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.
