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The Roth Management Guide

7 Wealth Building Blocks of an IRA

Roth Primer

Accounts Tax Advantage

Contribution Limits

Risks

The 2010 Conversion Loophole & the Workaround

Moving Roth IRA Assets

Income Restructions

Roth IRAs For Minors

Non-deductibleTraditional IRAs

The Impact of a Conversion of Social Security

Roth IRA as a Graduation Gift

Calculating Contributions

120 Day Rule

Roth 401(k)

Reporting Roth Contributions

First Time Homebuyers Qualification Rules

A Roth IRA Withdrawl

Traditional IRA Conversion Considerations

Prohibited Transactions

Helpful Hints

Helpful Hints – Tax Trepidations

Recharacterization: How to Undo a Roth IRA Conversion

Traditional IRA to Roth IRA Conversion Tax Example

Review of Guidelines


The Seven Wealth Building Blocks of an IRA

Building Block #1: Tax Deferred Savings.

An IRA grows faster because the earnings remain in the account instead of being used to pay state and federal taxes. An IRA is in a tax-deferred account. Therefore, the progressively larger sum of money earns interest.

There are two types of IRAs: traditional and Roth.

Taxes on the traditional IRA’s investment are deferred along with the taxes on its earnings. This IRA will be 100 percent taxable upon withdrawal. All monies are tax deferred until the money is withdrawn.

Taxes on the Roth’s investments have been paid prior to deposit. There is no tax on the earnings so that all funds will be totally tax-free when withdrawn.

To review: The money invested in a traditional IRA is pre-tax dollars, deducted before taxes are assessed. At time of withdrawal, taxes must be paid. On the other hand, the money invested in a Roth IRA is after-tax dollars which means that the government has already received the tax payment.

Building Block #2: Flexibility.

The investor has the privilege of changing his/her mind. The investor may start with a traditional IRA, and then convert it to a Roth IRA. After having made the conversion, the investor can again change it back to a traditional IRA. An investor can own both a traditional IRA and a Roth IRA at the same time. It is also possible to make contributions to both a traditional IRA and a Roth IRA in the same year.

Building Block #3: Withdrawal Exemption Privileges.

The IRS allows the investor to reclaim some or all of the money in an IRA under certain circumstances and to avoid the payment of the penalties set out in the law.

No tax or penalty will be charged if the withdrawn funds are repaid into the IRA within 60 days. No penalties will be charged if the IRA owner becomes disabled, dies, or takes substantially equal periodic payments or the money is needed to pay medical expenses, medical premiums, purchase a house, cover educational costs or pay back taxes levied by the IRS.

Building Block #4: Risk Based Choices.

The term, risk, is used to describe the volatility of the investment. The investor can choose the risk level he/she is comfortable with, own multiple risk choices, and/or change the risk tolerance. For example, the risk may be demonstrated through the products an investor chooses, such as stocks, bonds, mutual funds, annuities, certificates of deposit, etc.

Building Block #5: Asset Allocation.

Once an investor has determined his/her risk tolerance, he/she then has the latitude to determine how much to spend.

Building Block #6: Personal Involvement.

The investor controls when money will be deposited into the account. Money can be deposited at a regular interval – automatic deposit, or a buy-and-hold purchasing strategy. The investor becomes personally involved in the decision of making deposits, such as timing a deposit to the best market opportunity.

Building Block #7: Portability.

Attempting to forecast the investment future or to buy to a future return is a risk. However, an IRA purchased at one risk tolerance level or from a particular firm, is allowed to be moved to a new/different risk tolerance, product or firm.

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Roth Primer

The Roth IRA was named after Delaware Senator William Roth as part of the Taxpayer Relief Act of 1997, and signed into law by President Clinton. The Roth IRA is a tax-free retirement investment account. Contributions to a Roth IRA are not tax deductible and gains will not be taxed upon distribution. This concept allows the investor to diversify tax exposure.

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Accounts Tax Advantage

Direct contributions to a Roth IRA can be withdrawn tax free at anytime because the tax on the money has already been paid. The earnings can be withdrawn tax and penalty free if certain conditions exist, such as being over 59 ½ years old.

Contributions to a Roth IRA are allowed regardless of an investor’s other retirement options. In other words, with the Roth IRA, the employer’s options are irrelevant.

Up to $10,000 of earnings tax-free can be withdrawn if it is used to buy a primary residence by a first time homebuyer. To qualify as a first time homebuyer means the buyer cannot have owned a home in the past 24 months.

With other retirement accounts, there are required minimum distributions based on age. The Roth IRA has no such requirement.

Earnings can be withdrawn tax-free if they are used for educational expenses.

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Contribution limits

All pension plans have a contribution limit. All IRAs have a catch up provision including the Roth IRA. A catch up provision allows those age 50 and older to exceed the contribution limit by a designated amount.

In 2010, the contribution limit will be $5000. For example an individual age 49 and younger may contribute up to $5000 and for those ages 50 and older, the catch up provision will allow a maximum contribution of $6000.

Prior to 2010, an investor with income exceeding $100,000 could not roll over a traditional IRA into a Roth IRA. In 2010, that restriction was lifted and now allows conversion from a traditional IRA into a Roth IRA. Taxes must be paid on the amount being converted from a traditional IRA to a Roth IRA.

Income limits are still in place. When an investor wants to contribute to a Roth IRA but cannot because of income limit restrictions, the investor can contribute to a non-deductible traditional IRA and then immediately convert it to a Roth IRA.

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Risks

The Roth IRA is not without risk. The obvious risk is the investment risk. The value of the stock, bond, mutual fund etc. may be lower at redemption than at the time the money was invested.

A less obvious risk is that taxes could decrease. When a Roth IRA is established, the money deposited is after tax dollars. A Roth IRA is a long term pension plan. As an example of risk, income taxes could decrease as sales taxes increase. If that were to happen, the Roth IRA would be taxed twice: once when the contribution was made and then again when the money is spent in retirement.

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The 2010 conversion loophole and the workaround

Prior to 2010, those who earned more than $100,000 MAGI (Modified Adjusted Gross Income) could not convert a traditional IRA to a Roth IRA. This limit was the same for both married and single persons. Starting in 2010, the conversion rule disappeared.

Unique only for conversions made in 2010 will determine when taxation on the conversion could be paid. If a conversion to a Roth IRA is made in 2010 the owner of the converted IRA may select when to pay the taxes. The owner may pay 100% of the taxes due in 2010 or pay 50% of the taxes due in 2011 and the remaining 50% in 2012.

The repeal of the income limit restriction on IRA conversions is a permanent rule. However, the income restrictions pertaining to annual contributions to a Roth IRA continue. Anyone may make an annual contribution to a Roth IRA. This is referred to as a workaround technique.

Review point #1: Income limits remain in place. This means that in 2010 those who are involved in an employer pension plan, married, filling jointly and their MAGI exceeds $109,000 cannot contribute to either a traditional or a Roth IRA. If the MAGI is between $89,000 and $109,000, those investors can make deposits but with restricted amounts.

Review point #2: Traditional IRAs have two classifications: deductible and non-deductible. Deductible means the money deposited into the account has been claimed on a IRS Form 1040 as a deduction in the year it was contributed. Non-deductible (this is different than a Roth) means that the money deposited into this account cannot be declared on taxes; however the earnings growth is not taxable until it is withdrawn.

In the past, individuals made deposits into their traditional deductible IRAs, and at tax filing time determined the amount that was deductible and non-deductible. All the money was left in the same account and only the allowable amounts were reported to the IRS. This technique causes a horrendous accounting nightmare at the time of withdrawal, including possible double taxation.

The workaround works like this:

  1. Establish a non-deductible traditional IRA and then convert it to a Roth IRA.
  2. At time of conversion, taxes will be will owed on any appreciation. To reduce taxation and prevent surrender penalties, establish a non-deductible traditional IRA money market.
  3. File IRS Form 8606. This informs the IRS that a contribution was made to a non-deductible traditional IRA. This will establish a clear paper trail. This technique requires keeping seriously detailed records.

Note: Always keep non-deductible traditional IRAs separated from all other traditional IRAs.

The ability to recharacterize means that each time a traditional Roth IRA is converted to a Roth IRA, a new account should be established. Multiple Roths do not have to remain segregated forever. Once the converted Roth IRAs are beyond the recharacterization deadline, they can be merged into one master Roth for easier administration.

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Moving Roth IRA assets

Moving Roth IRA assets from one Roth IRA to another Roth IRA is very easy. It is known as a transfer and is a tax-free, non-reportable movement of assets between retirement plans. Moving assets from one Roth IRA to another can be accomplished through a transfer and there is no limit on the number of transfers between the trustees or custodians.

Special attention must be paid if Roth IRA assets are going to be invested in a certificate of deposit. A conventional certificate of deposit cannot be purchased through a typical Roth IRA brokerage account. It will be necessary to open a special IRS certificate of deposit from the financial institution of the owner’s choice.

The principle amount in a Roth IRA is always available; however, if a certificate of deposit is used to hold the Roth money, withdrawal of any of the principle sum may be restricted. A certificate of deposit is a type of deposit accounts with a guaranteed a rate of return over a specified period of time, know as the term. It differs from other accounts because the rate is guaranteed, whereas for many types of accounts the rate is not guaranteed. In return for this guarantee, the money is locked into that account until the maturity date of the certificate of deposit. If funds are needed before the certificate of deposit matures, there will often be a penalty.

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Income restrictions

The lower income limit means that earned income was required in order to contribute to a Roth IRA. Every dollar contributed must have been earned in that year, so if the tax return filing says $500 (after taxes) was earned this year, then only $500 can be contributed this year. The $500 contributed does not necessarily have to be the $500 earned. For example, if a child earned $500 but spent it on clothes, the parent can give the child $500 to contribute.

The upper income limit: There is a phase-out range for the upper limit, where the maximum contribution limit is slowly phased out in $20 increments. However, when the 2010 conversion rule was established, it allowed for the workaround technique which circumvents the phase-out limit.

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Roth IRAs for minors

The contribution rule for a Roth IRA is a contribution based on the amount of earned income reported on the Form 1040. A minor may open a custodial Roth IRA. A custodial account is opened when a child is under the age of 18 or handicapped and under the continued supervision of a legal guardian. A minor cannot open his/her own account but an adult can open one on his/her behalf.

The minor can only contribute as much as is declared on his/her taxes. If the minor has been working and does not claim the money earned, he/she cannot contribute to a Roth IRA.

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Non-deductible traditional IRAs

The non-deductible traditional IRA is an important account used in the workaround technique when the MAGI phases out the ability to contribute to a Roth IRA. By avoiding the co-mingling of deductible and non-deductible IRA dollars, the conversion process becomes less complicated. 

When a conversion is made from a non-deductible traditional IRA to a Roth IRA, the owner will not pay any taxes on the principle because that money had never shown on the owners 1040 income tax form as a deduction. The owner will pay taxes on the interest earned while the money was in the non-deductible traditional IRA.

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The impact of a conversion on Social Security

Converting a traditional IRA to a Roth IRA can be done at any age; however taxation will always be a dominant determining factor. For example: someone currently taking Social Security benefits, and depending on age, might want to talk to a professional tax advisor. The conversion will be reported as income and may impact the Social Security benefit.

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Roth IRA as a graduation gift

A post-secondary graduate will be earning a paycheck in a very short period of time. The rule with contributions is that a person has to have a minimum earned income equal to the contribution. The dollars earned do not necessarily have to be the dollars contributed as long as the graduate will be earning money. Open a Roth IRA on their behalf.

The graduation gift will be available to the graduate in subsequent years to help pay for additional education, children’s education, a home or retirement. The account is open and will continue to be a reminder of how important a retirement saving account can be.

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Calculating contributions

How much can be contributed to a Roth IRA depends on an individual or family’s income and the contribution limits of the year in which the money is to be credited.

For example: When covered by a retirement plan at work.

If the adjusted gross income (AGI) is under $5000 in 2010, only an amount equal to the AGI can be contributed. 

If the individual AGI is greater than $5000 but less than $66,000, the maximum contribution is $5000; or the family’s AGI is less than $109,000 in 2010, $5000 is the maximum contribution per individual. For individuals age 50 and older, the catch up rule applies. This rule changes the $5000 to $6000.

For example: When not covered by a retirement plan at work.

If the individual AGI is under $5000 in 2010, only the adjusted gross income can be contributed. 

If the individual AGI is greater than $5000, the maximum contribution is $5000; or the family’s AGI is less than $177,000, then $5000 is the maximum contribution per individual in 2010. If you are 50 years old or older, the catch up provision applies. 

Remember, the annual contribution limit still exists. The MAGI will determine if the contribution may be phased out. 

How to calculate the Roth phase out contribution: The Formula: 

Contribution Limit=

Maximum contribution x (Upper limit of phase out range – Your MAGI)

Upper limit – Lower limit

Numbers you need to know:

2010 Roth limits: Single filer lower limit = $105,000

upper limit = $120,000

Married filer lower limit = $167,000

upper limit = $177,000 

2010 maximum contribution: Under age 50 = $5000

50 and older = $6000 

Example: 40 year old, single filer with MAGI of $115,000

Contribution limit = $5000 x ($120,000 — $115,000)

$120,000 — $105,000

Contribution limit = 5000 x 5000

15000 

Contribution limit = 5000 x 0.34

Contribution limit = $1700

Special rule: The limit is always in increments of $10 rounded up. The AGI is probably not a round number, so always round up.

The minimum maximum contribution amount is $200. If the AGI is within 4% of the maximum, credit is given for the 4% ($200).

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120 day rule

The Roth IRA 120 day rule refers to the amount of time allowed between withdrawing funds from a Roth IRA and when the money must be used to pay for ‘qualified acquisition costs, i.e. closing costs related to a first home. When running close to the 120 day limit, simply contribute the funds back into the IRA (or roll it over to a new IRA) and then withdraw them later. Failure to use the funds within 120 days is considered a disbursement and may be subject to penalties.

If there is a problem resulting in rolling it over to another account, the typical 60 day rule no longer applies. This is considered a special rollover. Do not worry about the rule regarding only one rollover within a 12 month period. When running close to the 120 day limit, if the money is rolled over into a new IRA, be aware that there may be loading expenses, commissions and/or surrender fees.

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Roth 401(k)

A Roth is one of the options in a traditional 401(k) pension plan. Within the 401(k) plan design, the employer is offering the employee the opportunity to have money deposited into the account as after tax dollars. However, the employer wants the tax deduction and therefore all money deposited into the employees 401(k) by the employer will be non-Roth dollars. At time of retirement and proceeds are withdrawn from a Roth 401(k), there will be a mixture of tax free money (the employee’s contribution) and 100% taxable dollars (the employer’s contribution).

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Reporting Roth contributions

When making a Roth IRA contribution, there is no tax deduction; there is no need to report the contribution on any returns. The financial institution holding the Roth IRA will be reporting the contributions, so if the amount contributed exceeds allowable limits, the owner will be penalized by the IRS.

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First time homebuyer qualification rules

  1. The five year test: In order to withdraw any qualified money—interest and growth– from a Roth IRA without penalty, the first dollar of interest must be at least 5 years old. On January 1 of the fifth year after the first year the Roth IRA was established, the five year test passes. There is no need for five actual years to pass, just that the year rolled through five digits.
  2. Principal residence: The home you are buying has to be your place of principal residence and cannot be a vacation home or part-time home. It does not have to be a traditional home, but it has to be home.
  3. IRA owner’s principal residence: If it is your Roth IRA, it has to be your principal residence. You cannot buy a principal residence for someone else with your Roth IRA funds.
  4. First time homebuyer: First time is not exactly first time. If you have not owned a principal residence during a 2 year period ending on the date of acquisition of your new principal residence you will qualify as a first time homebuyer. If you are married, the same rule applies to your spouse.
  5. Must cover qualified acquisition costs: The amount has to go toward the acquisition, construction or reconstruction of the principal residence and can include the usual settlement, financing, paperwork, processing fees and other closing costs.
  6. 6) $10,000 limit: There is a limit to only one $10,000 withdrawal per lifetime per individual
  7. 120 day rule: Once the funds are withdrawn, they must be used within 120 days. If the money cannot be used within the 120 days, it can be put back into the Roth and then withdrawn later.

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A Roth IRA withdrawal

Your own contributions can always be withdrawn from a Roth IRA without penalty. If funds are withdrawn from the account, the withdrawal will come from the contributions first, then from earnings.

In the case of accidentally over-contributing, money needs to be withdrawn to correct the contribution level. There will be a penalty because the rules require that the portion of earnings attributable to the overage also be withdrawn.

The withdrawal of earnings and growth is referred to as a qualified distribution. In order to have distribution of qualified funds without any taxes or penalties two criteria must be met:

The five year test. In order to withdraw any qualified money, the first dollar of interest must be at least five years old. On January 1 of the fifth year after the first year the Roth IRA was established, the five year test passes. There is no need for five actual years to pass, just that the year rolled through five digits.

Reason or type of distribution. If the owner is taking a distribution because he/she is 59 ½; disabled; a qualified homebuyer; or the distribution is needed for education, or is being paid to a beneficiary, the rules have been followed.

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Traditional IRA conversion considerations

Something to consider before converting a traditional IRA is the impact the taxation will have on the budget. The tax paid will be based on the marginal tax rate. Payment can be made with IRA funds or with outside funds. The concept of paying taxes with the dollars that have been saved for retirement is not sound financial management. It is better to have the larger dollar amount sitting tax deferred than a smaller dollar amount sitting tax free.

A partial conversion is a sound solution if there are limited assets to commit to the tax obligation. Be aware that the conversion could possibly move the income into a higher tax bracket.

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Prohibited transactions

Generally, a prohibited transaction is any improper use of an IRA account by the owner, a beneficiary or a disqualified person. The following are examples of prohibited transactions with an IRA:

Borrowing money from it.
Selling property to it.
Receiving unreasonable compensation for managing it.
Using it as security for a loan
Buying property for personal use.

There are also products that cannot be used as qualifying IRA investments. These investments are usually only a problem when someone tries to establish a self-directed IRA. These prohibited investments are generally described as collectibles. Examples of these collectibles would be art, rugs, beverages, antiques, gems, coins, metals, stamps, etc. The exception is that an IRA can invest in one, one-half, one-quarter or one-tenth ounce US gold coins, or one ounce silver coins minted by the Treasury Department. It can also invest in certain platinum coins and certain gold, silver, palladium and platinum bullion. IRAs established through traditional sources such as banks, insurance companies and mutual funds do not invest in prohibited products.

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Helpful Hints

1. When a contribution is made to a Roth fund, there is a tax credit. It is necessary to claim the credit and satisfy the following requirements:

Turned 18 during the tax year.
Not a full-time student for five months out of the year.
Not a dependent on someone else’s return.
The AGI in 2009 filing single is less than $27,750, married filing jointly $55,500, head of household $41,625.

To receive the credit, Tax Form 8880 must be attached to the 1040 return. If you contributed to your Roth IRA last year and had a qualifying income, use the 1040X tax form to amend your return.

2. All IRAs share contribution limits. Allow the traditional IRA and Roth IRA to work in cooperation with one another. Use the Roth IRA as the primary saving vehicle and use the traditional IRA only to reduce any taxation.

3. 2010 is the only year that allows the choice of when to pay taxes on the traditional IRA conversion. When the conversion is made in 2010, the choices are to pay 100% of the taxes due in 2010 or to pay 50% of the converted amount of taxes due in 2011 and the second half in 2012.

4. Use a Roth IRA as an emergency fund. This will take pre-planning. It is practical to select a savings vehicle which will provide a level of liquidity and stability. This emergency fund does have contribution limits. Assets will be limited if the money in this account is needed early; however if there is never a need to draw on this emergency fund account, it will become an additional retirement income source.

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Helpful Hints – Tax Trepidation

5. Due to various economic circumstances, there may be a year when income is low. The tax owed on a conversion is based on current taxable income. Be careful that the conversion will not move you to a significantly higher tax bracket. Also, convert only what you can afford to pay. 

6. The amount of tax paid on an IRA conversion is based on the value of the IRA at the time of conversion. If the Roth IRA went down in value after conversion, it may make sense to undo the conversion and reconvert at a lower value. This maneuver will not recover market losses, but at least there will be no need to pay tax on money that is no longer in the Roth IRA.

Any amount that was converted to a Roth IRA and then switched back to a traditional IRA in a recharacterization cannot be reconverted in the same year as the original conversion, and also cannot be reconverted within 30 days of the recharacterization.

7. If a partial conversion is done, there is greater flexibility in undoing a conversion and effectively redoing it. That is because the rule delaying the reconversion only applies to the amount that was originally converted. It does not apply to an amount that was previously converted. 

8. Reverse conversion. A traditional IRA is effectively used to reduce the amount of taxation due. After the preliminary tax calculations, the owner determines the impact an amount deposited into a traditional IRA would have. For instance, throughout the year, deposits have been made into a Roth IRA. After taxes have been calculated, the owner recharacterizes and transfers only enough funds from the Roth IRA to the traditional IRA to help reduce taxation.

To help reduce market volatility, establish two identical investment accounts. For example, one account is the XYZ balanced mutual fund as a traditional IRA. The second account will also be opened with the XYZ balanced mutual fund as a Roth IRA. This will allow for movement between the two accounts without the volatility concern.

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Recharacterization: How to undo a Roth IRA conversion

This might be called the “oops” rule. It is possible to switch an IRA contribution from one type of IRA to another, or to undo a conversion. Movement of funds can go from Roth to traditional or from traditional to Roth. This rule can be used to recover from a failed conversion, or simply changed your mind. This rule can even reduce taxes by reversing a conversion following stock market losses. 

Recharacterization rules:

Read the recharacterization instructions on IRS Form 8606 and consult a tax professional.
Read the section on recharacterization in IRS Publication 590.
A contribution or conversion can be recharacterized any time up to the income tax filing deadline, plus extension, for the tax year of the conversion. For example, if you convert in the 2010 tax year, you can recharacterize as late as October 15, 2011.
If an IRA was converted from a traditional IRA to a Roth IRA, and later was recharacterized, that conversion cannot be reconverted back to a Roth until the calendar year following the original conversion and there is a waiting time of at least 31 days after the recharacterization.
Action alert! The trustee has to complete the transfer before the deadline. Recharacterize well in advance so there is enough time to follow up and confirm that the trustee finished the paperwork.

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Traditional IRA to Roth IRA conversion tax example

Note: The IRS will look at all IRAs as one. The calculations will become complex if the plan is to convert non-deductible* funds with deferred earnings or funds that have deductible and non-deductible funds in the same account along with deferred earnings. Always seek the help of a qualified tax advisor before converting any funds to determine the financial impact it may have both now and in the future.

(*Non-deductible contribution: A traditional IRA deposit that exceeded the allowable limit due to the MAGI but did not exceed the annual contribution limit.)

Conversion Tax Example:

You have an SEP-IRA at work. You own a traditional IRA and a Roth IRA. You have never made a non-deductible contribution to your traditional IRA. You want to convert 100% of your traditional IRA.

You file as single.

You annual earned income is $110,000.

Your 1040 deductions and credits are $20,000.

Your SEP-IRAs current value is $60,000.

Your traditional IRAs current value is $30,000.

You Roth IRAs current value is $10,000.

2010 Income Tax Table for your income range.

Income $82,400 – $171,850 Taxed rate $16,781 + 25%

Worksheet:

Earned income plus converted amount = $__________

minus

All qualified deductions & credits = $__________

Taxes based on total Modified Adjusted Gross Income = $_________

Example:

$140,000

– $ 20,000

MAGI $120,000

First $82,400 MAGI @ annual tax of $16,781

Balance: $120,000 — $82,400 = $37,600 x .25 = $ 9,400

Total tax = $26,181

Total tax due before conversion = $18,681

Total tax due after conversion = $26,181

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Review of the Guidelines

Contribution limits remained at 2009 levels: $5000 for ages 49 and under; $6000 for ages 50 and over.
2010 is the only year that an IRA can be converted and the tax obligation can be deferred to another year.
The deadline is October 15 of the calendar year after the year an IRA was converted to recharacterize. This is also known as the conversion “take back”.
Phaseout limits increased slightly for 2010: for single filers $105,000-$120,000; for joint filers $167,000-$177,000.
Phaseout limits exist for the Roth IRA but a workaround will allow contributions to a non-deductible IRA with the sole intention of converting it to a Roth IRA. Owners will only be responsible to pay gains earned up to the time of the conversion.
College savings instrument. The earnings in a Roth IRA may be withdrawn for qualified higher educational expenses and will avoid the 10% early withdrawal penalty.
Direct rollovers from 401(k)s to Roth IRAs are now possible.
Keep accurate records of IRA contributions. Do not rely on the IRA custodian to do it for you.
IRS form 8606 must be filed each year in which non-deductible contributions are made or for a rollover after tax amounts to a traditional IRA.
10. Before converting to a Roth, calculate the tax liability.

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