From Ed Slott and Company: Several Good Points on IRA's

Thursday, January 14, 2010

Slott Report Mailbag: January 14th

It is time for another edition of The Slott Report Mailbag with three consumer questions and answers from our IRA Technical Consultants.

1.

Thanks for your very informative website, which was recommended by The Wall Street Journal. Just to be sure, I have two questions: My wife and I are both age 72 and in very good health. I manage her traditional IRA through TD-AMERITRADE and have quite well in the past (easily beat the S&P) but don't do anything unsound, safety first by all means.

I do so by virtue of well accepted and proven "swing" trading methods spelled out in various Dr. Alexander Elder Publications, you may have heard of him. This helps me to remain active (still up at 5 am - old habits die heard), while making gains in finances if she survives me. At this time we are considering converting her traditional IRA account entirely to a Roth. We have solid, six-figure retirement income from a source separate from my wife's IRA. So, we don't anticipate needing the money from her Roth IRA anytime soon and the Roth tax advantage is very attractive to us. But one can never be sure of the future, though so we have two questions as indicated.

1. I am well aware of the 5-year rule for Roth withdrawals, but I have gotten the opinion elsewhere that the original conversion funds (what I call seed money), can be withdrawn once taxes have been paid, at least for someone aged 70 or older. Meaning that the 5-year rule only applies to earning after conversion. Am I correct in this thinking?

2. What are the rules for withdrawals of all money in a Roth, including earnings; for example, say 5 years from now she had some kind of catastrophic and debilitating illness? We use her money as a sort of life insurance/long-term-health care combo account. Thanks for your time and expertise.

Answer:

Congratulations on doing a good investment job on your IRAs. The fact that you don't think you will need the funds from your IRAs to live on is an excellent reason to consider converting to a Roth IRA. There are no required minimum distributions during the Roth owner's lifetime.

Here are the rules concerning distributions and the five-year rule for Roth IRAs:

You can always take a distribution of basis from the Roth IRA. Basis is annual contributions and converted amounts. Those distributions will not be income taxed when they are withdrawn as they were subject to income tax when they went into the Roth IRA (or they were after-tax amounts).

There are what is called ordering rules for Roth IRA distributions. Contribution amounts come out first, converted amounts come out next (first in, first out) and earnings come out last.

Distributions must be qualified distributions to be free of all takes and penalties. To be considered a qualified distribution, you must have had a Roth IRA for five years AND you must be at least 59 1/2, or the distribution is due to death, or the distribution is due to the disability of the account owner, or the distribution qualifies for the first time home buyer exemption.

The five years start with the establishment of your first Roth IRA and covers all future Roth IRAs you may establish. In other words, it only runs once. If a distribution is qualified (see above), all funds come out of the Roth IRA income tax and penalty free. If the distribution is not qualified, a distribution of earnings (see ordering rules above) will be subjected to income tax and the early distribution penalty, if applicable.

2.

Can a 50-year-old who has been in a 72(t) for 18 months do a partial conversion to a Roth? Could the above person return all funds to the IRA and "erase" the effects of the 72(t)? Then do a conversion?

Thank you!

Answer:
If you are taking payments under the 72(t) exemption you can convert all of your traditional IRA to a Roth IRA. There is no consensus of opinion as to whether you can do a partial conversion. You will, however, have to continue to take the full 72(t) payments on the account after the conversion. You can not erase the effects of the 72(t) payments when you do a conversion to a Roth IRA. Any 72(t) payments from the Roth will be income tax free because you would have paid the income tax due when you converted.

3.

Ed and Company --

I have several of your books. Can you explain the rules or choices on when income taxes are due when converting IRA(s) to Roth IRA(s) in 2010 both a)if you choose to defer to 2011 and 2012 and b)if you decide to pay in 2010?

If you are not required to make quarterly payments, are the payments only 90% required by January 15th and the remainder (<10%) style="font-weight: bold;">

Answer:
For Roth IRA conversions in 2010, the income tax on the conversion can be paid in 2010 (your 2010 income tax return) or you could chose not to pay the income tax in 2010 and pay it in 2011 and 2012. For example, if you converted $100,000 to a Roth IRA in 2010 and decide to pay the income tax due in 2011 and 2012 you would add $50,000 to your 2011 income and $50,000 to your 2012 income to compute the income tax due. The deferral to 2011 and 2012 is only for Roth conversions completed in 2010.

Regarding the payment of estimated income tax, which may or may not be due, you should consult a tax advisor.


By IRA Technical Consultant Marvin Rotenberg and Jared Trexler