Can you reconvert an IRA?
Suppose you converted your IRA to a Roth IRA just before the bottom fell out of the stock market last year. Because the tax liability for the conversion is based on the value of the account on the last day of the prior year – Dec. 31, 2007 — you would have paid tax on an inflated value. So you may have opted to recharacterize your Roth into a traditional IRA.
But now you see signs of a market rebound. And you’d like to take advantage of the Roth IRA setup for all the same reasons that attracted you to it in the first place.
In this case, you might “reconvert” your IRA. In other words, you can convert your recharacterized traditional IRA back into a Roth IRA. This is essentially treated as a new conversion for tax purposes.
With a Roth IRA in existence at least five years, qualified distributions are completely exempt from federal income tax. A qualified distribution is one that is paid after reaching age 59 1/2, received on account of death or disability or used for first-time homebuyer expenses (up to a lifetime limit of $10,000). In contrast, traditional IRA distributions are taxed at ordinary income rates as high as 35% — probably even higher in future years.
However, the IRS doesn’t allow you to keep flip-flopping back and forth between the two types of IRAs. You must meet specific time restrictions for a reconversion. Specifically, a traditional IRA can’t be reconverted to a Roth before the later of:
1. The beginning of the tax year following the tax year of the conversion
2. The end of the 30-day period beginning on the day of the recharacterization.
This rule applies regardless of whether the recharacterization falls into the year of the conversion or the following year.
This is an important decision for taxpayers rapidly approaching retirement. We can help you analyze your personal needs. Call us to arrange a consultation.
When is income taxable, and when is it not?
You only have to examine your paycheck to realize certain income is tax-free. For example, health insurance premiums paid by your employer are generally not includible in your income.
Do you know the tax status of other types of income? Here’s a quiz to test your knowledge.
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You tell your son he’ll be the sole beneficiary of your estate, and that you’ve decided to give him an advance on his inheritance. You hand him a check for $10,000. He wants to know how much he’ll have to pay in taxes. What do you tell him?
Answer: Gifts, bequests, devises, and inheritances are generally not taxable to the beneficiary. Income produced from those sources is taxable to the beneficiary.
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You withdraw $20,000 of the contributions you made to your Roth IRA over the past five years, but you’re not of retirement age. Do you have a taxable event?
Answer: Unlike traditional IRAs, distributions from Roths are first allocated to amounts you contributed to the account. To the extent the distribution is a return of your contributions, it’s not included in your income and you can withdraw it penalty- and tax-free.
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You purchase a piano at an auction and take it home. While cleaning it, you discover $5,000 inside. Is this money taxable to you?
Answer: Yes. Once it becomes yours, “treasure trove” property is taxable to you at fair market value.
Benefit from Roth “ordering rules”
For the first time ever, taxpayers can convert a traditional IRA to a Roth, regardless of their annual income. Previously, conversions weren’t allowed for taxpayers with a modified adjusted gross income (MAGI) over $100,000.
But nothing has changed in the rules for Roth IRA distributions. Unless payouts are treated as “qualified distributions,” they are subject to tax.
Nevertheless, despite th
e common perception, the tax burden on taxable distributions may be less than you think. Some “taxable” distributions might be completely tax-free. The exact tax treatment depends on the “ordering rules” for Roth IRA distributions.
If a withdrawal meets the requirements for a qualified distribution, it is 100% exempt from tax. A qualified distribution is one that is made from a Roth IRA in existence for at least five years after reaching age 59 1/2, upon death or disability or used to pay first-time homebuyer expenses (up to a lifetime limit of $10,000).
All other distributions are nonqualified. Nonqualified distributions are treated as coming from Roth IRA assets in the following order:
- Regular Roth IRA contributions
- Taxable traditional IRA conversions
- Nontaxable traditional IRA conversions
- Earnings on Roth IRA assets
Because distributions are treated as coming first from Roth contributions, you may be able to take out as much as you put in — at any time — without any dire tax consequences.
We can walk you through the “ordering rules” to minimize the tax liability, if any, for your particular situation. There may be additional complications for early withdrawals. We can provide the necessary guidance in this area. Contact us for more details and we will be glad to assist you.
Roth IRA conversion in 2010
The buzz about Roth IRA conversions is getting louder. And why not: For the first time ever, higher-income taxpayers can convert their traditional IRAs into a Roth. Beginning in 2010, the prior restriction for taxpayers with an adjusted gross income (AGI) above $100,000 is eliminated. Also, you can split the tax bill for a 2010 Roth conversion evenly over 2011 and 2012. (You report 50% of the income in each of those years.)
But should you convert to a Roth? That’s another story. Don’t assume that a conversion is right for you just because you can do it for the first time. Also, if it suits your purposes, you might convert only part of your traditional IRA assets and leave the rest alone.
Qualified distributions from a Roth (e.g., distributions after age 59 ½ and after having a Roth IRA in existence for more than five years) are federal-income-tax-free. Plus, you’re not required to take minimum distributions after age 70 1/2 like you are with a traditional IRA. These future benefits offer plenty of incentive to convert to a Roth this year.
However, there are other variables to consider. For example:
- Many online calculations assume that you’ll be paying the full amount of tax on the conversion with funds outside of your IRA. That might not the case. If you have to use some or all of the IRA assets to pay the tax piper, this will dilute or even wipe out the benefit of the conversion.
- The numbers will also change if you’ve contributed to IRAs on a nondeductible basis. There’s no tax on the portion attributable to these contributions.
- Consider the impact of any state and local income taxes owed in addition to federal income tax. This is especially critical if you live in a high-tax state.
- The additional tax liability on the conversion could push you into a higher tax bracket. Conversely, if you delay the conversion until you’re in a lower tax bracket, you might come out ahead.
This critical decision requires a thorough analysis of the facts. Remember: Every situation is different. Do not hesitate to contact our office to schedule a consultation for personal guidance.
