Jul 30 2012
A continuation from last weeks article answering common questions about IRAs.
Nine Frequently Asked Questions About IRAs
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Question: I am 74-year-old single male. I currently have a traditional IRA that is worth approximately $170,000. My main purpose is to give this to my children upon my death. Would it be better to leave it in the traditional IRA or convert it to a Roth IRA?
Answer: Converting to a Roth is probably the way to go. You will no longer have to take mandatory distributions. You will save your children the trouble of paying federal income tax on your IRA after your death. And you will reduce your taxable estate by the amount of the tax bill on your Roth conversion. (Because you are over 59 1/2, you can use your IRA assets to pay the tax, penalty-free. Or you can pay the tax from your other assets, preserving the value of your IRA.)
Once you die, a Roth IRA is treated like any other IRA. That means that if your spouse is your beneficiary, she can treat the Roth IRA as her own. So no minimum withdrawals are required as long as she lives. If your beneficiary is not your spouse, the following rules apply.
If your children are named as your IRA beneficiaries, they can start to liquidate the IRA beginning on Dec. 31 following the year of your death. That liquidation must be completed over a period based on their life expectancies. Your children would also have the option to leave the money in the account, and liquidate it by December 31 of the fifth year after your death.
Another thing to keep in mind is that earnings must be in the Roth for at least five years before they can be withdrawn tax-free. So, if the Roth IRA is not five years old, beneficiaries taking withdrawals need to follow the ordering rules for Roth IRAs. That means the first withdrawals will come from annual after-tax contributions. The next layer comes from contributions of converted traditional IRA money first the taxable amount, then from the nontaxable amount (if any). The last layer comes from Roth IRA earnings.
Question: Can I roll over only the nondeductible contribution portion of my traditional IRA to a Roth IRA and thereby avoid the taxes that would be due on a rollover of my IRA earnings?
Answer: No. “You can’t just take out the cream,” says Ed Slott, a CPA in Rockville Centre, N.Y., and publisher of the newsletter. If you choose to do a partial conversion, every dollar you convert will be treated as a “blended” dollar. For example, if 20% of your current IRA assets consists of nondeductible contributions and the remainder is deductible contributions and earnings, you will owe income tax on 80 cents of each dollar you convert to Roth IRA status. Note: If you have multiple IRAs, you must add the assets together when calculating what portion of your partial conversion will be taxable.
Question: My spouse and I are both self-employed and have each been contributing to a SEP IRA. Can we convert this SEP IRA to a Roth IRA?
Answer:Yes. The tax regulations allow you to directly convert a SEP account into a Roth IRA. However, after the conversion, you can’t continue making deductible SEP contributions to what is now a Roth IRA. So, you’ll have to set up a new SEP account if you want to make further deductible pay-ins.
Question: If I convert from a traditional IRA to a Roth, is the gain considered ordinary income or a long-term capital gain?
Answer: The gain in your IRA is taxed as ordinary income. So, your federal income tax rate can be as high as 35%.
Question: I am single and retired with an AGI well under $110,000 but no earned income for 2012. Can I contribute to a Roth IRA for this year?
Answer: Unfortunately not. Annual contributions to Roth IRAs, just like traditional IRAs, can only be made for years when you have earned income. However, you can convert your traditional IRA into a Roth if you are willing to pay the upfront tax hit. There is no earned income requirement for conversions, there is no longer any restriction on Roth conversions for those with high incomes.