1 R t h IRAs : Hw They W r k and Hw t Use Them Rth IRAs differ frm ther tax-favred retirement plans, including ther IRAs (called "traditinal IRAs"), in that they prmise cmplete tax exemptin n distributin. But there are ther imprtant differences as well, and many qualificatins abut their use. This Financial Guide shws hw they wrk, hw they cmpare with ther retirement devices--and why YOU might want ne, r mre. Rth IRAs differ frm ther tax-favred retirement plans, including ther IRAs (called "traditinal IRAs"), in that they prmise cmplete tax exemptin n distributin, but there are ther imprtant differences as well, and many qualificatins abut their use. This Financial Guide shws hw they wrk, hw they cmpare with ther retirement devices--and why YOU might want ne, r mre. Table f Cntents Hw Cntributins Are Treated Hw Withdrawals Are Treated Cnverting Frm a Traditinal IRA r Other Retirement Plan Unding a Cnversin t a Rth IRA Withdrawal Requirements Retirement Savings Cntributins Credit Use in Estate Planning With mst tax-favred retirement plans, the cntributin t (i.e., investment in) the plan is deductible, the investment cmpunds tax-free until distributed, and distributins are taxable as received. There are variatins frm this pattern, as with 401(k)s where the exemptin fr salary diverted t a 401(k) takes the place f a deductin and fr after-tax investments where invested capital is tax-free when distributed. With a Rth IRA, there's never an up-frnt deductin fr cntributins. Funds cntributed cmpund tax-free until distributed (standard fr all tax-favred plans) and distributins are cmpletely exempt frm incme tax. Hw Cntributins Are Treated The 2012 annual cntributin limit t a Rth IRA is $5,000, (same in 2011). An additinal "catch-up" cntributin f $1,000 (same as 2011) is allwed fr persns age 50 r ver bringing the cntributin ttal t $6,000 fr certain taxpayers. T make the full cntributin, yu must earn at least $5,000 in 2012 frm persnal services and have incme (mdified adjusted grss incme r MAGI) belw $110,000 if single r $173,000 n a jint return in The $5,000 limit in 2012 phases ut n incmes between $110,000 and $125,000 (single filers) and $173,000 and $183,000 (jint filers). Als, the $5,000 limit is reduced fr cntributins t traditinal IRAs thugh nt SEP r SIMPLE IRAs. Yu can cntribute t a Rth IRA fr yur spuse, subject t the incme limits abve. S assuming earnings (yur wn r cmbined with yur spuse) f at least $10,000, up t $10,000 ($5,000 each) can g int the cuple's Rth IRAs. As with traditinal IRAs, there's a 6% penalty n excess cntributins. The rule cntinues that the dllar limits are reduced by cntributins t traditinal IRAs.
2 Hw Withdrawals Are Treated Yu may withdraw mney frm a Rth IRA at all time; hwever, taxes and penalty culd apply depending n timing f cntributins and withdrawals. Qualified Distributins Since all yur investments in a Rth IRA are after-tax, yur withdrawals, whenever yu make them, are ften tax-free. But the best kind f withdrawal, which allws earnings as well as cntributins and cnversin amunts t cme ut cmpletely tax-free, are qualified distributins. These are withdrawals meeting the fllwing cnditins: 1. At least 5 years have elapsed since the first year a Rth IRA cntributin was made r, in the case f a cnversin, since the cnversin ccurred and 2. At least ne f these additinal cnditins is met: The wner is age 59 ½. The wner is disabled. The wner has died (distributin is t estate r heir). Withdrawal is fr a first-time hme purchase (lifetime limit up t $10,000). Nte: A distributin used t buy, build r rebuild a first hme must be used t pay qualified csts fr the main hme f a first time hme buyer wh is either yurself, yur spuse r yu r yur spuse's child, grandchild, parent r ther ancestr. Nn-Qualified Distributins T discurage the use f pensin funds fr purpses ther than nrmal retirement, the law impses an additinal 10% tax n certain early distributins frm Rth IRAs unless an exceptin applies. Generally, early distributins are thse yu receive frm an IRA befre reaching age 59 1/2. Exceptins: Yu may nt have t pay the 10% additinal tax in the fllwing situatins: Yu are disabled. Yu are the beneficiary f a deceased IRA wner. Yu use the distributin t pay certain qualified first-time hmebuyer amunts. The distributins are part f a series f substantially equal payments. Yu have significant unreimbursed medical expenses. Yu are paying medical insurance premiums after lsing yur jb. The distributins are nt mre than yur qualified higher educatin expenses. The distributin is due t an IRS levy f the qualified plan. The distributin is a qualified reservist distributin. Part f any distributin that is nt a qualified distributin may be taxable as rdinary incme and subject t the additinal 10% tax n early distributins. Distributins f cnversin cntributins within a 5-year perid fllwing a cnversin may be subject t the 10% early distributin tax, even if the cntributins have been included as incme in an earlier year. Ordering Rules fr Distributins If yu receive a distributin frm yur Rth IRA that is nt a qualified distributin, part f it may be taxable. There is a set rder in which cntributins (including cnversin cntributins) and earnings are cnsidered t be distributed frm yur Rth IRA. Order the distributins as fllws.
3 1. Regular cntributins. 2. Cnversin cntributins, n a first-in-first-ut basis (generally, ttal cnversins frm the earliest year first). See Aggregatin (gruping and adding) rules, later. Take these cnversin cntributins int accunt as fllws: Taxable prtin (the amunt required t be included in grss incme because f cnversin) first, and then the Nntaxable prtin. 3. Earnings n cntributins. Disregard rllver cntributins frm ther Rth IRAs fr this purpse. Aggregatin (gruping and adding) rules. Determine the taxable amunts distributed (withdrawn), distributins, and cntributins by gruping and adding them tgether as fllws. Add all distributins frm all yur Rth IRAs during the year tgether. Add all regular cntributins made fr the year (including cntributins made after the clse f the year, but befre the due date f yur return) tgether. Add this ttal t the ttal undistributed regular cntributins made in prir years. Add all cnversin and rllver cntributins made during the year tgether. Fr purpses f the rdering rules, in the case f any cnversin r rllver in which the cnversin r rllver distributin is made in 2011 and the cnversin r rllver cntributin is made in 2012, treat the cnversin r rllver cntributin as cntributed befre any ther cnversin r rllver cntributins made in Add any re-characterized cntributins that end up in a Rth IRA t the apprpriate cntributin grup fr the year that the riginal cntributin wuld have been taken int accunt if it had been made directly t the Rth IRA. Disregard any re-characterized cntributin that ends up in an IRA ther than a Rth IRA fr the purpse f gruping (aggregating) bth cntributins and distributins. Als disregard any amunt withdrawn t crrect an excess cntributin (including the earnings withdrawn) fr this purpse. Example: On Octber 15, 2007, Justin cnverted all $80,000 in his traditinal IRA t his Rth IRA. His Frms 8606 frm prir years shw that $20,000 f the amunt cnverted is his basis. Justin included $60,000 ($80,000 - $20,000) in his grss incme. On February 23, 2007, Justin makes a regular cntributin f $4,000 t a Rth IRA. On Nvember 7, 2007, at age 60, Justin takes a $7,000 distributin frm his Rth IRA. The first $4,000 f the distributin is a return f Justin's regular cntributin and is nt includible in his incme. The next $3,000 f the distributin is nt includible in incme because it was included previusly. Distributins After Owner's Death Qualified distributins after the wner's death are tax-free t heirs. Nnqualified distributins after death, which are distributins where the 5-year hlding perid wasn't met, are taxable incme t heirs as they wuld be t the wner (the earnings are taxed), except there's n penalty tax n early withdrawal. Hwever, an wner's surviving spuse can cnvert an inherited Rth IRA int his r her wn Rth IRA. This way, distributin can be pstpned, s that nnqualified amunts can becme qualified, and the tax shelter prlnged. Rth IRA assets left at death are subject t federal estate tax, just as traditinal IRA assets are.
4 Cnverting Frm a Traditinal IRA r Other Eligible Retirement Plan t A Rth IRA The cnversin f yur traditinal IRA t a Rth IRA was the feature that caused mst excitement abut Rth IRAs. Cnversin means that what wuld be a taxable traditinal IRA distributin can be made int a tax-exempt Rth IRA distributin. Starting in 2008, further cnversin r rllver pprtunities frm ther eligible retirement plans were available t taxpayers cnversins and rllvers t Rth IRAs, if yu cnverted r rlled ver amunts t yur Rth IRAs in 2010 and did nt elect t include the entire amunt in incme in 2010, yu must include part f the amunt in incme fr Cnversin Methds Yu can cnvert a traditinal IRA t a Rth IRA. The cnversin is treated as a rllver, regardless f the cnversin methd used. Yu can cnvert amunts frm a traditinal IRA t a Rth IRA in any f the fllwing three ways. Rllver. Yu can receive a distributin frm a traditinal IRA and rll it ver (cntribute it) t a Rth IRA within 60 days after the distributin. Trustee-t-trustee transfer. Yu can direct the trustee f the traditinal IRA t transfer an amunt frm the traditinal IRA t the trustee f the Rth IRA. Same trustee transfer. If the trustee f the traditinal IRA als maintains the Rth IRA, yu can direct the trustee t transfer an amunt frm the traditinal IRA t the Rth IRA. Nte: Cnversins made with the same trustee can be made by re-designating the traditinal IRA as a Rth IRA, rather than pening a new accunt r issuing a new cntract. Prir t 2008, yu culd nly rllver (cnvert) amunts frm either a traditinal, SEP, r SIMPLE IRA int a Rth IRA. Yu can nw rll ver amunts frm the fllwing plans int a Rth IRA. A qualified pensin, prfit-sharing r stck bnus plan (including a 401(k) plan), An annuity plan, A tax-sheltered annuity plan (sectin 403(b) plan), A deferred cmpensatin plan f a state r lcal gvernment (sectin 457 plan), r An IRA. Any amunt rlled ver is subject t the same rules fr cnverting a traditinal IRA int a Rth IRA. Als, the rllver cntributin must meet the rllver requirements that apply t the specific type f retirement plan. There is a cst t the rllver. The amunt cnverted is fully taxable in the year cnverted, except fr the prtin f after-tax investment in the traditinal IRA. S yu must pay tax nw (thugh there's n early withdrawal penalty) fr the pprtunity t withdraw tax-free later, an pprtunity that can extend t yur heirs. Cnversin is nw allwed t all taxpayers in The prir incme restrictin allwing cnversin nly fr taxpayers f incme (again, MAGI) f $100,000 r less in the cnversin year has been terminated. All taxpayers are able t cnvert a regular IRA t a Rth IRA starting in The cnversin is a taxable distributin, which can be taken int incme in the cnversin year r averaged ver the next tw years. The cnversin will nt be subject t the 10% early distributin penalty.
5 Unding a Cnversin t a Rth IRA Since everyne recgnizes that cnversin is a high-risk exercise, the law and liberal IRS rules prvide an escape hatch: Yu can und a Rth IRA cnversin by what IRS calls a "recharacterizatin". This mve, by which yu mve yur cnversin assets frm a Rth IRA back t a traditinal IRA, makes what wuld have been a taxable cnversin int a tax-free rllver between traditinal IRAs. Re-characterizatin can be dne any time until the due date fr the return fr the year f cnversin. Tip: One reasn t d this wuld be where yu find yu've exceeded the $100,000 incme ceiling fr Rth IRA cnversins. Tip: Anther reasn t d this, dramatized by a vlatile stck market, is where the value f yur prtfli drps sharply after the cnversin. Example: If yur assets are wrth $180,000 at cnversin and fall t $140,000 later, yu're taxed n up t $180,000, which is $40,000 mre than yu nw have. Unding-re-characterizatin-avids the tax, and gets yu ut f the Rth IRA. Can yu und ne Rth IRA cnversin and then make anther ne-a recnversin? Yes-nce, subject t these requirements: Recnversin must take place in the tax year fllwing the riginal cnversin t Rth IRA, and the recnversin date must als be mre than 30 days after the previus re-characterizatin transfer frm the Rth IRA back t the traditinal IRA. Withdrawal Requirements Yu are nt required t take distributins frm yur Rth IRA at any age. The minimum distributin rules that apply t traditinal IRAs d nt apply t Rth IRAs while the wner is alive. Hwever, after the death f a Rth IRA wner, certain f the minimum distributin rules that apply t traditinal IRAs als apply t Rth IRAs Als, unlike traditinal IRAs (but like ther tax-favred retirement plans), a Rth IRA wner wh cntinues wrking may cntinue t cntribute t the Rth IRA. Retirement Savings Cntributins Credit Als knwn as the saver's credit, this credit helps lw and mderate incme wrkers save fr retirement. Taxpayers age 18 and ver are allwed a tax credit fr their cntributins t a wrkplace retirement plan, traditinal r Rth IRA if their mdified adjusted grss incme (MAGI) in 2012 fr a married filer is belw $57,500 ($56,500 in 2011), heads-f-husehld belw $43,125 in 2012 ($42,375 in 2011) and thers (single, married filing separately) belw $28,750 in 2012 ($28,250 in 2011). These amunts are indexed fr inflatin each year. The credit, up t $1,000, is a percentage frm 10-50% f each dllar placed int a qualified retirement plan up t the first $2,000. The lwer the MAGI, the higher the credit percentage; are resulting in the maximum credit f $1,000 (50% f $2,000). Nte: Bth yu and yur spuse may be eligible t receive this credit if yu bth cntributed t a qualified retirement plan and meet the adjusted grss incme limits. The fllwing table details the percentage f Saver's credit based n Adjusted Grss Incme (AGI):
6 2012 Saver's Credit Single Filers AGI Head f Husehld AGI Jint Filers AGI 50% f cntributin $0-$17,250 $0-$25,875 $0-$34,500 20% f cntributin $17,251-$18,750 $25,876-$28,125 $34,501-$37,500 10% f cntributin $18,751-$28,750 $28,126-$43,125 $37,501-$57,500 Credit Nt Available mre than $28,750 mre than $43,125 mre than $57, Saver's Credit Single Filers AGI Head f Husehld AGI Jint Filers AGI 50% f cntributin $0-$17,000 $0-$25,500 $0-$34,000 20% f cntributin $17,001-$18,250 $25,501-$27,375 $34,001-$36,500 10% f cntributin $18,251-$28,250 $27,376-$42,375 $36,501-$56,500 Credit Nt Available mre than $28,250 mre than $42,375 mre than $56, Saver's Credit Single Filers AGI Head f Husehld AGI Jint Filers AGI 50% f cntributin $0-$16,750 $0-$25,125 $0-$33,500 20% f cntributin $16,751-$18,000 $24,751-$27,000 $33,501-$36,000 10% f cntributin $18,001-$27,750 $27,001-$41,625 $36,001-$55,500 Credit Nt Available mre than $27,750 mre than $41,625 mre than $55,500 Nte: The saver's credit is available in additin t any ther tax savings that apply. Further, IRA cntributins can be made until April 15 f the fllwing year and still be cnsidered in the current tax year. Use In Estate Planning Thugh Rth IRAs enjy n estate tax relief, they are already figuring in estate plans. The aim is t build a large Rth IRA fund-largely thrugh cnversin f traditinal IRAs-t pass t beneficiaries in later generatins. The beneficiaries will be tax exempt n withdrawals (f qualified distributins) and the Rth IRA tax shelter cntinues by spreading withdrawal ver their lifetimes. Lng-term planning with Rth IRAs. If yu wuld be allwed a deductin fr a cntributin t a traditinal IRA, cntributing t a Rth IRA means surrendering current tax reductin fr future tax reductin (t zer) fr qualified distributins. This can be presented as an after-tax return-ninvestment calculatin invlving assumed future tax rates. The higher the prjected tax rate at withdrawal, the mre tax Rth IRA saves.
7 Cmparable cnsideratins apply t cnversins t Rth IRAs. Here the taxpayer incurs substantial current tax cst (directly r indirectly reducing the amunt invested) fr future tax relief t the taxpayer r an heir. S the return n investment resulting frm cnversin increases as prjected future rates rise. A key element in making such prjectins is the pssibility that current and future federal deficits will lead t future tax rate increases-a factr which wuld tend t encurage current Rth IRA investment and cnversin. On the ther hand, there's the questin whether Rth IRA benefits currently prmised will survive int future decades. Highly sphisticated planning is required fr Rth IRA cnversins. Cnsultatin with a qualified advisr is a must. Please call us if yu have any questins.