IRAs. You Benefit by Making a Nondeductible IRA Contribution. Questions & Answers

Transcription

1 IRAs You Benefit by Making a Nondeductible IRA Contribution Questions & Answers

2 Purpose The purpose of this brochure is to explain the tax benefits so that you can decide whether it is in your best interest to make nondeductible traditional IRA contributions. Most individuals will benefit by making nondeductible traditional IRA contributions as it allows them to move such funds into a Roth IRA by doing a conversion. Having as much money in a Roth IRA as possible is a great idea as the income earned by such Roth IRA will be taxfree if certain rules are met. Having an account which can earn tax-free income for years is truly amazing. What is a nondeductible traditional IRA contribution? A nondeductible traditional IRA contribution is a contribution for which you receive no deduction on your income tax return. Normally, an individual will make a nondeductible IRA contribution because they are ineligible to make a deductible traditional IRA contribution or a Roth IRA contribution. Why should I make nondeductible traditional IRA contributions now because I have always been told either I was ineligible to make such contributions or it was not a good idea? You will benefit by making these contributions because various laws changed. Your spouse, if applicable, might also benefit by making nondeductible contributions. Am I eligible to make a nondeductible traditional IRA contribution? Most likely you are eligible. Many people mistakenly believe they are ineligible because they have a high income or they participate in a 401(k) plan or they are married and their spouse has a high income or participates in a 401(k) plan. You are eligible to make a nondeductible contribution to a traditional IRA as long as you have earned income, and have not attained age or older in the year for which you are making the contribution(s). High income and high net worth do not disqualify you from making a nondeductible traditional IRA contribution. Earned income is defined as wages, self-employment income, or business income. Even though you may be ineligible to make a deductible traditional IRA contribution or a Roth IRA contribution because your income is too high and/or you are a participant in a 401(k) plan or other retirement plan, you are still eligible to make a nondeductible IRA contribution, up to the applicable limit for the year, according to your age.

3 How much may I contribute to my traditional IRA? If you meet the eligibility requirements described above, you may contribute the following to your traditional IRA. Chart of IRA Contribution Limits Amount If Amount If Not Age 50 Age 50 Tax Year or Over or Over 2015 $5,500 $6, $5,500 $6,500 You may or may not be able to claim a tax deduction for your contribution. The purpose of this brochure is to explain that you will generally be better-off by making nondeductible contributions even if you are unable to claim tax deductions. Why should I consider making a nondeductible traditional IRA contribution? Your main benefit is, you will be able to convert (i.e. move) such funds into a Roth IRA and no taxes are owed with respect to your non-deductible contributions. Any income included in the conversion will need to be included in your income and you will pay tax on such amount. If you make a nondeductible conversion and then immediately convert it, there is no taxable income. May I roll over or convert part or all of my traditional IRA to a Roth IRA? A conversion is accomplished by having funds distributed from a traditional IRA and rolling them over to a Roth IRA within 60 days or by doing a transfer from the traditional IRA to a Roth IRA. This can be done internally at your financial institution, or by transfer of the traditional IRA funds at one institution to a Roth IRA at another institution. The conversion requirements were repealed for 2010 and subsequent years, and any individual, regardless of income or filing status, is now able to convert funds from a traditional IRA to a Roth IRA. Whatever conversion method is used, the custodian/ trustee of the traditional IRA will prepare a Form 1099-R to report the distribution, and the custodian/trustee of the Roth IRA will prepare a 5498 to report the conversion contribution.

4 Why might I want to convert my traditional IRA to a Roth IRA? You may find it advantageous to incur the tax consequences of a present distribution in order to qualify to earn the right to have no taxation when the earnings are ultimately distributed from the Roth IRA. What are the tax consequences of receiving a distribution from a traditional IRA and converting the distribution to a Roth IRA? In general, the amount distributed to you from your traditional IRA will be included in your income in the year of receipt and will be subject to income taxes for that year. The 10% premature distribution excise tax, however, will not be owed even if you are younger than age Will taxes be owing on a conversion of nondeductible traditional IRA contributions? Because no tax deduction is allowed for nondeductible traditional IRA contributions, when such contributions are converted to a Roth IRA, you will only owe tax on the earnings in the traditional IRA. You have already paid taxes on the basis in the account; you will not be taxed when those funds are withdrawn (converted). What is the advantage of a Roth IRA? Earnings with respect to a Roth IRA are never taxed, if the distribution is a qualified distribution. Who is eligible to make a Roth conversion? Individuals, regardless of income or marital status, may convert a traditional IRA to a Roth IRA. Is there a tax benefit for making nondeductible traditional IRA contributions if I currently have a traditional IRA? Yes, the conversion amount attributable to nondeductible contributions is not taxed. However, if you have taxable funds within a traditional IRA then, the situation is more complicated than if you presently did not have a traditional IRA. These tradional IRA funds will be taxable when converted. You will have to decide if you are willing to pay the related taxes. Keep in mind there is no requirement to convert the entire account within one year. You may convert 10% of the account over each of the next

5 10 years or 20% of the account over each of the next 5 years. There is no requirement to have a set schedule for conversions. What conversion tax rules apply when a person has both taxable and non-taxable funds within the traditional/sep/simple IRA? The standard pro-rata IRA distribution rule applies and in many situations an individual will be required to pay substantial taxes on account of his or her conversion. Having to apply the pro-rata IRA distribution rule influences many individuals do not make a conversion. Illustration. Jane has a traditional IRA with IRA custodian #l. The IRA has a balance of $17,000 and all funds are taxable. Jane also has a SEP-IRA with IRA custodian #2. It has a balance of $40,000 and all funds are taxable. Jane has another traditional IRA with IRA custodian #3. It has a balance of $18,000 with $15,000 being non-taxable and $3,000 being taxable. If Jane converts all three IRAs, she will include in her income $60,000 and she is able to exclude her basis of $15,000. If Jane converts the $40,000 in her SEP-IRA, she is required to include in her income $32,000 (80%) and she will exclude $8,000 (20%). If Jane converts the $18,000 in her IRA with IRA custodian #3, she is required to include in her income $14,400 (80%) and she will exclude $3,600 (20%). Is there any tax planning technique which allows Jane to convert the $15,000 of non-taxable funds? Yes. If Jane is a participant of a 401(k) plan or similar employer plan she could rollover the taxable amount of $60,000 she has in her 3 IRAs into the 401(k) plan. This assumes the plan will accept her rollover. Many plans do. In many cases she is the employer and she can have the plan written to permit such a rollover. The law prohibits her from rolling over the $15,000 of non-taxable IRA funds into the 401(k) plan. After rolling over the taxable funds of $60,000, the remaining funds of $15,000 are non-taxable and if converted, she does include any portion in her taxable income. How do I make a nondeductible traditional IRA contribution? You will simply complete the IRA custodian s IRA contribution form and deposit the applicable dollars into the account. This assumes you already have established a traditional IRA. You will not take a tax deduction for this contribution on your tax return for the applicable year. You will want to make certain you have

6 not exceeded the IRA contribution limit for the applicable year. If you do not have a pre-existing traditional IRA plan agreement, you will need to establish one. What records must I keep to prove that I made nondeductible IRA contributions? You will need to keep track of your nondeductible traditional IRA contributions on Form For each year you make such contribution, you must file Form 8606 and include it with your 1040 tax return. Even if you are not required to file a tax return, you must still submit Form 8606 if you made nondeductible IRA contributions, and mail it to the address where you would send a Form 1040, if you were required to file one. Summary Most individuals will conclude making nondeductible traditional IRA contributions is an intelligent thing to do and one for which your children and grandchildren will be grateful for a very long time. Before Roth IRAs existed, there were legitimate reasons why a person would not want to make nondeductible contributions to a traditional IRA. This was so even though the person was eligible to make nondeductible contributions. For many people, the administrative tax work associated with nondeductible IRA contributions did not make them worthwhile. That has now changed since every traditional IRA accountholder will be able to withdraw funds from their traditional IRA and convert them to Roth IRA funds in 2010 and subsequent years since the eligibility rules for a conversion have been repealed. You will want to start making your own nondeductible contributions as soon as possible. The information provided in this brochure is not intended to be legal or tax advice. You should consult your attorney or tax advisor for information that relates to your specific circumstances. IRA #129 (11/15) 2015 Collin W. Fritz and Associates, Ltd.