Christine W Egnor, CPA PLC

October 2011

In 2010 the normal $100,000 gross income limit applied in earlier years was removed.

Characteristics of the Roth IRA

The Roth IRA is a non-deductible savings account, whose earnings and withdrawals are non-taxable after two basic rules (with exceptions) are met; attainment of age 59 and ½, and holding the money in the account for five years. For 2011 the deposit may be made at any time from January 1, 2011 through April 15, 2012. The maximum 2011 deposit is $5,000 per taxpayer, with an additional $1,000 allowed if the taxpayer is over age 49 on December 31, 2011.

Because Roth contributions are not deductible, they are not reported on the tax return, but the account must be separately established and maintained as a Roth IRA. Nonworking spouses may make Roth contributions following the same rules as used for traditional IRAs. Finally, contributions to traditional IRAs reduce allowable Roth IRA contributions for the same tax year and vice-versa. However, contributions to other pension plans and SEPs or SIMPLEs do not reduce the allowable Roth IRA contribution amount.

In order to deposit money into the account the taxpayer must have earned income that falls under the IRS imposed limits.

Can You Make a 2011 IRA Contribution?

In contrast to the traditional IRA, the Roth account holder has no requirement to take money out at age 59 and ½. Additionally, the taxpayer may continue to make Roth deposits in years after reaching 70 and ½ as long as the taxpayer has earned income.

Roth IRAs also have a few advantages over traditional, deductible IRAs in that contributions may be made to Roth IRAs after age 70 and 1/2 (not allowed in traditional IRAs) and Roth's may be passed, along with their tax-free characteristics, to heirs.

Convert any account.
 In 2008 Congress substantially relaxed the rules limiting conversions to Roth IRAs. This IRS table at www.irs.gov/ep provides an excellent summary of rollover rules.

Convert Any Amount 
The taxpayer has total flexibility on the amount to be converted. Partial, complete or no conversions of individual accounts, some accounts, all accounts, different types of accounts and different amounts are allowed, based solely on the taxpayer’s individual decisions.

The fair market value is taxable on the date converted 
The conversion itself creates taxable income at the value of the account on the date converted. The value of common stock, bonds or mutual funds will be included in income and reported to the taxpayer on Form 1099-R. The 1099-R should reflect Code 2 if the taxpayer is under age 59 and ½ on the date of conversion, or Code 7 of the taxpayer is 59 and ½ or over on the date of conversion.
 
There is no automatic tax due on the conversion
 Although the conversion creates taxable income, it does not necessarily create a tax debt. If the taxpayer has low income, losses from other activities, large itemized deductions, personal exemptions or other items, these losses and deductions may be used to reduce any potential tax burden from including the converted amounts in income in 2010.
 
There is no penalty on conversion
 The actual conversion and inclusion in income of the converted amount does not cause penalty, because conversions are specifically excluded from any early withdrawal penalty.
 
Where will the money come from to pay the tax?
 Here is an interesting question that is ignored by the conversion sales people. If the taxpayer takes money out of their IRA to pay the tax, then it is treated just like any other IRA withdrawal, meaning if the converting taxpayer is under age 59 and ½ a 10% penalty will apply on any conversion money used to pay tax rather than converted to the Roth!. Similarly if money is withdrawn from the Roth to pay the tax, that money has not been in the account for 5 years and will also be subject to a 10% early withdrawal penalty unless the taxpayer is over age 59 and ½! Meaning that the taxpayer had better have some separate cash available outside of retirement accounts to pay any tax arising from the conversion. Don’t forget if the taxpayer is receiving Social Security during the conversion year, the income exclusion could also make more of the Social Security taxable.


Do not co-mingle the conversion money into an existing Roth!
Possibly the most overlooked conversion issue is the co-mingling issue. When a taxpayer mingles conversion money into a traditional contributory Roth IRA two bad things can happen. First, if the converted assets decline in value the taxpayer may wish to re-characterize back to the traditional IRA, and this may be impossible once the funds are co-mingled.
 
More importantly, converted money uses its own 5-year holding period. This means that co-mingled contributory/converted Roth IRAs will use the new conversion date to calculate the beginning of the 5 year holding period, rather than the old contributory date. This could be disastrous for an individual using old contributory Roth accounts!
 
Remember President Roosevelt
Many years ago my elderly mother sold some land and we did not plan that the additional income would cause her Social Security to become taxable. When I told my Mom she owed a few hundred dollars in tax on her Social Security she looked me in the eye and said “That can’t be right, President Roosevelt said we would never have to pay tax on Social Security”. Of course Congress changed that rule in the mid-1980’s when they needed money. Do you really believe our current crop of politicians will ever actually cut funding to anything when there is a several trillion dollar pool of never-to-be-taxed Roth IRAs just waiting there ready to be taxed?
 
Summary
Do not blindly convert anything without seeking professional tax advice!