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The last great, completely legal tax shelters

By Hal Rogers    

In bad economic times, good retirement planning is more important than ever. For personal accounts, one of the besttax shelter opportunities still available comes from Individual Retirement Accounts, more commonly known as IRAs. 

Provisions for IRAs are found in the U.S. Tax Code Section 408(a).  Traditional IRAs were introduced into law in 1974 with the Employee Retirement Income Security Act (ERISA).  Originally limited to people who were not participants in employer-sponsored plans, they became available to all taxpayers in 1981 with the passage of the Economic Recovery Tax Act.  The Taxpayer Relief Act brought us Roth IRAs in 1997. 

Between traditional IRAs and Roth IRAs, the traditional IRA, referred to simply as an IRA, is the more popular. However the Roth IRA is generally considered to be the more advantageous of the two. Subject to income limitations, the traditional IRA allows an account owner to take an income tax deduction for the amount of the contribution in the year of the contribution, and then earnings accumulate tax deferred.  All distributions from the account are fully taxable at the account owner’s ordinary income tax bracket. 

The Roth IRA doesn’t have income limitations on tax deductibility; Roth IRA contributions are not tax deductible.  However, in addition to tax deferral during the life of the account, for account owners who are at least 59½ and have held the account for at least five years, Roth IRAs provide completely tax-free income.

So, which is best, an income tax deduction on the contribution, or tax-free income from the entire account?  This is not difficult to determine if you ask the question a different way: “Would you rather pay taxes on the seed or on the harvest?”  The Roth IRA makes you pay taxes on the seed, but the harvest is income tax-free.

Beginning in January 2010, anyone who earns income can contribute to a Roth IRA.  Contribution limits are the lesser of: 

• Your earned income for the year, or

• $5,000 if you are under age 50, or

• $6,000 if you are age 50 or older.

What’s more important for most individuals, however, is the opportunity to convert a traditional IRA to a Roth IRA.  The advantage of the Roth IRA is that at distribution time it allows tax-free distributions for the life of the account owner, the owner’s beneficiary spouse, and even beneficiary children, grandchildren, and other heirs. 

So where’s the rub?  Funds transferred to a Roth IRA are taxable in the year of the transfer—except for funds transferred in 2010. IRS has taxes “on sale” in 2010 for taxpayers who convert to a Roth IRA.  For this year only, there are no taxes on Roth Conversions.  Instead, half the taxes on the distribution are due for the 2011 tax year (paid in 2012) and half are due for the 2012 tax year (paid in 2013). 

So, what happens if you execute a Roth conversion, and the market subsequently plummets? You have now paid taxes on account values that no longer exist.  Not to worry.  Imagine that you are in a game of Texas Hold ’em.  You have been dealt a hand that looks pretty good, and you place your bet.  But, after seeing two more cards, you discover that your hand hasn’t worked out to your liking at all.  How would you like to be able to not only fold your hand, but get your bet back?

This is exactly what the IRS allows you to do.  It is called a Roth re-characterization.  If you act within a prescribed period of time from the time you executed the conversion, you simply return the money from the Roth conversion back to a traditional IRA and file an amended tax return. The IRS will give you your taxes back.  By the way, after a prescribed period of time, the IRS then allows you to start over and do the Roth conversion again, this time at the lower account values, thus permanently reducing your taxes on the transaction.  My kind of poker!

Timing is important in these transactions; check with a financial or tax advisor who is “in the know” for details to make sure you don’t run afoul of the rules. 

Hal rogersHarold J. Rogers, CFP, CSA, president of Retirement Services, is a registered representative with ProEquities, Inc.  Securities offered through ProEquities, Inc., a Registered Broker/Dealer, Member FINRA & SIPC.  Information is for informational purposes and should not be construed to be specific tax, legal, or investment advice. 


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