Tag: modified adjusted gross income

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Roth IRA

5 Ways to Reduce Your Tax Liability Using Roth IRA Conversions

One of the most important financial goals for retirees is maximization of after-tax income. There are two ways to accomplish this: (a) maximize pre-tax income and (b) minimize income tax liability. A Roth IRA can go a long way toward helping you achieve the latter.

There are two ways to fund a Roth IRA: (a) annual contributions and (b) conversions. Annual contributions, in and of themselves, generally won’t result in a significant source of retirement income due to the relatively low limitation – currently $5,500 or $6,500 if you’re age 50 or older. In addition, eligibility to make Roth IRA contributions is limited to the extent that your income exceeds defined limits.

Roth IRA conversions, on the other hand, have the ability to generate substantial after-tax income while also reducing income tax liability for up to 20 to 30 years or more of retirement. Since income tax liability on the value of Roth IRA conversions will need to be paid, timing of conversions is key. See the May 10, 2010 post, Be on the Lookout for Roth IRA Conversion Opportunities, for a discussion of this topic.

There are five ways that you can potentially reduce your income tax liability and increase your after-tax income during your retirement years by doing Roth IRA conversions.

1. Never pay income tax on the growth of your Roth IRA

While you’re required to include the value of your IRA, 401(k) or other qualified plan assets that you convert to a Roth IRA in your taxable income in the year of conversion, 100% of the growth of your Roth IRA is excluded from taxation. This is true whether or not you ever take any distributions from your Roth IRA.

Individuals who did Roth IRA conversions in March, 2009 when the Dow dipped below 7,000 didn’t mind paying income tax on those conversions in retrospect given the fact that the Dow is currently hovering over 17,000 less than six years later. The income tax savings on the growth of the equity portion of their converted accounts over this period of time plus future potential growth is significant for those in this situation.

2. Roth IRA accounts aren’t subject to required minimum distribution rules

If you don’t do a Roth IRA conversion, 100% of the value of your traditional IRA, 401(k), and other qualified plan assets, including appreciation, will be subject to IRS’ required minimum distribution, or RMD, rules. These rules require you to take annual minimum distributions from your retirement plan accounts beginning by April 1st of the year following the year that you turn 70-1/2. 100% of distributions reduced by any allowable portion of nondeductible contributions are taxable.

As an example, suppose you were born on January 7, 1940 and you own a traditional IRA account with a value of $500,000 on December 31, 2013, you would be required to take a minimum distribution of $21,008.40 from your account by December 31, 2014 and include it in your 2014 taxable income. If instead you owned a Roth IRA account with the same value, you wouldn’t be required to take any distributions from your account.

3. Potentially reduce net investment income tax

The RMD rules sometimes force people to take distributions from their taxable IRA accounts that they don’t need. Often times, they transfer RMDs from their taxable IRA account to a nonretirement investment account and leave them there. For individuals with high levels of income, this can result in additional taxation as a result of subjecting the earnings on their nonretirement account to the net investment income tax of 3.8%. This isn’t an issue for Roth IRA account holders since the RMD rules don’t apply to them.

4. Roth IRA distributions aren’t included when calculating taxable Social Security benefits

The taxation of Social Security benefits is dependent upon your combined income and tax filing status. Combined income includes adjusted gross income, nontaxable interest, and 50% of Social Security benefits.

Single filers are subject to tax on 50% of their Social Security benefits for combined income between $25,000 and $34,000 and up to 85% of benefits when combined income exceeds $34,000. Married filing joint taxpayers are subject to tax on 50% of their Social Security benefits for combined income between $32,000 and $44,000 and up to 85% of benefits when combined income exceeds $44,000.

Roth IRA distributions aren’t included in adjusted gross income, therefore, they don’t affect taxation of Social Security benefits.

5. More opportunities for income tax bracket planning

For all taxpayers, taxable income is subject to seven different rates of tax ranging from 10% to 39.6% depending upon the amount of taxable income. Given the foregoing four potential ways of reducing taxable income and associated income tax liability, Roth IRA conversions can also reduce the income tax rates that are used to calculate income tax liability on other sources of income. This allows for more opportunities for income tax bracket planning to potentially further reduce income tax liability in one or more years.

Although it’s not income-tax related, one other potential benefit of Roth IRA conversions that shouldn’t be overlooked is their impact on the calculation of Medicare Part B premiums. Monthly Medicare Part B premiums currently range from $104.90 to $335.70 depending upon tax filing status and the amount of modified adjusted gross income from two years ago. Roth IRA distributions aren’t included in the calculation of adjusted gross income. As such, they don’t affect the amount of Medicare Part B premiums paid.

As you can see, assuming (a) you can get over the hurdle of prepaying a portion of your income tax liability when you do Roth IRA conversions and (b) you have sufficient nonretirement funds to pay the tax, this can create several tax reduction opportunities as well as a potential reduction of Medicare Part B premiums throughout your retirement years. These benefits, combined with the ability to eliminate taxation on the growth of Roth IRA accounts, can result in greater and longer-lasting after-tax retirement income compared to not doing any Roth IRA conversions.

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Income Tax Planning

New Tax Law – Don’t Let the Tax Tail Wag the Dog – Part 2 of 2

Part 1 of this post focused on the two investment-related tax areas of the new tax law that went into effect on January 1st – (a) the Medicare investment income tax and (b) long-term capital gains and qualified dividends. It made the point that while the amount of potential income tax liability resulting from exposure to one or both of these changes may be significant, neither one in and of itself, or in combination for that matter, should cause you to overhaul an otherwise appropriate retirement income planning investment strategy.

After preparing income tax projections using current vs. prior tax law, your CPA or other income tax professional will be able to determine two things: (a) the total amount of your additional projected income tax liability attributable to various changes in the law, and (b) the amount of your additional projected income tax liability attributable to specific changes in the law, including the Medicare investment income tax and 20% long-term capital gains and qualified dividends tax.

Once you determine the amount of your projected income tax liability attributable to specific changes in the law, the next step is to determine (a) the applicable income threshold type and amount that you have exceeded, and (b) the projected amount of excess income over the applicable threshold amount. In the case of the Medicare investment income tax, the threshold type is modified adjusted gross income (“MAGI”) and the amount is $200,000 if single or $250,000 if married filing joint. If your additional projected income tax liability is attributable to long-term capital gains and/or qualified dividends, the threshold type is taxable income and the amount is $400,000 if single or $450,000 if married filing joint.

Whether you’re affected by the Medicare investment income tax or the 20% (vs. 15%) tax on long-term capital gains and dividends, the next step is to determine the various components of income that comprise your gross income. Once you do this, you need to determine which specific non-investment related components can be reduced, as well as the amount of reductions for each component, in order to reduce the amount of your projected income tax liability attributable to changes in the tax law.

It’s important to keep in mind that some types of income can be reduced indirectly. An example of this is taxable salary which can be reduced significantly by various types of pre-tax deductions as available, including, but not limited to, 401(k) plan and cafeteria plan contributions. Another example is self-employment income which can be reduced by self-employment expenses.

In addition to determining which specific non-investment related components can be reduced, it’s also important to determine if any losses can be created or freed up as another means of reducing gross income. This can include capital losses to offset capital gains, net operating losses, as well as passive activity loss carryovers that can be freed up as a result of the sale of a rental property. The latter strategy can be a double-edged sword since this may also result in a capital gain that may increase exposure to the Medicare investment income tax and/or the 20% capital gains tax.

Since the starting point for determining exposure to both the Medicare investment income tax and 20% capital gains tax calculations is adjusted gross income (“AGI”), the next step is to determine potential deductions for AGI, or “above-the-line” deductions, that you may not be currently taking advantage of. This includes self-employed retirement plan contributions, self-employed health insurance premiums, and health savings account (“HSA”) contributions, to name a few.

If your issue is the 20% capital gains tax, in addition to reducing your AGI, there’s another way that you can potentially reduce your exposure to this tax and retain the 15% favorable capital gains tax. Keeping in mind that the threshold type in the case of the 20% capital gains tax is taxable income which is calculated by subtracting itemized deductions and personal exemptions from AGI, you may be able to increase your itemized deductions in order to reduce your taxable income.

As you can see, there are things you can do to reduce your exposure to the Medicare investment income tax and 20% capital gains tax without changing your investment strategy. If you have an otherwise appropriate retirement income planning investment strategy, don’t let the tax tail wag the dog.

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Income Tax Planning

New Tax Law – Don’t Let the Tax Tail Wag the Dog – Part 1 of 2

The new tax law which went into effect on January 1st, which is actually a combination of provisions from two different tax bills – the American Taxpayer Relief Act of 2012 (ATRA) and the Health Care and Education Reconciliation Act of 2010 – penalizes individuals with certain types and amounts of income. See parts 1 and 2 of The 2013 Tax Law Schizophrenic Definition of Income published on January 7th and January 14th for a discussion of the affected income types and threshold amounts, including a summary table of same.

As pointed out in the two posts, there are now five different definitions of income affecting seven different tax areas as a result of the new legislation. What I have found interesting as a CPA retirement income planner is the fact that while only two of the seven affected tax areas are directly related to investments, these two areas have commanded the vast majority of the media’s attention to date.

The two investment-related tax areas, both of which were discussed in detail in the two posts, are (a) the Medicare investment income tax and (b) long-term capital gains and qualified dividends. The Medicare investment income tax affects those with modified adjusted gross income (“MAGI”) in excess of $200,000 if single or $250,000 if married filing joint while long-term capital gains and qualified dividends are problematic if taxable income exceeds $400,000 if single or $450,000 if married filing joint.

The penalty for crossing these thresholds is 3.8% of the lesser of net investment income or MAGI in excess of the specified threshold amounts in the case of the new Medicare investment income tax and a 20% vs. 15% tax rate on long-term capital gains and qualified dividends. While the amount of potential additional income tax liability resulting from exposure to one or both of these changes may be significant, neither one in and of itself, or in combination for that matter, should cause you to overhaul an otherwise appropriate retirement income planning investment strategy.

As with all major tax law changes, and I’ve been through many, including the Economic Recovery Tax Act of 1981 (ERTA), the Tax Reform Act of 1986 (TRA), and the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRA), to name a few of the biggies, the first step in evaluating how the legislation will affect you is to prepare an income tax projection for the current and future tax years. The number of years that you choose to include in your projection depends upon a number of factors that are beyond the scope of this post. Needless to say, preparation of your projection by a CPA specializing in income taxation or by another income tax professional is recommended.

In order to determine how specific tax law changes will affect you, a baseline tax projection using prior law before the various changes took effect should be prepared. The next step is to prepare a projection under the new tax law. This will enable you to determine the total amount of your additional projected income tax liability attributable to various changes in the law. Once you know this, you can fine tune your analysis to determine the amount of additional projected income tax liability attributable to specific individual changes in the law. Your analysis should include types of income, affected tax areas, and additional income tax liability resulting from exceeding specified threshold amounts.

Assuming that your income tax projection reveals that you’re projected to incur more than a nominal amount of additional income tax liability that’s attributable to various types and amounts of investment income, you need to read Part 2 of this post in order to learn what to do next.

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Income Tax Planning

The 2013 Tax Law Schizophrenic Definition of Income – Part 1 of 2

QUOTED AND LINKED IN JANUARY 11, 2013 WALL STREET JOURNAL

And you thought that the tax law was already too complex. As a result of President Obama’s signing on January 2nd of the American Taxpayer Relief Act of 2012 following changes legislated by the 2010 Health Care Reform Act effective beginning in 2013, there are now five different definitions of income affecting seven different tax areas.

With a schizophrenic name (“Taxpayer Relief Act”), this comes as no surprise.

Although the most publicized affected income level is individuals with taxable income exceeding $400,000 for single tax filers and $450,000 for married filing joint tax filers, everyone with employment or self-employment income of any amount with limited exceptions will pay more tax in 2013 than they did in 2012, all else being equal.

Exhibit 1 summarizes 2013 individual federal income-based tax law changes, comparing each one with the law in effect in 2012. The five different definitions of income are as follows, with dollars amounts depending upon single vs. married filing joint tax status with the exception of #1 which applies to everyone with earned income with limited exceptions:

  1. Earned income of between $0 and $113,700
  2. Earned income and modified adjusted gross income exceeding $200,000 or $250,000
  3. Modified adjusted gross income exceeding $200,000 or $250,000
  4. Adjusted gross income exceeding $250,000 or $300,000
  5. Taxable income exceeding $400,000 or $450,000

The first three definitions of income will be discussed in the remainder of this post, with the last two deferred to next week’s post.

Earned Income Between $0 and $113,700

The employee Social Security tax rate which was reduced from 6.2% to 4.2% for 2011 and 2012 is back to 6.2% beginning in 2013. In addition, the Social Security wage base, which was $106,800 in 2010 and 2011 and $110,100 in 2012 is $113,700 in 2013. This translates to a Social Security tax increase of $2,425.20 in 2013 vs. 2012 for individuals with Social Security wages of at least $113,700, with the tax going from $4,624.20 (110,100 x 4.2%) in 2012 to $7,049.40 ($113,700 x 6.2%) in 2013.

Earned Income and Modified Adjusted Gross Income Exceeding $200,000 or $250,000

In recent years, everyone with earned income has been subject to Medicare tax at a rate of 1.45% on all earned income with limited exceptions. Beginning in 2013, the rate is increased by 0.9% to 2.35% on earned income exceeding $200,000 if single or $250,000 if married filing joint if modified adjusted gross income (“MAGI”) also exceeds the specified threshold amounts. MAGI is adjusted gross income (“AGI”) with certain adjustments, the details of which are beyond the scope of this post.

Modified Adjusted Gross Income Exceeding $200,000 or $250,000

The first two definitions of income are dependent upon the presence of earned income. It doesn’t matter if you have any earned income for purposes of meeting the next three definitions of income. If your MAGI exceeds $200,000 if single or $250,000 if married filing joint, and you have investment income, you will be subject to the new Medicare investment income tax. The tax is assessed at a rate of 3.8% on the lesser of net investment income or MAGI in excess of the specified threshold amounts. Net investment income includes taxable interest, dividends, and capital gains.

If you have income of at least $100,000 and you haven’t retired TurboTax and rehired your CPA yet, I’ll guarantee you will do so after reading part 2 of this post.

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Roth IRA

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 1 of 6

Retirement Income Center

I’m always amazed at how many people are motivated solely by tax incentives when it comes to investment decisions, paying little attention to, and in many cases, completely ignoring the potential long-term economic benefits that should be the driving force behind implementation of any investment strategy. With 2010 behind us, I can safely say that the Roth IRA conversion decision definitely falls in the “tax tail wag the dog” category.

Although the jury is still out on how many 2010 Roth IRA conversions will stick due to the ability to recharacterize, or undo, a Roth IRA conversion by the tax return due date (April 18, 2011), plus extension (October 17, 2011), of the conversion year, 2010 should turn out to be a banner year for Roth IRA conversions. The last time that Roth IRA conversions received so much attention was in their debut year in 1998 when the IRS allowed you to spread the tax from a conversion over four years.

So, even though the ability to do a Roth IRA conversion has been around since 1998, what was different about 2010 that drove more people than usual to consider, and actually transfer, a portion, or all in many cases, of their traditional IRA accounts into Roth IRA accounts? Two things: (1) Before 2010, only taxpayers with modified adjusted gross income (“MAGI”) of less than $100,000 were able to convert a traditional IRA to a Roth IRA. With the removal of this threshold in 2010, everyone with a traditional IRA account became eligible to do a Roth IRA conversion. (2) The “tax tail wave the dog” provision that enabled 2010 converters to avoid inclusion of the income from their conversion on their 2010 income tax returns and instead defer 50% of it to 2011 and the other 50% to 2012. As a matter of fact, this is the default. In order to report the income from a 2010 conversion on your 2010 tax return, you’re required to make an election to do so by checking a box on Line 19 of Part II of Form 8606 – Nondeductible IRAs when you file your 2010 income tax return.

While the $100,000 modified adjusted gross income change opened the door to more converters, this change, in and of itself, wasn’t, and shouldn’t continue to be, a reason for higher income individuals to do a conversion. Even though I labeled factor #2 the “tax tail wag the dog” provision, when you examine it closer, it was actually a potential tax trap for many individuals at the time it came into being. Prior to the enactment of the 2010 Tax Relief Act on December 17th, marginal income tax rates were scheduled to increase from 10, 15, 25, 28, 33 and 35 percent to 15, 28, 31, 36, and 39.6 percent. Consequently, up until the last two weeks of 2010, even though 2010 conversion income could be deferred to 2011 and 2012, it appeared that it would be subject to higher tax rates in many cases unless an election was made to report the income in 2010.

It’s ironic that many people who did conversions before the 2010 Tax Relief Act was enacted were motivated solely by the ability to defer the inclusion of their conversion income from 2010 to 2011 and 2012. When faced with the prospect of higher tax rates beginning in 2011, many of these individuals should have instead been prompted to do their conversions in 2010 due to the fact that they could take advantage of lower tax rates by electing to report the income from their conversions on their 2010 income tax return.

So what are the long-term economic benefits of a Roth IRA conversion that should have overridden any potential tax incentives in 2010 and should continue to do so in 2011 and in future years? You’ll have to wait until next week when you read Part 2 of this post to find out.

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Roth IRA

Year of the Extension

Retirement Income Center

“Year of the Conversion,” the initial post on January 11th of this year kicked off a weekly series of informative posts regarding a tax/financial planning technique that was authorized by Congress beginning in 1998. As explained in “Year of the Conversion,” from 1998 through 2009, only taxpayers with modified adjusted gross income of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA. Beginning in 2010, the $100,000 income threshold has been eliminated and, as a result, anyone who has a traditional IRA can convert part or all of his/her accounts to one or more Roth IRA accounts.

I felt it would be fitting to conclude the Roth IRA conversion series with “Year of the Extension” to remind anyone who has done a conversion in 2010 or is still planning on doing one in 2010 or in future years of a very important, and often overlooked, step in the Roth IRA conversion process. Unlike most tax planning techniques whereby once you’ve implemented the technique, it’s a done deal and you simply need to report the historical transaction on your income tax return, Roth IRA conversions need to be monitored for up to 22 months following the conversion date depending upon when the conversion occurs.

Given the fact that (1) the amount of income that you’re required to report on your income tax return is based on the value of the portion of your traditional IRA that you convert on the day of the conversion and (2) there exists the possibility that there can be a decline in value following the conversion, IRS has provided us with an insurance policy for this situation. Through a process referred to as recharacterization, you’re provided with a window of opportunity to undo your Roth IRA conversion and the associated income that you’re otherwise required to report on your tax return.

The April 19th post, “Recharacterization – Your Roth IRA Conversion Insurance Policy,” explains this technique, including the amount of time that must pass before you can do another Roth IRA conversion. Basically, as explained in the post, you have until April 15th following the year of your conversion, or until October 15th if you applied, and are approved, for an extension, to undo your Roth IRA conversion.

In order to minimize the income tax liability associated with your conversion, you need to monitor the value of your Roth IRA following the date of your conversion through April 15th following the year of your conversion to determine if you should recharacterize your conversion. Furthermore, if you haven’t done a recharacterization by April 15th of the year following the year of your conversion, it’s highly advisable to apply for an extension of time to file your income tax return. By doing this, you will extend your potential recharacterization timeframe by an additional six months until October 15th.

It’s important to keep in mind as always whenever you file an extension that 100% of your income tax liability must be paid by April 15th since an extension is only an extension of time for filing your return. It doesn’t extend the time for payment of your tax liability.

Unless you’re fortunate to either have enough basis in your traditional IRA or losses and/or deductions to offset the income attributable to your Roth IRA conversion so that you will incur minimal or no income tax liability attributable to your Roth IRA conversion, you need to monitor the value of your converted Roth IRA until at least April 15th following the year of your conversion and possibly for an additional six months until October 15th. If you’re in this situation, always remember to file an extension application by April 15th following the year of your conversion.

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IRA

Doing a Roth IRA Conversion? – Leave the Door Open

Retirement Income Center

You’re standing on the edge of the 10-meter diving platform ready to take the plunge into Roth IRA conversion waters, about to transfer 100% of your traditional IRA to a Roth IRA. Before you take that final step, there’s one more thing that you should consider if you’re still working or planning on working in the future and your income exceeds certain limits.

If you’re converting your entire traditional IRA to a Roth IRA, it doesn’t have to be, and in many cases shouldn’t be, the last Roth IRA conversion that you will do. In 2010, if you’re single and your modified adjusted gross income (“MAGI”) exceeds $120,000 or if you’re married and your MAGI exceeds $177,000, you’re prohibited from making direct contributions to a Roth IRA. It’s important to keep in mind that if your income doesn’t exceed these limits and you make a contribution to your Roth IRA, the maximum allowable amount is currently $5,000 or $6,000 if you’re 50 or older, and, furthermore, your contribution isn’t deductible.

While your income may limit your ability to make direct contributions to a Roth IRA, you may still make indirect contributions via a two-step process. In order to implement this strategy, you need to have a traditional IRA account in place. I recommend to all of my working clients who are considering full conversion of their traditional IRA’s to Roth IRA’s to keep one of their traditional IRA accounts open by leaving $1,000 in it. If you do this, even though you may be transferring 99% of your traditional IRA to a Roth IRA, you’re technically doing a partial, vs. a full, Roth IRA conversion.

Assuming that your income exceeds the specified deductible IRA contribution limits which in 2010 are $66,000 if you’re single and $109,000 if married, step one is to make a nondeductible IRA contribution to your traditional IRA account. The maximum allowable traditional IRA contribution, whether it is deductible or nondeductible, is identical to the maximum allowable Roth IRA contribution limit: $5,000 or $6,000 if you’re 50 or older.

Once you’ve made your nondeductible IRA contribution, you may immediately implement step two. Given the fact that, beginning in 2010, there are no income limitations in connection with converting traditional IRA accounts to Roth IRA accounts, step two is to complete your financial institution’s Roth IRA conversion form requesting transfer of the amount that you just contributed to your traditional IRA to your Roth IRA account. Once again, this will be a partial conversion since you generally want to leave funds in your traditional IRA account in order to keep it open for potential future contributions.

Although you have until April 15th to make an IRA contribution for the preceding year, it’s a good idea to execute this two-step process at the beginning of each year assuming that funds are available. This will get you in the habit of making sure that you implement this strategy each year, and, if done consistently over a number of years, can substantially add to the value of your Roth IRA account.

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Annuities Celebration Retirement Asset Planning Retirement Income Planning Roth IRA

Retirement Income Visions™ Celebrates 1-Year Anniversary!

Retirement Income Center

It’s hard to believe that a whole year has gone by since Retirement Income Visions™ initial blog post, but it has! This marks Retirement Income Visions™ 52nd post since it debuted on August 16, 2009 as a weekly blog, with new posts published each Monday morning.

As stated in the initial post, Retirement Income Visions™ Makes Its Debut, the blog, and the associated importance of retirement income planning as a separate and distinct niche, was inspired and motivated by my clients’ experience during the October, 2007 – March, 2009 stock market decline.

Also, as stated in the initial post, my goal in writing Retirement Income Visions™ was, and still is, to bring to your attention innovative planning strategies that you can use to create and optimize your retirement income, and, in many cases, reduce your exposure to adverse financial market conditions. If reader feedback, Twitter followers, and media attention, including a May 15th quote by The Wall Street Journal as the result of the timely publishing of the May 10th post, Be on the Lookout for Roth IRA Conversion Opportunities, is any indication, it appears that I’m off to a great start in achieving this goal.

I’ve covered a broad spectrum of information over the course of the last year, however, it’s been anything but random. If you’re a subscriber or regular reader, you’ve probably noticed the themed approach that’s been used to build upon, and provide a body of knowledge about, different retirement income planning topics. This has included the creation of a customized Glossary of Terms to assist in the understanding of the technical subject matter. The Glossary currently includes definitions of 84 terms.

Following the initial post, the next 11 posts addressed the retirement planning paradigm shift from retirement asset to retirement income planning, including associated risks associated with the former type of planning that has been the impetus for this shift.

The last 8 posts of 2009 focused on creating and optimizing retirement income via strategic systematic implementation of single premium immediate (“SPIA’s”) and deferred income (“DIA’s”) annuities. This series culminated in the December 28, 2009 interview of Curtis Cloke, the inventor of the Thrive® Income Distribution System, one of the leading retirement income planning solutions available to financial advisors.

2010 kicked off with the January 4th publishing of What Tools Does Your Financial Advisor Have In His or Her Toolbox? This post cited a 2009 Fidelity study that found that 83% of investors between the ages of 55 and 70 who are working with a fee-based adviser believe it’s more important for them to generate guaranteed (subject to individual insurers’ claims paying ability) income for retirement than to deliver above-average returns. The implied dilemma is that not all financial advisors have made the transition from using retirement asset to retirement income planning strategies for their clients.

Beginning with the January 11th post, Year of the Conversion, the last 30 posts have focused on a retirement income planning strategy that, although it has been around since 1998, was thrust into the limelight this year with the removal of its entrance barrier. I’m referring to the Roth IRA conversion technique that, up until 2010, was limited to taxpayers with modified adjusted gross income of less than $100,000.

While anyone who has a traditional IRA can convert part or all of his/her accounts to one or more Roth IRA accounts to embrace the two main attractions of a Roth IRA, i.e., nontaxable distributions and no required minimum distributions (“RMD’s”), this strategy isn’t necessarily beneficial for all traditional IRA owners. This is one area where multi-year income tax and retirement income planning analysis is essential for determining (1) who is a good candidate, (2) how much traditional IRA should be converted, and (3) when conversions should be made. In addition, there are various tricks and traps that need to be understood and incorporated in Roth IRA conversion planning in order to increase the probability for success.

I want to thank all of my readers for taking the time to read Retirement Income Visions™. A special thanks to my clients and non-clients, alike, who have given me great feedback regarding various blog posts. Last, but not least, thank you to my amazing wife, Nira, for all of her support with this endeavor. She has spent many a Saturday morning the last year doing other activities while I’ve been sitting at my desk writing this blog.

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Financial Planning Roth IRA

Remember Your IRA Basis Scorecard When Planning Roth IRA Conversions

Retirement Income Center

Most people who sell assets are familiar with the income tax concept of “basis.” Basis, in its simplest form, is essentially what you pay for something. When you sell an asset, you’re not taxed on the sales proceeds. Instead, you pay tax on the difference between your net sales proceeds and your cost basis. Net sales proceeds is equal to gross sales proceeds reduced by any selling expenses. Cost basis is equal to purchase price plus increases to the purchase price less accumulated depreciation or amortization. Basis, therefore, reduces the amount of otherwise taxable gain.

The concept of “basis” also applies to traditional IRA’s. When you make a contribution to a traditional IRA, your contribution is either deductible, partially deductible, or nondeductible depending upon (1) whether you’re an active participant in a qualified retirement plan, (2) the amount of your modified adjusted gross income, and (3) your tax filing status. To the extent that any portion of your IRA contributions are deductible, they aren’t credited with any basis. Nondeductible IRA contributions, on the other hand, are counted as, and increase, traditional IRA basis.

So what’s so important about basis when it comes to traditional IRA’s? As stated above, basis reduces the amount of otherwise taxable gain. When might you have taxable gain with IRA’s? Unlike assets which can result in a taxable gain when you sell them, traditional IRA’s can result in taxable gains when you take distributions from them. As we’ve learned from previous blog posts, a Roth IRA conversion is, in essence, an IRA distribution.

Similar to assets whereby you’re taxed on the difference between your net sales proceeds and your cost basis, with traditional IRA’s, you’re taxed on the difference between the value of your distribution and your basis in the distribution. How do you know what your basis is in your IRA? Keeping in mind that IRA basis originates from nondeductible IRA contributions, you need a way to keep track of your nondeductible IRA contributions. IRS has provided us with this ability with Form 8606 – Nondeductible IRAs. Form 8606 is your scorecard for keeping track of your traditional IRA basis.

Form 8606 is required to be filed with your tax return in any year that you make nondeductible contributions to a traditional IRA. In addition to reporting the amount of your current year’s nondeductible traditional IRA contributions on line 1, you are required to report your total basis in traditional IRAs on line 2. Total basis in traditional IRA’s represents your cumulative nondeductible IRA contributions reduced by any previously used basis.

Since Form 8606 isn’t required to be filed every year, it’s easy to forget about basis when calculating the amount of taxable IRA distributions, especially if it’s been a while since you’ve made nondeductible contributions to your traditional IRA and you haven’t retained copies of all of your tax returns. This can be especially problematic if you haven’t used a professional income tax preparer to prepare your income tax returns in all of the years that you’ve made nondeductible traditional IRA contributions or if you’ve changed tax preparers over the years. Tracking IRA basis can be further complicated to the extent that the basis in your traditional IRA is different for federal vs. state income tax purposes as a result of state vs. federal deductible IRA calculation differences such as has been the case in California.

If you’re considering doing a Roth IRA conversion, don’t forget about Form 8606 – your traditional IRA basis scorecard. It will reduce the amount of your taxable Roth IRA conversions and, in turn, will reduce the amount of income tax you will otherwise pay.

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Medicare Roth IRA

Will Your Medicare Premium Increase If You Do a Roth IRA Conversion? – Part 2

Retirement Income Center

Last week’s blog post, Will Your Medicare Premium Increase If You Do a Roth IRA Conversion? began a discussion of how Medicare Part B (medical insurance) premiums are calculated. As discussed last week, of importance is that Social Security Administration (“SSA”) will use the income reported on your federal income tax return from two years prior to the current year to determine the amount of your Part B Medicare premium. Also of importance is the distinction between IRS’ and Social Security Administration’s definition of “modified adjusted gross income,” or “MAGI.”

IRS uses MAGI for various purposes, including calculation of allowable real estate rental losses, deductibility of IRA contributions, and qualification for certain tax credits, to name a few. Prior to 2010, it was also used to determine eligibility for Roth IRA conversions. From 1998 through 2009, only taxpayers with MAGI of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA. For purposes of Roth IRA conversion eligibility determination, income attributable to the conversion was excluded from the calculation of MAGI. There are several adjustments, both negative and positive, made to “adjusted gross income,” or “AGI” to arrive at IRS’ definition of MAGI.

When SSA determines MAGI, the calculation is much simpler than the one used by IRS. SSA’s MAGI calculation increases AGI by tax-exempt interest income and that’s it. Since AGI includes income from Roth IRA conversions, unlike IRS’ pre-2010 Roth IRA conversion eligibility MAGI calculation which excluded income from the conversion, SSA includes Roth IRA conversion income in its MAGI calculation.

What does this mean if you’re a Medicare-eligible individual contemplating a Roth IRA conversion in 2010? Any income resulting from a Roth IRA conversion will be added to your other income to determine the amount of Medicare Part B monthly premium that you will pay two years after the year the Roth IRA conversion is included in your income. Your Medicare Part B premium amount could be greater for either one or two years depending upon whether you use the “default” or “election” method for reporting your 2010 Roth IRA conversion income.

Since Medicare premiums are based on SSA’s calculation of MAGI from your tax return two years prior to the current year and since the default for the reporting of 2010 Roth IRA conversion income is the deferral of 50% of the income to 2011 and 50% to 2012 (See In Which Tax Year(s) Should You Include Your 2010 Roth IRA Conversion Income? – Part 1), depending upon the amount of conversion income, your Medicare Part B annual premium assuming that you are married and both eligible for Medicare could increase by more than $6,000 in both 2013 and 2014 for a 2010 conversion. Alternatively, if you elect to report 100% of the income from your conversion in 2010, your Medicare Part B annual premium could increase by more than $6,000 in 2012.

Next week we will look at an example of how a 2010 Roth IRA conversion can directly impact the amount of your Part B monthly premium.

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Medicare Roth IRA

Will Your Medicare Premium Increase If You Do a Roth IRA Conversion? – Part 1

Retirement Income Center

It’s always amazing to me how one thing in life leads to another. This phenomenon is so true when it comes to the Roth IRA conversion series of blog posts that I’ve been writing and publishing since the beginning of the year, with the first post, Year of the Conversion, published six months ago on January 11th. As an example of the “one thing leads to another” phenomenon, the idea for last week’s post, Got Dormant 401(k)? Consider Converting to a Roth IRA came about as a result of writing the previous week’s post, Don’t Forget About Your SEP-IRA for Roth IRA Conversions.

This week’s post is yet another example of the “one thing leads to another” phenomenon. The second to last paragraph of Got Dormant 401(k)? Consider Converting to a Roth IRA discussed various factors to consider when contemplating the Roth IRA conversion decision. Included in the list of factors was the affect of the conversion on Medicare premiums. Since this is an important consideration for anyone 65 years of age or older who is evaluating a Roth IRA conversion, I am devoting this week and the next two week’s posts to this topic.

For those of you unfamiliar with Medicare insurance premiums and how they’re calculated by Social Security Administration (“SSA”), first some background regarding Medicare insurance premium amounts. There are two types of Medicare premiums: Part A and Part B. Both premium amounts are subject to change each year.

Part A is for hospital insurance. Most people don’t pay a monthly Part A premium because they or a spouse has 40 or more quarters of Medicare-covered employment. The amount of Part A premium is currently $254.00 per month for people having 30 – 39 quarters of Medicare-covered employment and is $461.00 per month for people who are not otherwise eligible for premium-free hospital insurance and have less than 30 quarters of Medicare-covered employment.

Part B is for medical insurance with a basic monthly premium that is currently either $96.40 or $110.50 per month for individuals who file an individual return with modified adjusted gross income (“MAGI”) of $85,000 or less or individuals who file a joint return with MAGI of $170,000 or less. The monthly premium is $96.40 for individuals who have their Part B premium withheld from their Social Security benefits and is $110.50 for all others. The 2010 Part B monthly premium for higher levels of income is as follows:

2010 Part B Monthly Premium

Individual Return With Income

Joint Return With Income

$154.70

$85,001 – $107,000

$170,001 – $214,000

$221.00

$107,001 – $160,000

$214,001 – $320,000

$287.30

$160,001 – $214,000

$320,001 – $428,000

$353.60

Above $214,000

Above $428,000

What’s important to keep in mind is that SSA will use the income reported on your federal income tax return from two years prior to the current year to determine the amount of your Part B Medicare premium. As an example, the income reported on your 2008 federal income tax return will be used to determine your monthly Part B premium in 2010. If your income has decreased since 2008, subject to meeting certain criteria, you may request that the income from a more recent tax year be used to determine your premium.

Part 2 will discuss the distinction between IRS’ and SSA’s definition of “modified adjusted gross income” and how this affects the Medicare Part B monthly premium amount. Part 3 will provide an example of how a 2010 Roth IRA conversion can directly impact the amount of your Part B monthly premium.

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Roth IRA

In Which Tax Year(s) Should You Include Your 2010 Roth IRA Conversion Income? – Part 1

Retirement Income Center

If you’ve read any of the last 15 blog posts, you understand that the decision to convert a traditional IRA to a Roth IRA isn’t typically a slam dunk. There are some instances when you should never do a Roth IRA conversion (see Three Roth IRA Conversion “Show Stoppers”). When a Roth IRA conversion is appropriate, in most cases it makes sense to convert a portion of a traditional IRA to a Roth IRA over several years rather than 100% in one year (see Roth IRA Conversion – A Multi-Year Strategy).

2010 is a unique year for Roth IRA conversions. In addition to the removal of the $100,000 modified adjusted gross income Roth IRA conversion eligibility threshold (see Year of the Conversion), if you do a conversion in 2010, the income from your conversion won’t be reported in 2010. Instead, one-half of the income will be included in 2011 and the other half will be included in 2012. You will need to make an election on your 2010 income tax return if you would like to report the income in 2010.

At first blush, the default of spreading your conversion income over two future years seems like a great opportunity since (a) you’re not recognizing any income from your conversion on your 2010 federal income tax return, (b) you’re deferring income to a future year, with 50% deferred for two years, and (c) depending upon the amount of your conversion, by splitting your income, you may be able to reduce the top marginal tax bracket at which your Roth IRA conversion income will be taxed in 2011 and 2012.

Unfortunately, the decision regarding when to recognize your Roth IRA conversion income is complicated by the fact that, in the absence of Congressional action, our current relatively low tax brackets will be replaced by the pre-2001 tax brackets which are generally higher. Assuming that Congress takes no action, 2010 income tax brackets will increase by at least 3% for most levels of income as follows:

2010 Tax Bracket

2011 Tax Bracket

10%

15%

15%

15%

25%

28%

28%

31%

33%

36%

35%

39.6%

While there will be no increase in the 15% tax bracket and the increase will be 3% for the 25%, 28%, and 33% tax brackets, the increases are more severe for the 10% and 35% brackets. The 10% bracket will increase by 5% to 15% and the 35% bracket will increase by 4.6% to 39.6%. It’s important to keep in mind that the tax brackets being illustrated are marginal tax brackets. As an example, if you’re currently in the 33% tax bracket, you are affected by the changes in all of the brackets below 33% as well as the 33% tax bracket, since different layers of your income are taxed at 10%, 15%, 25%, 28%, and 33%, respectively, to calculate your 2010 tax liability.

As if it isn’t difficult enough deciding whether or not you should do a Roth IRA conversion this year and how much of your traditional IRA you should convert to a Roth IRA, you must also decide in which tax year(s) you should include the income from your conversion. Part 2 will show the different levels of income associated with the above 2010 and projected 2011 tax brackets. Part 3 will use an example to compare the use of the 2010 Roth IRA conversion income deferral default to the optional 2010 inclusion.

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IRA Roth IRA

Roth IRA Conversion – A Multi-Year Strategy

Retirement Income Center

With all of the buzz about Roth IRA conversions this year as a result of the elimination of the $100,000 modified adjusted gross income threshold for converting traditional IRA’s to Roth IRA’s, clients and non-clients alike have been asking me the million-dollar question, “Should I do a Roth IRA conversion?” The underlying implied question usually is, “Should I convert 100% of my traditional IRA to a Roth IRA this year?”

Despite the media frenzy and the associated rush to do Roth IRA conversions in 2010 to obtain the alleged benefit of recognition of 50% of the income from the conversion in 2011 and 50% in 2012, a Roth IRA conversion, if it makes sense, doesn’t have to be, and in most cases shouldn’t be, a one-time event. Unless you meet the criteria of one or more of the four ideal candidates presented in The Ideal Roth IRA Conversion Candidate – Parts 1 and 2, you should be using a multi-year strategy for your Roth IRA conversions. Even if you’re an “ideal candidate,” it still may make sense to defer a portion of your conversion to 2011 and later years.

One of my clients, Mr. and Mrs. Retired, meet the criteria of Ideal Candidate #1 presented in the February 8th blog, The Ideal Roth IRA Conversion Candidate – Part 1, i.e., no current income tax liability without any tax losses. Mr. and Mrs. R. are both less than 70-1/2, are taking distributions from nonretirement accounts, a large portion of which are nontaxable or tax-favored, and their itemized deductions and personal exemptions offset whatever otherwise taxable income they have so that they aren’t subject to any income tax liability. Mr. R. retired at the end of 2006.

A substantial portion of Mr. and Mrs. R.’s investment assets are in retirement accounts, including traditional IRA’s and Roth IRA’s that have been converted from traditional IRA’s over the last three years since Mr. R. retired. Even though their tax situation is such that they aren’t incurring any income tax liability, it didn’t make sense to convert 100% of Mr. and Mrs. R’s traditional IRA’s to Roth IRA’s in 2007, the year after Mr. R. retired, nor did it make sense to do this over three years since Mr. and Mrs. R. would incur income tax liability they would otherwise not incur.

The strategy that I’m using with Mr. and Mrs. R. has been to prepare one or more income tax projections each year to determine the optimal amount of traditional IRA’s that can be converted to Roth IRA’s without incurring any income tax liability. This is tricky since the conversion amount is limited by the inclusion of a portion of Mr. R.’s Social Security benefits in income that wouldn’t otherwise be includible without the conversion. This strategy has resulted in the successful conversions of $30,000 to $60,000 a year, or a total of $140,000 over the last three years, without any associated income tax liability. We will continue to employ this strategy over the next several years to convert the remainder of Mr. and Mrs. R.’s traditional IRA’s to Roth IRA’s without recognizing any income tax liability.

The next time you ask your financial advisor, “Should I do a Roth IRA conversion?,” you might want to add to the end of the question, “…this year or over the next several years?”

Categories
IRA Roth IRA

Consequences of Not Doing Your RMD Before Your RIC

Retirement Income Center

The lesson of last week’s blog post is that if you’re 70-1/2+, IRS deems the first distributions from your traditional IRA to satisfy your required minimum distribution(“RMD”) and therefore you must always take your RMD before doing a Roth IRA conversion. What are the consequences of not taking your RMD before doing your Roth IRA conversion? This post will answer this question and will discuss how to correct this situation.

At first blush, there would appear to be two potentially serious repercussions:

  1. 50% penalty on the amount that should have been withdrawn but was not, and
  2. 6% excise penalty for every year the money remains in your Roth IRA

Answer 6(c) of IRS Regulation 1.408A-4 (Converting amounts to Roth IRAs) enables you to potentially avoid both penalties by treating this situation as two distinct and separate events:

  1. A required minimum distribution, and
  2. Regular contribution to a Roth IRA vs. a Roth IRA conversion

If you do a Roth IRA conversion without first taking your RMD, IRS deems the portion of the conversion amount that is equal to your RMD amount to satisfy the RMD rules for that year and thus avoid a potential 50% penalty. This assumes that the conversion amount is at least equal to the amount of your RMD. The portion of your conversion amount that is less than your RMD would still be subject to the 50% penalty.

Assuming that your conversion amount is equal to or greater than your RMD amount, you’re out of the woods as far as your potential exposure to the 50% penalty. What about the 6% excise penalty? There are different rules for eligibility for a regular contribution to a Roth IRA vs. a Roth IRA conversion. Since your RMD amount is now treated as a regular contribution to a Roth IRA, your avoidance of the 6% excise penalty depends upon whether or not you are eligible to make a regular contribution to a Roth IRA as well as your RMD amount.

Eligibility for regular contributions to Roth IRA’s is dependent upon having earned income equal to at least the amount of the contribution and is also dependent upon the amount of one’s modified adjusted gross income (“MAGI”) which differs by filing status, the details of which are beyond the scope of this blog post. Even if you meet the eligibility requirements, the maximum amount of your Roth IRA contribution is limited to $6,000 if you’re age 50 or older.

If you don’t meet the eligibility rules for making a regular contribution to a Roth IRA, the portion of your Roth IRA conversion that is deemed to be an RMD will be subject to the 6% excise penalty. Furthermore, even if you satisfy the Roth IRA regular contribution rules, to the extent that the RMD portion of your Roth IRA conversion exceeds $6,000, it will be subject to the 6% excise penalty until it is corrected.

If you are either ineligible to make a regular contribution to a Roth IRA or, if you are eligible and the RMD portion of your Roth IRA conversion exceeds $6,000, how do you correct this situation and avoid the 6% excise penalty? In order to avoid the penalty, you must transfer the portion of the conversion that is deemed to be an RMD that doesn’t meet the Roth IRA regular contribution eligibility requirements plus earnings thereon back to your traditional IRA by the due date, including extension, for filing your tax return for the year of conversion.

Categories
IRA Roth IRA

Do Your RMD Before Your RIC

Retirement Income Center

I’m not a big fan of acronyms because there’s way too many of them and it’s easy to get confused by them, however, my original title for this post, “Don’t Forget to Take Your Required Minimum Distribution (“RMD”) Before You Do Your Roth IRA Conversion (“RIC”)” was way too long. So, for my fellow non-acronym fans (otherwise known as “NAF’s”), please bear with me on this one.

With the one-year suspension of required minimum distributions (“RMD’s”) in 2009, it’s easy to forget that if you’re at least 70-1/2 years old, you must start, or resume, taking mandatory minimum withdrawals from your traditional IRA accounts in 2010 based on their account value on December 31, 2009 and an IRS life expectancy factor. The RMD rules are even further off the radar screen for those individuals age 70-1/2+ with modified adjusted gross incomes in excess of $100,000 who were previously ineligible for a Roth IRA conversion who were anxiously waiting for 2010 to roll around so that they could finally do a conversion.

If you’re 70-1/2, before you rush out and convert a portion, or all, of your traditional IRA to a Roth IRA, you must first take your RMD. Why is this? If you own a traditional IRA at any time during the year and you’re at least 70-1/2 years old, IRS says that the first distribution from your IRA always includes your RMD amount. Furthermore, RMD’s aren’t eligible to be rolled over to other IRA’s, including conversion to a Roth IRA.

Consequently, even though your RMD and your Roth IRA conversion are both taxed exactly the same way as ordinary income, you must always first take your RMD before converting any portion of your traditional IRA to a Roth IRA. What are the consequences of not taking your RMD before doing a Roth IRA conversion and is there a way to correct this? For the answer to these questions, you’ll need to wait for next week’s blog post.