Beware of the Pro Rata Rule for Roth Conversions

Posted on by in 401(k), Educational Resources, IRAs, IRS, Roth 401(k), Roth IRA, Roth IRA Conversions, Traditional IRA and tagged , , , , , , , .

What is the Pro Rata rule for Roth conversions?

The Pro Rata rule for Roth conversions states that if you have any other deductible IRAs (i.e. a previous 401k that you’ve rolled over), the conversion of any contributions becomes a taxable event that you’ll need to pay taxes on upfront.

The Pro Rata rule for Roth conversions determines whether or not your conversion will be taxable! For taxation purposes, the IRS will look at your entire IRA holdings (even if they are in different accounts), not just the traditional IRA you are converting to a Roth IRA, and will determine what your tax bill will be based upon a ratio of IRA assets that have already been taxed to those IRA assets in total.

The IRS determines the tax on this conversion based on the value of all of your IRA assets. For example Jane, a high income earner, already has $94,500 in an IRA account, all of which has never been taxed.  She decides on January 2nd to put $5,500 into a new traditional IRA. The next day she converts the new traditional non-deductible IRA to a Roth IRA.  Jane’s income is too high for her to make a direct contribution into a Roth IRA, but there’s no income limit on conversions.  Unlike Bill she has $94,500 in other IRAs (previously non-taxed), so her total IRA assets are now $100,000. When she converts $5,500 to a Roth IRA, the IRS pro-rates her tax basis on the previous taxation of her total IRA assets, therefore making this conversion 94.5% taxable ($94,500/100,000 = 94.5%).

So if you plan on using this backdoor IRA strategy, you want to be clear as to whether or not you have any other IRAs. As you can see, this can be a confusing area and this is where we can help.  If you are a high income earner we would be happy to review your situation to determine if this strategy is in your best interest.

Also, please remember that your spouse’s IRA is separate from yours.

Stay tuned for my next blog post, Benefits of a Roth IRA!

Want to learn more? Give us a call at 412-521-2732.

– James Lange

Example of a Backdoor Roth IRA

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As promised from our last blog post, here is an example of a Backdoor Roth IRA

Bill, a high income earner decides on January 2nd to put $5,500 into a traditional IRA for himself and another $5,500 into a traditional IRA for his wife Mary.  Bill’s income is too high to be able to deduct these contributions from his taxes.

So the next day, he converts the traditional IRAs to Roth IRAs completely tax-free.  His income is too high for him to make a direct contribution into a Roth IRA, but there’s no income limit on conversions!

Since Bill and Mary couldn’t deduct the contribution anyway, they might as well get the advantage of never paying taxes on that money again available through the Roth IRA.

Stay tuned for my next blog post, Beware of the Pro Rata Rule for Roth Conversions!

Want to learn more? Give us a call at 412-521-2732.

– James Lange

 

Backdoor Roth IRAs: How Does the Backdoor Roth IRA Conversion Work?

Posted on by in 401(k), 403(b), Educational Resources, IRAs, Roth 401(k), Roth IRA, Roth IRA Conversions, Traditional IRA and tagged , , , , , .

The backdoor Roth conversion consists of two simple steps:

1)      You make a nondeductible contribution to your traditional IRA.

2)      Within a couple of days you convert this IRA into a Roth IRA (potentially paying little to no taxes on the conversion).

There’s one big caveat: This strategy works best tax-wise for people who don’t already have money in traditional IRAs. That’s because in conversions, earnings and previously untaxed contributions in traditional IRAs are taxed—and that tax is figured based on all your traditional IRAs, even ones you aren’t converting.

For an investor who doesn’t already hold any traditional IRAs, creating one and then quickly converting it into a Roth IRA will incur little or no tax, because after a short holding period there’s likely to be little or no appreciation or interest earned in the account.  However, if you already have money in traditional deductible IRAs, you could face a far higher tax bill on the conversion.

If you choose to, you can contribute to a non-deductible IRA for 2014 (the maximum is $5,500 or $6,500 for those age 50 or older). Remember, you must contribute to your IRAs prior to the April 15 2015 tax deadline. This non-deductible IRA can then be used for your backdoor Roth IRA conversion (please call us prior to doing so because the rules for Roth conversions can be complicated).

Want to learn more? Give us a call at 412-521-2732.

Examples of a Backdoor Roth IRA coming soon.

– James Lange

(7/16/2014) Tonight’s Radio Show: The View of Pittsburgh from the Mayor’s Office

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The View of Pittsburgh from the Mayor’s Office

Join us tonight at 7:05 pm on KQV 1410 AM. Program also streams live at www.kqv.com. Encore presentations air EVERY SUNDAY at 9:05 am.

Tune in KQV 1410 AM tonight at 7:05 p.m. as The Lange Money Hour welcomes a very special guest, Pittsburgh Mayor Bill Peduto.

After serving three terms on City Council representing the East End, he was elected Pittsburgh’s 60th mayor last November capturing 84 percent of the vote. Inaugurated on January 6th, he has just completed his first six months in office.

A self-described progressive Democrat, Mayor Peduto has been a consistent voice for fiscal discipline in Pittsburgh. As a councilman, he was the only city politician to call for Act 47 state protection; a controversial step in addressing decades of financial mismanagement that left Pittsburgh with the highest debt ratio and the lowest pension funding in the nation. Despite some improvement in the fiscal situation, he feels the city needs to remain under financial oversight to take care of its long-term problems such as pensions, debt, and need for capital improvements. After only six months in office, Mayor Peduto has already taken active positions on a broad range of issues from same-sex marriage, achieving sustainable revenue by establishing relationships with major non-profits, and technology and efficiency, to dedicated bike lanes and supporting ride-sharing services like Lyft and Uber.

These are just a few of the subjects on tonight’s agenda, and listeners, since our show will be live, you can join the conversation by calling KQV at 412-333-9385 after 7:05 p.m. You can also email questions in advance of the show by clicking here.

If you can’t tune in tonight, KQV will rebroadcast the show this Sunday, July 20th at 9:05 a.m. The audio will also be archived on our web site at www.paytaxeslater.com/radioshow.php, along with a written transcript.

Finally, please join us on Wednesday, August 6th at 7:05 p.m., when we’ll welcome another financial industry giant, Dr. Roger Ibbotson, to the next edition of The Lange Money Hour.

www.paytaxeslater.com 800 387-1129 or 412 521-2732 admin@paytaxeslater.com

Backdoor Roth IRAs: A Potential Way for High Income Earners to Participate

Posted on by in 401(k), 403(b), Educational Resources, IRAs, Roth 401(k), Roth IRA, Roth IRA Conversions, Traditional IRA and tagged , , , , .

The traditional contribution (“front door”) for Roth IRAs is currently not available for higher income earners. Married couples earning $191,000 or more and singles earning $129,000 or more in 2014 are still barred from contributing directly to Roth IRAs.

In 2010, Congress changed the rules and since then anyone can convert a traditional IRA to a Roth IRA. However, higher income earners are still ineligible to contribute to a Roth IRA.

A Backdoor Roth IRA is a strategy for some higher income earners to participate in Roth IRAs.  It is a way for higher income earners to put money into a traditional IRA and then roll that into a Roth IRA, getting all the benefits.  While this strategy sounds simple, there are several rules that you must know and follow to make sure you do not incur unintended tax consequences.  This is where working with a knowledgeable financial or tax professional can provide some great guidance and value.

One of the primary benefits of a Roth IRA is that any money contributed grows tax-free and is withdrawn without any further income taxation. In addition, unlike a traditional IRA, Roth IRAs have no required lifetime minimum distributions. Another benefit of a Roth IRA is it can be passed on to your heirs income tax free. This allows your funds to grow and compound tax free over many years.

Want to learn more? Give us a call at 412-521-2732.

More on this subject in the coming weeks.

– James Lange