FROM WEBCPA.COM -
The Internal Revenue Service has increased its forecasts for the number of information-reporting forms it expects to receive this year and in subsequent years as a result of increased reporting requirements.
In a 2010 report, the IRS predicted that it would receive 2.175 billion information and withholding documents from U.S. businesses and individuals in 2012. But in a recently released update to that report, the IRS is now forecasting that it will receive 2.855 billion information reports in 2012, a readjustment of nearly 700 million forms, effectively a 31 percent increase. In its updated projections, the IRS is taking into account new 1099-K reporting requirements for merchants handling credit card transactions, and 1099-B requirements for buyers and sellers of shares who are now required to report information on the cost basis of the stock.
“Companies have had this 1099 reporting responsibility for 25-plus years now,” said Troy Thibodeau, executive vice president at Convey, a developer of software for automating 1099 reporting. “But the last two to three years has seen a significant increase in the amount of third-party reporting that’s taking place.”
For example, companies that process credit card payments on behalf of merchants and businesses are now required to file a 1099-K for all of their credit card proceeds as a result of the Housing Assistance Tax Act of 2008 (see IRS Postpones Credit Card Withholding Requirements).
“The IRS says that reporting alone is going to yield another 50-plus million forms that are going to need to be filed each year,” said Thibodeau.
In addition, the cost basis reporting rules in the Emergency Economic Stabilization Act of 2008 are going to lead to increased 1099-B information reporting (see Cost-Basis Reporting Changes Portend ‘Messy” Tax Season Ahead).
“This year, when you receive your 1099s as a taxpayer, if you sold or traded on stocks, you’re going to get a new 1099-B, which is going to indicate the cost of that stock on the form,” said Thibodeau. “In the past, if you sold stock, you would get a 1099 that said how much in proceeds you received from the sale of that stock, but now whoever sold the stock on your behalf is also going to have to tell you what your cost basis in that stock was. It’s the IRS’s way of determining the gains or losses you received by the sale of that stock. That legislation is going to yield up a lot more 1099 reporting because there’s a bunch of nuanced rules around that saying that if you had made, say, three purchases to accumulate all the stock that you sold, there’s a different cost basis you probably have in each of those purchases, and they have to issue you a 1099-B for every one of those purchases that you then sold. So there’s significantly more 1099-B volume reflected in those projections.”
The increased information reporting requirements are intended to help the IRS reduce its recently expanded estimates for the tax gap between money owed to the IRS and money collected (see Tax Gap Widens to $450 Billion). “The Service has declared that one of the best ways for them to continue to chip away at this tax gap of money owed is through third-party reporting,” said Thibodeau. “If they receive third-party reports of income, then the likelihood that taxpayers are going to report properly goes up significantly and compliance goes up. There’s a lot of additional third-party reporting that the Service and Congress has been looking for, and that will continue to be the case as we move forward.”
Thibodeau thinks that will be the case even though Congress repealed the expanded 1099 information reporting of business-to-business transactions in the Patient Protection and Affordable Care Act of 2010 and the Small Business Jobs Act of 2010 (see Congress Votes to Repeal 1099 Requirements). Despite the outcry over the expanded 1099 reporting requirements in the health care reform law especially, he has seen lawmakers proposing bills with tough new 1099 requirements.
“There’s been other third-party reporting legislation introduced this year,” he said. “For example, today if you receive interest on some savings account, you may only need to receive a 1099 if you have at least $10 or more of interest. Congress is actually looking to waive that, to say that for any interest you may get, even if it’s only a penny, you need to receive a 1099 for that. And part of the reason for that is because they believe there’s underreported interest income that they want to make sure is being collected. The stuff that was in the health care bill that was repealed was likely repealed because it was pretty aggressive in the amount of additional reporting that was going to be required, but what we’re hearing is that there is a likelihood that that additional reporting in some way, shape or form is probably going to be revisited and re-proposed by Congress.”
The 1099 reporting requirements in the health care reform law provoked a backlash because the increased volume was seen as too burdensome, especially for small businesses.
“The health care legislation required that the additional reporting be for any payment that you make, even to a corporation, which in the past had been exempt from any reporting, as well as on all goods, and I think that both of those pieces added up to a lot of additional 1099 reporting,” said Thibodeau. “I think we’ll see something come back that maybe isn’t both goods and corporations reporting, but maybe some subset of that. Or there will be some thresholds created that don’t make that quite as burdensome on American business.”
Tuesday, January 31, 2012
Monday, January 30, 2012
Tackling Those Confusing 1099 And W-2 Changes.
FROM FORBES.COM-
It’s that time of year when envelopes marked “Important Tax Return Document Enclosed” come in the mail, mixed in with the credit card come-ons. Open and scrutinize these W-2s, 1099s and K-1s right away. If they report more income than your records show, try to get corrected forms issued now to avoid a battle with the Internal Revenue Service’s document-matching computers later. Read the pointers below to avoid tripping over changes to the forms.
The 1099-B makeover
Both tax pros and financial service firms expect the new 1099-B, Proceeds From Broker and Barter Exchange Transactions, to cause mass confusion. The 2011 version, in addition to the old boxes for the date and proceeds from a securities sale, has new boxes for the date you bought a stock; your cost or basis (including adjustments for commissions and splits); whether your gain or loss was short or long term; and even if the transaction was a wash sale (one where you can’t claim a loss because you bought back the shares too soon). If your broker sends a 1099 composite report instead of a 1099-B, the composite must also have the new info.
Don’t be surprised, however, if some new 1099-B boxes are blank. That’s because the extra reporting is only required for stock bought on or after Jan. 1, 2011; mutual funds bought on or after Jan. 1, 2012; and bonds, options and private placements bought on or after Jan. 1, 2013. When reporting isn’t required, your broker should check “noncovered security” in Box 6. Note that an outfit like Charles Schwab, if it knows your basis on a “noncovered security” sale, will calculate your gain for you on the composite—but won’t send it to the IRS.
All this new info is supposed to help the IRS detect underreporting of gains while cutting paperwork for taxpayers. Right. Truth is, it’s now more important than ever to keep good records to make sure what your broker tells the IRS is correct. Retain monthly statements, year-end reports and trade confirmations, and annotate them as appropriate. Warning: If you sell only some of your holdings in a covered stock, the broker must calculate your gains using the first-in, first-out method—unless you designate another method before a sale settles. (For advice on how to find your basis on old securities, see p. 55.)
Tattletale 1099-Ks
If you run a business or sell something on the side and accept credit card payments or payments through a third-party network like eBay’s PayPal, watch out for the new form 1099-K, Merchant Card and Third-Party Network Payments. This form, too, is designed to help the IRS flag juicy audit targets. Unfortunately the 1099-K reports the gross amount paid to you, with no adjustments for fees or charge-backs, so it may not match up with the (possibly smaller) amount you report on your income tax return from such transactions. Give your tax pro records of fees and charge-backs to explain any disparity—annotated statements from the credit card company should do.
W-2 insurance scare
Employers with more than 250 workers must begin reporting on 2012 W-2s the value of health care benefits paid on an employee’s behalf. But some are already doing it on 2011 W-2s now in the mail. The amount appears in Box 12, using code DD. If there’s a big number there, don’t panic—it doesn’t affect your taxable income. The reporting is for the new “individual mandate” in Obama’s health plan. If that mandate isn’t repealed or found unconstitutional, a penalty tax on folks who don’t get insurance will be phased in, starting in 2014.
It’s that time of year when envelopes marked “Important Tax Return Document Enclosed” come in the mail, mixed in with the credit card come-ons. Open and scrutinize these W-2s, 1099s and K-1s right away. If they report more income than your records show, try to get corrected forms issued now to avoid a battle with the Internal Revenue Service’s document-matching computers later. Read the pointers below to avoid tripping over changes to the forms.
The 1099-B makeover
Both tax pros and financial service firms expect the new 1099-B, Proceeds From Broker and Barter Exchange Transactions, to cause mass confusion. The 2011 version, in addition to the old boxes for the date and proceeds from a securities sale, has new boxes for the date you bought a stock; your cost or basis (including adjustments for commissions and splits); whether your gain or loss was short or long term; and even if the transaction was a wash sale (one where you can’t claim a loss because you bought back the shares too soon). If your broker sends a 1099 composite report instead of a 1099-B, the composite must also have the new info.
Don’t be surprised, however, if some new 1099-B boxes are blank. That’s because the extra reporting is only required for stock bought on or after Jan. 1, 2011; mutual funds bought on or after Jan. 1, 2012; and bonds, options and private placements bought on or after Jan. 1, 2013. When reporting isn’t required, your broker should check “noncovered security” in Box 6. Note that an outfit like Charles Schwab, if it knows your basis on a “noncovered security” sale, will calculate your gain for you on the composite—but won’t send it to the IRS.
All this new info is supposed to help the IRS detect underreporting of gains while cutting paperwork for taxpayers. Right. Truth is, it’s now more important than ever to keep good records to make sure what your broker tells the IRS is correct. Retain monthly statements, year-end reports and trade confirmations, and annotate them as appropriate. Warning: If you sell only some of your holdings in a covered stock, the broker must calculate your gains using the first-in, first-out method—unless you designate another method before a sale settles. (For advice on how to find your basis on old securities, see p. 55.)
Tattletale 1099-Ks
If you run a business or sell something on the side and accept credit card payments or payments through a third-party network like eBay’s PayPal, watch out for the new form 1099-K, Merchant Card and Third-Party Network Payments. This form, too, is designed to help the IRS flag juicy audit targets. Unfortunately the 1099-K reports the gross amount paid to you, with no adjustments for fees or charge-backs, so it may not match up with the (possibly smaller) amount you report on your income tax return from such transactions. Give your tax pro records of fees and charge-backs to explain any disparity—annotated statements from the credit card company should do.
W-2 insurance scare
Employers with more than 250 workers must begin reporting on 2012 W-2s the value of health care benefits paid on an employee’s behalf. But some are already doing it on 2011 W-2s now in the mail. The amount appears in Box 12, using code DD. If there’s a big number there, don’t panic—it doesn’t affect your taxable income. The reporting is for the new “individual mandate” in Obama’s health plan. If that mandate isn’t repealed or found unconstitutional, a penalty tax on folks who don’t get insurance will be phased in, starting in 2014.
Saturday, January 28, 2012
Tax return scheme delays early filers' IRS refunds.
From the Detroit Free Press -
Bad news is hitting consumers who filed 1040 federal income tax returns early. They're going to wait possibly a week or so longer than expected to get refunds as the Internal Revenue Service attempts a tougher crackdown on criminals who file fake returns to snag illegal refunds early in the season.
We got news of one such case involving a group out of Detroit this week.
John Hewitt, CEO and founder of Liberty Tax Service, based in Virginia Beach, Va., said taxpayers who filed returns any time from the first day of the tax season, Jan. 17, through Jan. 24 are facing potential delays.
"Usually, the refunds take a week to 10 days," said Hewitt, adding that refunds are likely to take up to 14 days.
Taxpayers didn't expect these delays and are upset. Many intentionally file early in the season because they need that tax refund to pay bills. Families could experience more hardship than others even with only an extra few days of delay, he said.
Though IRS officials would not say it directly, the crackdown delaying some refunds could involve a case from Detroit, where a suspected criminal ring was disrupted by federal officials.
Federal officials say that a group of metro Detroit tax preparers submitted at least 352 fake tax returns using names and Social Security numbers of the dead in an attempt to obtain more than $800,000 in refunds, according to court documents.
Two area tax preparers were arrested Friday for conspiracy to defraud the government by filing false tax returns and obtaining refunds, using the names and information of recently deceased individuals, according to U.S. Attorney Barbara L. McQuade.
According to court documents, the tax returns filed in the scheme reported false household employee income and used various credits, including the Earned Income Tax Credit and education credits, to create fake returns to generate refunds.
The best advice taxpayers are getting when it comes to preventing tax-time cybercrime is to file tax returns early. But the crooks know this, too, so maybe they're filing even earlier, too?
"It's definitely in favor of the identity thief right now," said Tami Nealy, a spokeswoman for LifeLock in Tempe, Ariz.
She noted that the IRS system has a first-come, first-served process that can give ID thieves an advantage during tax season. Say someone stole your Social Security number and name, and then filed a fake return for a refund using your ID.
If you file your real return a month or so later, again using your ID, your return is rejected if the thief filed first and was successful. And then, the headaches start.
Nina E. Olson, the national taxpayer advocate, stated in the advocates' annual report to Congress that the "IRS's approach to identity theft is still not working as intended."
The report noted that the centralized Identity Protection Specialized Unit -- the IRS department that deals specifically with ID theft -- received more than 226,000 cases in the 2011 fiscal year -- a 20% increase from fiscal year 2010.
And the Taxpayer Advocate Service experienced a 97% increase in stolen identity cases in 2011 -- on top of a 23% increase in 2010.
H&R Block told clients that the IRS is using a new technology this year that has caused the agency to take more time to validate returns at the beginning of the season.
If you're looking at a delay, tax preparers want you to know that it's not them -- it's the IRS.
Hewitt said he understands that the refunds are expected to be back to a more normal pattern for taxpayers who file returns now or later.
At the opening of the 2012 filing season, the IRS advised taxpayers who electronically file and select direct deposit that they could see their refunds in as few as 10 days and 90% of refunds are provided within 21 days.
Some taxpayers are getting refunds much faster, the IRS said, but at this time, taxpayers should expect refunds to be issued as indicated in the original IRS guidelines.
Taxpayers can go to http://www.irs.gov/ to see "Where's My Refund?"
The IRS said it apologizes for any inconvenience caused by the revised refund dates.
Bad news is hitting consumers who filed 1040 federal income tax returns early. They're going to wait possibly a week or so longer than expected to get refunds as the Internal Revenue Service attempts a tougher crackdown on criminals who file fake returns to snag illegal refunds early in the season.
We got news of one such case involving a group out of Detroit this week.
John Hewitt, CEO and founder of Liberty Tax Service, based in Virginia Beach, Va., said taxpayers who filed returns any time from the first day of the tax season, Jan. 17, through Jan. 24 are facing potential delays.
"Usually, the refunds take a week to 10 days," said Hewitt, adding that refunds are likely to take up to 14 days.
Taxpayers didn't expect these delays and are upset. Many intentionally file early in the season because they need that tax refund to pay bills. Families could experience more hardship than others even with only an extra few days of delay, he said.
Though IRS officials would not say it directly, the crackdown delaying some refunds could involve a case from Detroit, where a suspected criminal ring was disrupted by federal officials.
Federal officials say that a group of metro Detroit tax preparers submitted at least 352 fake tax returns using names and Social Security numbers of the dead in an attempt to obtain more than $800,000 in refunds, according to court documents.
Two area tax preparers were arrested Friday for conspiracy to defraud the government by filing false tax returns and obtaining refunds, using the names and information of recently deceased individuals, according to U.S. Attorney Barbara L. McQuade.
According to court documents, the tax returns filed in the scheme reported false household employee income and used various credits, including the Earned Income Tax Credit and education credits, to create fake returns to generate refunds.
ID thieves file early
The IRS said, generally, that the delays are related to growing concerns about cyber-fraud and crooks who obtain refunds by stealing Social Security numbers, creating fake returns, filing 1040s electronically early in the season and obtaining tax refunds.The best advice taxpayers are getting when it comes to preventing tax-time cybercrime is to file tax returns early. But the crooks know this, too, so maybe they're filing even earlier, too?
"It's definitely in favor of the identity thief right now," said Tami Nealy, a spokeswoman for LifeLock in Tempe, Ariz.
She noted that the IRS system has a first-come, first-served process that can give ID thieves an advantage during tax season. Say someone stole your Social Security number and name, and then filed a fake return for a refund using your ID.
If you file your real return a month or so later, again using your ID, your return is rejected if the thief filed first and was successful. And then, the headaches start.
Nina E. Olson, the national taxpayer advocate, stated in the advocates' annual report to Congress that the "IRS's approach to identity theft is still not working as intended."
The report noted that the centralized Identity Protection Specialized Unit -- the IRS department that deals specifically with ID theft -- received more than 226,000 cases in the 2011 fiscal year -- a 20% increase from fiscal year 2010.
And the Taxpayer Advocate Service experienced a 97% increase in stolen identity cases in 2011 -- on top of a 23% increase in 2010.
H&R Block told clients that the IRS is using a new technology this year that has caused the agency to take more time to validate returns at the beginning of the season.
If you're looking at a delay, tax preparers want you to know that it's not them -- it's the IRS.
Hewitt said he understands that the refunds are expected to be back to a more normal pattern for taxpayers who file returns now or later.
At the opening of the 2012 filing season, the IRS advised taxpayers who electronically file and select direct deposit that they could see their refunds in as few as 10 days and 90% of refunds are provided within 21 days.
Some taxpayers are getting refunds much faster, the IRS said, but at this time, taxpayers should expect refunds to be issued as indicated in the original IRS guidelines.
Taxpayers can go to http://www.irs.gov/ to see "Where's My Refund?"
The IRS said it apologizes for any inconvenience caused by the revised refund dates.
Thursday, January 26, 2012
IRS Issues Could Delay Tax Refunds
It's news you don't want to hear. It could take longer to get your tax refund this year.
Turbo Tax and H&R Block said problems at the IRS are causing big delays.
The IRS started its e-file system two days late. Usually it starts on Jan. 15th, this year it was Jan 17th.
Now for those people who have filed, they're going to this site(https://sa2.www4.irs.gov/irfof/lang/en/irfofgetstatus.jsp) to check the status of their refund and getting an error message.
That's because of an unplanned outage of the IRS e-file system.
Companies like H&R Block and Turbo Tax are letting customers know via Facebook and in-person about the e-file issues.
H&R Block's Central Coast district manager in Watsonville told Central Coast News Wednesday, he sees quite a few people filing their taxes early, especially families.
The delay is putting refund's behind schedule. For example, if you filed your taxes on Jan. 17th, you should expect to see a refund Feb. 1st, a week later than normal.
"We try to explain before they start doing their taxes. We give expectations and we try to explain what the IRS is doing this year, so that when we do the return they aren't shocked or surprised," said Fernando Paco.
Even when the IRS fixes the problems in e-filing, you could still be waiting longer to get your refund, that's because funding to the agency has been reduced the past two years.
Right now, the IRS said it is unable to answer three out of ten calls from taxpayers.
There is some good news. Changes to the tax codes could get you some more money when you do file.
First, for every dependent you claim the credit is increasing from $99 to $315.
Next, you can continue to put money into an IRA all the way through April 17th of this year, and that will be included in your 2011 tax return. The deadline used to be December 31st.
Finally, there are new stimulus fund credits good for one or two years. This year those include people who attend community college and trade schools. In the past, credits included first-time home buyers and energy efficient home improvements.
Monday, January 23, 2012
Saturday, January 21, 2012
The Serial Backdoor Roth, A Tax-Free Retirement Kitty
FROM FORBES.COM -
If your income is too high, you can’t contribute directly to a Roth individual retirement account, but you can get one in a backdoor way. Step 1: Open a traditional IRA (in your case, it’s nondeductible). Step 2: Convert it to a Roth IRA. Is it worth it? “It’s a no-brainer if you have the cash to do it,” says Kevin Huston, an enrolled agent in Asheville, N.C. who has clients both young and old doing it to shore up their retirement savings. “It especially makes sense for people who are younger because they have all these years of tax-free growth,” he says.
Basically, you get an extra $5,000 (or $6,000 if you’re 50 or older) each year that grows in the Roth IRA income-tax free. That’s $10,000 (or $12,000) a year for a married couple. Repeat each year, and you can amass a nice retirement kitty. The audience for backdoor Roths is a niche, appealing to those earning too much to contribute to Roths directly but not so much that the extra tax savings doesn’t seem worth the effort. Vanguard says that “backdoor Roth” contributions represented about 2 percent of traditional IRA contributions in 2010. That’s the year that income restrictions were lifted, and anyone—regardless of income—could convert a traditional IRA to a Roth, leading to a boomlet of Roth conversions.
Why go through the hoops of getting money into a Roth IRA? They are an amazing deal, especially for folks looking long-term and expecting higher tax rates in the future. With a Roth IRA you don’t ever have to take money out, and when you do start taking money out, it’s all income-tax-free, including the earnings. By contrast, with a traditional IRA, earnings grow tax-deferred, you have to start taking required mandatory distributions the year after you turn 70.5, and distributions count as income. A Roth can help keep your tax bite down in retirement. (Ideally you want a mix of taxable, tax-deferred and tax-free accounts to draw from in retirement.)
A Roth IRA also has other benefits. Medicare premiums are based on income, so by keeping your income down, you’ll pay a lower premium. And if you leave a Roth account to a child, he or she will have to take money out each year, but there will be no income tax hit. (Inheriting a $100,000 Roth IRA is a whole lot better than inheriting a $100,000 traditional IRA; the higher your beneficiary’s tax bracket, the bigger the savings).
Here’s how the strategy is helping a couple in their 40s build their nest egg. The wife’s in marketing with a pharmaceutical company, and the husband is a stay-at-home dad. First, she’s maxing out on her company pre-tax 401(k) plan contributions—putting away the full $17,000 for 2012—her employer doesn’t offer a Roth 401(k) option. The couple told their tax advisor Huston they want to save more, but they can’t contribute to Roth IRAs directly because her income is nearly $200,000 a year. (Once your modified adjusted gross income is $183,000 for a couple filing jointly or $125,000 for singles, no Roth IRA contributions are allowed).
But they can each contribute to a traditional IRA. They don’t get a deduction because of the wife’s high income, so it’s called a nondeductible IRA. She puts away $5,000, and he puts away $5,000 (his IRA is based on her earning and called a nondeductible spousal IRA; otherwise you have to have earned income to contribute to an IRA). Then they convert the IRAs into Roth IRAs. That sounds complicated but you can do it online, and it’s almost as easy as transferring money from checking to savings. You pay income tax the next April only on any earnings accrued between the time you contributed to the nondeductible IRA and converted to a Roth.
There’s one big caveat to the backdoor Roth: the pro rata rule. When you calculate the taxes due on a conversion, you have to take into account all your IRA assets, not just the new $5,000 nondeductible IRA. For example, if you have a traditional IRA with $95,000 of money from a 401(k) rollover (the $95,000 contributions were made on a pre-tax basis), and you make a $5,000 nondeductible contribution to a new IRA, the conversion would be 95% taxable.
So when might it make sense to skip this whole exercise? Ronald Finkelstein, a CPA and lawyer with Marcum in Melville, N.Y., said he personally makes nondeductible IRA contributions each year and has considered doing a Roth conversion but passed because he has accumulated a large sum in a traditional IRA he opened 30 years ago when he had a newspaper route. Plus, he may retire to Florida, so paying the New York state tax bite wouldn’t make sense. “You have to do the calculations,” he warns.
But sometimes it can still make sense for folks, even older folks, with big traditional IRAs, to do the backdoor Roth. Another Huston client, a 68-year-old builder, does them as part of a holistic plan to get more of his net worth into tax-free accounts so he and his wife (and grandchildren) will have the accounts to tap as part of a tax diversification strategy. He just did a $6,000 backdoor Roth for the third year in a row. At the end of each calendar year, Huston and he look at his income and decide how much to convert from his traditional IRA too (one year it was $50,000; one year $25,000), keeping in mind what would push him into a higher tax bracket.
There’s still time to make an IRA contribution for calendar year 2011 through April 17, 2012. You can double up and make your 2012 contribution too. How long should you wait to convert? “It’s a grey area,” says Robert Keebler, a CPA in Green Bay, Wisc. He suggests a waiting period of six months, although other advisors say to convert the next day to limit the tax bite on the conversion.
If your income is too high, you can’t contribute directly to a Roth individual retirement account, but you can get one in a backdoor way. Step 1: Open a traditional IRA (in your case, it’s nondeductible). Step 2: Convert it to a Roth IRA. Is it worth it? “It’s a no-brainer if you have the cash to do it,” says Kevin Huston, an enrolled agent in Asheville, N.C. who has clients both young and old doing it to shore up their retirement savings. “It especially makes sense for people who are younger because they have all these years of tax-free growth,” he says.
Basically, you get an extra $5,000 (or $6,000 if you’re 50 or older) each year that grows in the Roth IRA income-tax free. That’s $10,000 (or $12,000) a year for a married couple. Repeat each year, and you can amass a nice retirement kitty. The audience for backdoor Roths is a niche, appealing to those earning too much to contribute to Roths directly but not so much that the extra tax savings doesn’t seem worth the effort. Vanguard says that “backdoor Roth” contributions represented about 2 percent of traditional IRA contributions in 2010. That’s the year that income restrictions were lifted, and anyone—regardless of income—could convert a traditional IRA to a Roth, leading to a boomlet of Roth conversions.
Why go through the hoops of getting money into a Roth IRA? They are an amazing deal, especially for folks looking long-term and expecting higher tax rates in the future. With a Roth IRA you don’t ever have to take money out, and when you do start taking money out, it’s all income-tax-free, including the earnings. By contrast, with a traditional IRA, earnings grow tax-deferred, you have to start taking required mandatory distributions the year after you turn 70.5, and distributions count as income. A Roth can help keep your tax bite down in retirement. (Ideally you want a mix of taxable, tax-deferred and tax-free accounts to draw from in retirement.)
A Roth IRA also has other benefits. Medicare premiums are based on income, so by keeping your income down, you’ll pay a lower premium. And if you leave a Roth account to a child, he or she will have to take money out each year, but there will be no income tax hit. (Inheriting a $100,000 Roth IRA is a whole lot better than inheriting a $100,000 traditional IRA; the higher your beneficiary’s tax bracket, the bigger the savings).
Here’s how the strategy is helping a couple in their 40s build their nest egg. The wife’s in marketing with a pharmaceutical company, and the husband is a stay-at-home dad. First, she’s maxing out on her company pre-tax 401(k) plan contributions—putting away the full $17,000 for 2012—her employer doesn’t offer a Roth 401(k) option. The couple told their tax advisor Huston they want to save more, but they can’t contribute to Roth IRAs directly because her income is nearly $200,000 a year. (Once your modified adjusted gross income is $183,000 for a couple filing jointly or $125,000 for singles, no Roth IRA contributions are allowed).
But they can each contribute to a traditional IRA. They don’t get a deduction because of the wife’s high income, so it’s called a nondeductible IRA. She puts away $5,000, and he puts away $5,000 (his IRA is based on her earning and called a nondeductible spousal IRA; otherwise you have to have earned income to contribute to an IRA). Then they convert the IRAs into Roth IRAs. That sounds complicated but you can do it online, and it’s almost as easy as transferring money from checking to savings. You pay income tax the next April only on any earnings accrued between the time you contributed to the nondeductible IRA and converted to a Roth.
There’s one big caveat to the backdoor Roth: the pro rata rule. When you calculate the taxes due on a conversion, you have to take into account all your IRA assets, not just the new $5,000 nondeductible IRA. For example, if you have a traditional IRA with $95,000 of money from a 401(k) rollover (the $95,000 contributions were made on a pre-tax basis), and you make a $5,000 nondeductible contribution to a new IRA, the conversion would be 95% taxable.
So when might it make sense to skip this whole exercise? Ronald Finkelstein, a CPA and lawyer with Marcum in Melville, N.Y., said he personally makes nondeductible IRA contributions each year and has considered doing a Roth conversion but passed because he has accumulated a large sum in a traditional IRA he opened 30 years ago when he had a newspaper route. Plus, he may retire to Florida, so paying the New York state tax bite wouldn’t make sense. “You have to do the calculations,” he warns.
But sometimes it can still make sense for folks, even older folks, with big traditional IRAs, to do the backdoor Roth. Another Huston client, a 68-year-old builder, does them as part of a holistic plan to get more of his net worth into tax-free accounts so he and his wife (and grandchildren) will have the accounts to tap as part of a tax diversification strategy. He just did a $6,000 backdoor Roth for the third year in a row. At the end of each calendar year, Huston and he look at his income and decide how much to convert from his traditional IRA too (one year it was $50,000; one year $25,000), keeping in mind what would push him into a higher tax bracket.
There’s still time to make an IRA contribution for calendar year 2011 through April 17, 2012. You can double up and make your 2012 contribution too. How long should you wait to convert? “It’s a grey area,” says Robert Keebler, a CPA in Green Bay, Wisc. He suggests a waiting period of six months, although other advisors say to convert the next day to limit the tax bite on the conversion.
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