Michigan Tax Law

Archive for March, 2011

Individual Retirement Accounts have been available since 1974, and have proven useful for people who do not have retirement plans through their employers, or for people who do have other retirement plans but have relatively low income. All taxpayers can contribute an amount equal to their earnings, up to $5,000 ($6,000 if over 50 years of age) to an IRA; if they have no other retirement plan, they can deduct that contribution from their taxable income, and earnings in the account are free of tax until withdrawn.

Persons with income under $120,000 (single) or $176,000 (married) can deduct their contributions to a traditional IRA even if they are covered by another retirement plan. Taxpayers covered by retirement plans whose income is above the limits for deducting contributions have for years been allowed to make their $5,000 or $6,000 contributions to an IRA, but can’t deduct the contributions. The non-deductible contribution comes out tax-free when withdrawn. While the earnings from the IRA are taxed when withdrawn, there would still be the advantage that income earned in the IRA compounds free of tax until withdrawn.

IRAs are generally subject to minimum distribution requirements once the owner reaches age 70-1/2. The minimum distribution requires people to withdraw funds from IRAs, creating a taxable event, making taxpayers pay income tax on the deferred contribution and on the earnings in the account.

Roth IRAs  are a new breed of IRAs that were created in 1997. Roth IRAs have tax advantages for many people. Roth IRAs are created with after-tax funds. There is no deduction in the year contributions are made. When withdrawals are made the withdrawals are totally tax-free—not only the amount contributed, but the income earned in the account as well.

Roth IRAs are a good tool for transferring wealth to the next generation. Since withdrawal from a Roth does not create a taxable event, there is no minimum distribution requirement forcing a taxpayer withdraw his Roth IRA. The taxpayer leave his Roth IRA intact, and withdrawals from the Roth IRA will not be taxable income to whomever would inherit it. Beneficiaries are required to withdraw the Roth over their life expectancies (hopefully a long time), but the funds withdrawn are tax-free.

Congress enacted an income limit for Roth IRAs—you cannot contribute to a Roth IRA if your income exceeds $100,000.

The advantages of Roth IRAs are so great that Congress created a way for taxpayers to convert their traditional IRAs into Roth IRAs, by paying tax on the amount converted in the year of conversion. And the advantages are so great that many taxpayers are willing to pay the tax before they would otherwise be required to, in order to qualify for the Roth rules.

Prior to 2010, only taxpayers with incomes of under $100,000 could convert traditional IRAs into Roth IRAs. Effective in 2010 and thereafter, however, taxpayers making any amount are allowed to convert their traditional IRAs into Roth IRAs.

The ability to convert non-deductible IRAs into Roth IRAs gives higher income taxpayers an unanticipated advantage. Taxpayers can contribute up to the maximum contribution to IRAs ($5,000 if younger than 50, $6,000 if 50 or over) even if they are covered by a retirement plan, regardless of their income level, although they can only deduct the contribution if they are not covered by a retirement plan, or, if they are covered and their income is below the levels of $120,000 or $176,000. By contributing to a non-deductible IRA, and then converting that IRA into a Roth, taxpayers can avoid the income limitation on contributing a Roth.

There are some technicalities with which to comply in completing the two-step transaction of (1) investing in a non-deductible IRA so that (2) you can then convert that IRA into a Roth. The biggest issue to watch for is a complication if you already have other IRAs. For purposes of computing the basis of an IRA withdrawal, all IRAs are treated as a single entity. If you already have a traditional after-tax $20,000 IRA, if you contribute $5,000 to a non-deductible IRA, the rules say that if you then make a withdrawal (to transfer to a Roth or to spend), one-fifth ($5,000/$25,000) of your withdrawal comes from the latest contribution, the balance from the earlier contributions. Failure to anticipate this rule might result in having taxable income of $9,000 when you combine the $5,000 non-deductible IRA contribution with the taxable four-fifths of the $5,000 transfer to the Roth.

If you have no previous IRAs, or if you are willing to convert all of your IRAs into Roths at once, with a little work you can contribute indirectly to a Roth IRA regardless of your income.