another source — a CD or savings account, for instance. So the second question is, do you have this kind of money readily available?

If you do, then a Roth might make sense. Because once you pay the taxes on the conversion amount, then all of the gains the Roth IRA earns from then on are income tax-free.

Another bonus: Earnings and withdrawals from a Roth IRA are not included in the calculation that must be done to determine if part of your Social Security is taxable.

Furthermore, unlike a traditional IRA, the owner of a Roth never has to take any money out. You've probably heard that owners of traditional IRAs are required to take minimum distributions once they reach age 70 1/2. But not with a Roth IRA. You can leave the money in as long as you like. And when you die, your beneficiary will be able to continue the tax-free growth of the Roth. When your beneficiary withdraws the money from your Roth IRA, it is income tax-free to them, as well.

On the other hand, if you think you're going to use up the money in your traditional IRA, then it makes less sense to do the conversion. Why pay the government ALL of the taxes right now when you could spread them over your remaining lifetime?

So while there are definite benefits to converting to a Roth IRA, you really need to think it through carefully. Sit down with a financial advisor and have them work through the numbers for you.

Best wishes —
Gail

Hi, Gail —
I read your answer about the Roth IRA as it concerns the availability of the initial funding. My accountant read me a statement which seems to contradict your statement about the withdrawal of the initial funds and a penalty only if you withdraw the income from those funds. The statement said no funds will be withdrawn without penalty unless the Roth IRA is older than five years, the individual is 59 1/2, or facing hardships.

Can you give me an IRS publication supporting your statement? Help would be appreciated.

John Kemp

Dear John,

Please refer your accountant to IRS Publication 590, the Technical Corrections Act, which clarified the rules governing the new Roth IRA (created by the Taxpayer Relief Act of 1997) and "The Individual Retirement Answer Book," p. 5-18.

To repeat: You can take your contributions or principal out of a Roth any time without it being subject to either income tax (it's after-tax money to begin with) or penalty. Converted dollars (from a "traditional" IRA) turn into "contributions" after five years. Only the earnings in a Roth have to be in the account for five years and until you are at least one of the following: 59 1/2, dead, disabled or withdrawing $10,000 toward a "first-time home purchase."

Hope this helps —
Gail

P.S. Tell your accountant that "hardship" is NOT a factor that affects any type of IRA withdrawal. It only applies to qualified plans such as 401(k)s.