I provided some basic rules, including information on contribution, conversion, recharacterization and tax implication. If some of these rules are still a little unclear, I am hoping that my answers below to real situation questions should provide additional clarity in helping investors to determine which type of a retirement is most beneficial for each individual case and how to maximize their savings for retirement.
A. This choice mainly depends on the comparison between your current taxation rates and your anticipated taxation rates in retirement. You also must consider that TIRAs have mandatory distributions after you reach a certain age. Your current deductible contribution to a TIRA would reduce your income tax this year and increase your income tax in the year you make a withdrawal from the TIRA. If you think that your marginal income tax rate will be higher now than in retirement, it probably makes more sense to take the tax deduction this year. Conversely, if you think that your marginal income tax rate is lower now than it will be in retirement, you should contribute your after-tax income to a RIRA. Additionally, because TIRAs have mandatory distribution requirements after you reach a certain age, it might make more sense to contribute to your RIRA if you think that you may not need to take withdrawals from your IRA at least in the first 10 years or so of retirement – into your 70s. RIRAs have no future minimum required distributions to their owners.
A. You have three options.
First, if the bonus does put you over the maximum AGI limit, you could just leave the money in the Roth IRA and, after October of the next year, pay the 6% excise tax on the contribution amount and then designate it as the contribution for the next year. This might be a good option if the value of the investments has increased significantly on the original contribution. But the drawbacks are the 6% penalty and the risk that you might not qualify to make a RIRA contribution next year.
Second, you could wait until next year just to make sure that you actually receive the bonus for this year. If the bonus is delayed and you do not have access to it until January, it will be considered income for the next year and you will have no issues with your RIRA contribution. However, if you indeed receive the bonus in December, then you could recharacterize the contribution to your TIRA. To do this, you will have to ask the IRA custodian to transfer the contribution, plus any earnings, to your TIRA and there would be no tax or penalty. This contribution will be treated as though you originally made the IRA contribution to your TIRA.
Third, you could ask the custodian for a return of contribution. You would have to complete this return by the tax filing deadline – usually April 15 of the next year. The custodian will return to you your original contribution, plus any earnings on the contributions. The associated earnings you must include as income for the contribution year, even if the return of contribution occurs the next year. These earnings must be reported on form 5329 and will be subject to the 10% early withdrawal penalty if the IRA owner is not yet 59.5 years old.
All situations are unique. However, in most cases, the second option would seem to be the best alternative.
A. There is a strategy for dealing with this relatively large investment-loss possibility. I will demonstrate it through an example.
Let us assume that you wish to convert $60,000 from your TIRA to your RIRA and that the full conversion amount is taxable that year as ordinary income. Also, assume that this $60,000 represents the risky part of your investment portfolio allocation. You could have invested that amount into an aggressive growth emerging market mutual fund that you are holding already as part of your carefully chosen investment allocation. You can convert the funds early in the year and you must report the full conversion amount as ordinary income for the year.
After you complete the conversion, let us assume that by September of the next year, the value of this high-risk fund has fallen by 33% to $40,000. You can then recharacterize this $40,000 RIRA conversion contribution back to the TIRA, file an amended tax return for the conversion year and get a refund of the tax paid on the $60,000 conversion. At the same time, you can do another RIRA conversion contribution using $40,000 different IRA dollars, which means that you may not use the recharacterized dollars until January of the next year. Once the conversion is in the RIRA, repurchase the same shares of the emerging market fund. There will be no wash sale rules, as you are not able to claim any of this as a loss. If this emerging market mutual fund eventually rebounds, you would have reduced the tax cost of the conversion using your existing portfolio without having to change your asset allocation.
Because this requires some work, it will be difficult to justify the time and effort needed unless the dollar amounts are relatively large. Remember, you have until October 15 of the year following the conversion year to recharacterize it and you have 3 years after the year of the RIRA conversion to amend your tax return and get a refund on the tax you originally paid for the conversion.
A. Two items will determine whether you will be subject to the new 3.8% surtax, or more accurately, the Net Investment Income Tax, or NIIT – your net investment income and your adjusted gross income. It is actually your modified AGI. For this example, I will assume that you have no foreign earned income.
For a single tax filer, the 3.8% surtax will apply to the lesser of your AGI over $200,000 or your net investment income. The ordinary income that you will have to add to your gross income from a RIRA conversion will add to your AGI, but it is not included as investment income. So, let us say that your AGI is already over $200,000. In that case, the taxable portion of your RIRA conversion would only increase the amount of the 3.8% surtax if your investment income is more than the amount of your AGI that is over $200,000. For example, if your AGI is $210,000, your net investment income – interest, dividends and net capital gains – is $20,000, then the 3.8% surtax will apply to $10,000, which is the amount that your AGI is over $200,000. Now, assume that you do a $55,000 Roth conversion and that all of it is taxable, i.e. your TIRA has no basis. This would increase your AGI to $265,000. Now the amount your AGI that exceeds $200,000 has gone from $10,000 to $65,000, which means $10,000 of this AGI increase will now be subject to the 3.8% surtax in addition to the $10,000 your AGI was already over the $200,000 threshold. Therefore, your net investment income will be $20,000 – which is the lesser of the two amounts used to determine the 3.8% surtax. In this case, any Roth conversion greater than $10,000 will not increase the 3.8% surtax.
A. Yes, you can use it as an indirect way to make a RIRA contribution despite your AGI exceeding the direct RIRA contribution limit. A “back door” RIRA contribution involves making a non-deductible TIRA contribution and then converting that TIRA into a RIRA, which after 2009 has no AGI limitation for doing the RIRA conversion. But be aware that all TIRAs, SEP IRAs and SIMPLE IRAs must be combined in doing the RIRA conversion. If there are existing TIRAs, SEP IRAs or SIMPLE IRAs, then part or most of the conversion amount will be pretax. Therefore, the amount of the conversion that is pre-tax must be included in that year’s income. The “back door” RIRA conversions make the most sense for those who do not have a TIRA, SEP IRA, SIMPLE IRA or for those whose combined value of these IRAs is small.
A. The major advantage to many high-income households is that they can contribute to a RIRA this way when they make too much to contribute to their own RIRA. While the current maximum contribution to this kind of RIRA is $18,000 per year, most plans will likely have a maximum below this amount. Another advantage is that this kind of a RIRA is fully protected from creditors. Individual RIRAs have limited protection and the protection depends on state laws.
The disadvantage of a 401(k)-Roth is that you can not recharacterize or withdraw the contributions. Investment options will be limited to what the employer’s plan offers and in-service withdrawals from the Roth or loans from it are not allowed. Also, if the Roth portion of the 401(k) plan is not rolled over to the individuals RIRA at age 70.5, the employee will have to begin required minimum distributions, something a RIRA would not have to do.
Since 2014, 401(k)-Roth plans can be modified to allow current account holders to convert monies in the 401(k) plan to the Roth part of the plan. The converted funds are taxable to the employee, but it is another way individuals can increase their RIRA savings.
A. Yes and no. Yes, she may contribute to your RIRA providing she has enough earned income – box 1 of her form W2 – to cover the contributions to both her and/or your RIRAs. But, she may not make any contribution to your TIRA – deductible or non-deductible – in the year you reach age 70.5 and later.
A. Yes. But, there are a couple of potential snags. The 401(k) plan must allow for TIRA rollovers. Also, you would have to roll over all your TIRA, SEP IRA and SIMPLE IRAs you might give to the employer sponsored 401(k). Otherwise, you would have to include them in determining how much of the Roth conversion will be includable as income that year.
A. When you reach age 59.5 then all withdrawals from that age on will be ‘qualified’ and so will be free of tax and penalty. Prior to that age, any withdrawal you make will be “Non-Qualified”, meaning you’ll have to withdraw basis (the total of all past after-tax contributions) first with no tax or penalty, and then withdrawals must be taken from any conversions that have occurred in the past 5 years. If past conversions are withdrawn prior to the 5-year period or prior to attaining age 59.5, then they will be subject to a 10% penalty but not taxed, as they were already taxed upon conversion. If all basis and any conversions have been withdrawn then the next withdrawal will be the RIRA earnings, which will be subject to taxation and subject to a 10% penalty.
I hope my answers have shed some light on the options available to investors in some of the specific situations. Because the questions here do not cover all possible situations, investors should always seek professional help for any new or unfamiliar situation. My next article will focus on the types of investment that are allowed in IRAs and the types of investments that are prohibited from IRAs.
Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.