Altering the course of retirement savings

Altering the course of retirement savings

Working Americans received a significant retirement-saving option when the Roth IRA went into effect on Jan. 1, 1998.

For many savers who couldn’t receive a tax-advantage benefit for contributing to an IRA account, it provided a breakthrough, after-tax savings option as investors began preparing for retirement.

In 2010, thanks to a provision of the Tax Increase Prevention and Reconciliation Act of 2005, many retirement savers will face important changes regarding Roth conversions and the potential tax consequences. Because of the changes, right now and during calendar year 2010, it is very important for IRA contributors or those taking a distribution from a qualified retirement plan to prepare for their potential impacts.

What do investors need to know about converting a traditional IRA or retirement plan distribution into a Roth IRA and the potential tax consequences?

First and foremost, more savers will be able to convert traditional IRAs to Roth IRAs because of liberalized conversion rules. Before Jan. 1, 2010, those in the higher income brackets were excluded from being able to convert traditional IRAs or qualified plan assets into a Roth IRA. Because of the earnings limit, many investors couldn’t take advantage of paying the taxes due on a traditional IRA or qualified plan assets now and allow after-tax dollars to accumulate tax free. That all went away as of Jan. 1.

There no longer will be the $100,000 modified adjusted gross income limit for conversion eligibility. All income levels now will be able to convert traditional IRAs and qualified plan assets into a Roth IRAs and take tax advantage on the growth of the after-tax dollars on a tax-free basis.

The joint-filing requirement for married individuals also will be eliminated, allowing married couples filing separate tax returns as much latitude in converting traditional IRAs to Roth IRAs.

What are the implications?

Probably the most important short-term change affects individuals who convert traditional IRAs or pre-tax qualified plan assets into Roth IRAs during calendar year 2010 by providing special tax treatment for those conversions. Individuals will have the ability to spread the taxable amount on their conversion dollars, pro rata, over 2011 and 2012. Individuals alternatively may choose to include the taxable amount as income for all of calendar year 2010. Note that individuals who convert before calendar year 2010 and after Dec. 31, 2010, must include their taxable amount in their income in the year of the conversion.

What are the tax implications for savers who decide to make a conversion? The following should be considered when determining whether a Roth IRA conversion is the right move:

• When a traditional IRA or pre-tax qualified plan asset is converted to a Roth IRA, the individual saver must pay taxes on any pre-tax assets (including contributions and gains) at the time of the conversion.

• If the traditional IRA or qualified plan asset being converted contains both pre-tax and after-tax dollars, the IRS requires the saver to treat the conversion amount as consisting of a pro rata share of pre-tax and after-tax dollars.

• IRS Form 8606 (nondeductible IRAs) must be completed by the individual saver to calculate the taxable portion of the traditional IRA converted to the Roth IRA. Individuals should seek the assistance of a tax professional to complete IRS Form 8606 and calculate the applicable tax liability.

Converting a traditional 401(k) to a Roth IRA does not require the use IRS Form 8606 to determine the taxable portion of the conversion, but is subject to the basis recovery rules applicable to qualified retirement plans for post-1986, after-tax assets. The plan administrator is responsible for reporting the taxable and nontaxable portion of a qualified plan-to-Roth IRA conversion on IRS Form 1099-R.

While converting a traditional IRA to a Roth appears to be a terrific opportunity for American taxpayers, determining the taxable portion of the converting assets can be quite complicated. Your tax bracket, time to retirement, and ability to pay taxes on the conversion assets all must be considered. Individuals should consult their tax professionals for assistance. No one wants to pay more in taxes than required, but one also doesn’t want to hear a knock at the door should the IRS determine you didn’t pay enough.
Source: Dolan Media Newswires