Roth IRAs: You Wanted to Know

FEBRUARY 5, 2013

Should you convert to a Roth? How do you convert? Bill Bischoff answers your questions.

 If we had a dollar — make that $10 — for every reader e-mail we’ve received about the Roth IRA, we’d be retired in Hawaii instead of working in an office in New York City. Should I convert? How do I convert? Can I open one? And those are just the simple questions.

So we gave a stack of them to accountant Bill Bischoff, who wore his copy of the tax code raw looking up the detailed replies. But before we get to that, here’s a brief rundown on the Roth IRA.

Roth IRAs are a terrific tax break, especially for individuals previously shut out of the deductible IRA game because their incomes were too high. Here’s why. Unlike traditional IRAs, Roth contributions are nondeductible. But the earnings build up tax-free. And withdrawals are free of federal income tax as long as the account has been open at least five years and you’re age 59 1/2 or older.

For 2013, eligibility for Roth contibutions is phased out between adjusted gross income (AGI) of $178,000 and $188,000 for joint filers and between $112,000 and $127,000 for singles. If you are eligible, you can contribute up to $5,000 annually — $11,000 for married couples. You can contribute $6,500 to a Roth IRA if you are age 50 or older at year-end, or $13,000 for a married couple if both spouses are age 50 or older. You can still contribute to a regular IRA, but your total IRA contributions cannot exceed $5,000 per person (or $6,500 if you are 50 or older).

You can also convert a traditional deductible or nondeductible IRA into a Roth. The conversion is treated as a taxable distribution from the traditional IRA.

If you read this story and still have questions, please see our features “Which IRA Is Best?” and “Roth IRAs: To Convert or Not

Now to your Q’s and our A’s.

Question: When figuring out whether to convert a traditional IRA to a Roth IRA, shouldn’t you consider the fact that the money used to pay the taxes on the conversion could have been invested instead?

Answer: Yes. Our Roth IRA Calculator assumes you invest your tax savings each year and earn the same return on that savings as on your IRA. However, we tax those returns annually as income.

Question: Are contributions to Roth IRAs limited by “earned” income in the same manner that contributions to traditional IRAs are?

Answer: Yes. You must have earned income at least equal to the amount you contribute to Roth accounts for the year. Net income from self-employment counts just the same as wage or salary income. If you file jointly, you and your spouse can each contribute $5,500 for 2013 as long as one spouse (or both) has at least $11,000 of earned income. As explained above, you can contribute another $1,000 if you are age 50 or older as of 12/31/2013.

Question: I’ll turn 70 1/2 this year, but I’m still working. Can I make a Roth IRA contribution for this year?

Answer: Yes. Even though you can’t make a traditional IRA contribution, you can open a Roth as long as you have earned income and your AGI is under the threshold. But your Roth account must be open at least five years before you can take out tax-free withdrawals. So you must be in good health for this strategy to make sense. One other note: After five years, your beneficiaries will not be taxed on the assets in your Roth IRA as they would be on assets in your traditional IRA.

Question: Our joint income was less than $100,000 for last year, but will be more than $100,000 for this year. Can I convert my existing IRA to a Roth this year?

Answer: Yes! Before 2011, conversions were limited to singles and couples with AGI of $100,000 or less in the year of conversion. That restriction is now gone.

Question: I’m 47. My wife is 53. We have a sizable amount saved for retirement in a traditional IRA. Due to a home-based business and deductions, our tax bracket is 15%. We expect our income and tax bracket to increase after retirement. Would it make sense to convert to a Roth? To contribute to a new Roth? Or to keep contributing to a traditional IRA?

Answer: In your circumstances, it’s smarter to start contributing to Roth accounts rather than continuing to make contributions to traditional deductible IRAs. Here’s why: At retirement, you can pull money out of Roth accounts tax-free. For you, this is more valuable than a current tax deduction, because you expect your postretirement tax rates to be above what you pay now.

As for converting existing traditional IRAs into Roth accounts, it makes sense in your case, if you believe your IRA investments will continue to generate healthy returns until retirement. However, you say you have a sizable amount in IRAs, which means a sizable tax. You can’t pay the tax from your IRA funds without paying a 10% penalty. And, if you have to borrow to pay the tax, the interest amounts to a penalty as well. So think hard before choosing to convert, and consider consulting a tax pro before pulling the trigger.

Question: My wife does not work outside the home. With a traditional IRA she was eligible for the “spousal IRA.” Can she open a Roth IRA as her spousal IRA, effectively allowing me to put away $11,000 of my 2013 income, with half of that in her name?

Answer: Yes. As long as one spouse (or both) has at least $11,000 of earned income, and your joint AGI is under $169,000, both spouses can contribute $5,500 ($11,000 total) to their respective Roth IRAs. Each spouse can contribute an additional $1,000 if he or she is age 50 or older by the end of 2013.

Question: I plan on converting my current nondeductible IRA to a Roth. When I do this, am I responsible for taxes on the capital gains on the date of the conversion? Will mutual funds provide me with the cost-basis information I need?

Answer: You don’t need to worry about capital gains and cost basis. If you convert your nondeductible IRA, you will simply pay income tax at your regular rate (which could be as high as 39.6%) on the difference between the account’s value on the conversion date and the total amount of your nondeductible contributions.

Question: For 2013, can I contribute $4,000 (a $2,000 contribution for each of my two children) to Coverdell Education Savings Accounts (CESAs) and still contribute a total of $11,000 to Roth IRAs for me and my spouse?

Answer: Yes, you can open both the CESAs and Roth IRAs as long as your AGI doesn’t exceed $178,000 for joint filers. That gives you $14,500 in tax-advantaged savings ($4,000 in CESAs plus $11,000 in Roth IRAs).

Question: I have self-employment income, and typically contribute to a SEP-IRA each year. Are Roth IRAs available for SEPs?

Answer: Not exactly, but here’s the deal. As long as your AGI is under the threshold, you can make annual Roth IRA contributions whether or not you are also covered by a tax-deferred retirement plan through self-employment (a SEP or Keogh plan) or at work (by a 401(k) plan, for example). Ditto if your spouse is covered. The only limitations on Roth contributions are the AGI rule and the requirement to have earned income (from self-employment or salary) at least equal to your contribution. In other words, most self-employed people will be able to make annual contributions to both SEP or Keogh retirement plans and Roth IRAs. So think of Roth IRAs as a nice tax-favored supplement to any retirement arrangements you already have.

Question: Can I contribute to a Roth IRA if I am in a 401(k) plan at work?

Answer: Yes, as long as you are unaffected by the Roth contribution phaseout rules. They start at adjusted gross incomes of $112,000 for singles and $178,000 for married couples.

Question: I am very interested in a Roth IRA. I currently have stock in my traditional IRA. In order for me to convert this to a Roth IRA, do I need to liquidate the stocks or can I just pay the tax on earnings and bring the shares over to the Roth IRA?

Answer: Here’s what the very nice folks at Schwab said about your question. If you stay with your current IRA trustee, you should be able to convert the existing IRA into a Roth account by simply filling out a form. With such an “in-house” conversion, there should be no need to liquidate your account’s stock holdings. If you intend to switch trustees in the process (for example, by taking your existing bank regular IRA and converting it into a Schwab Roth IRA), you’ll have to make a “trustee-to-trustee transfer” of your regular IRA assets. This step is tax-free, and it keeps your stock holdings intact. Then you should be able to make an “in-house” conversion to Roth status with the new trustee (this second step is, of course, taxable).

Question: I’m a bit confused by the timing for Roth IRA contributions. What are the rules?

Answer: You can make a contribution for the 2013 tax year as early as Jan. 1, 2013 and as late as April 15, 2014. (The same rules apply to traditional IRAs.) However, it’s best if you make Roth IRA contributions as early in the year as possible. That way, you can start taking advantage of tax-free growth sooner rather than later.

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