August 25, 2006If you're like me, it's hard to believe that a change in the tax code could be very exciting. But Bob Leins, a respected accountant and my colleague, convinced me to write about taxes last week and this week. If these changes result in lower taxes or if they make it easier to save my hard-earned dollars for my retirement, then I'm all ears. So listen up -- it's important. Last week, we discussed the 2006 Pension Protection Act and found that there is good news for workers planning to jump into retirement as well as for those already testing the water. This week, we'll see if we can dazzle you with the 2006 Tax Increase Prevention and Reconciliation Act, signed on May 17. If that's not enough, we will top it off with a brief discussion of the Heroes Earned Retirement Opportunities Act -- signed into law on May 29. The HERO Act, as it's called, affects our service members who have not contributed to their retirement savings while serving in combat zones.
Converting to Roth IRAs
TIPRA allows the conversion of traditional IRA balances to Roth IRAs beginning in 2010, by removing the restrictions that prevent some taxpayers from doing this. As it now stands, a taxpayer with an annual adjusted gross income (AGI) of more than $100,000, or who is married filing separately, is not entitled to change a traditional IRA to a Roth one. Also, even if you are eligible to make the change, under current rules the income generated by the switch is fully taxed in the year of conversion.
In the new law, Congress has waived the income ceiling and has included an attractive payment plan to ease the burden of paying taxes on the taxable portion of money that is transferred to Roth IRAs. For conversions in 2010, the taxable income can be spread over two years and will be included in income for 2011 and 2012. In other words, no tax will be due in 2010.
The benefit of a Roth IRA is that because the money in it has already been taxed, your savings can grow tax-free rather than tax-deferred. Another notable benefit is for those people affected by the alternative minimum tax, which applies to a small, but growing, percentage of taxpayers. By paying taxes on the conversion over two years, those taxpayers will save substantially.
Good News for CSRS Voluntary Contributions
Participants in the "voluntary contribution" program for CSRS employees may reap the largest tax break under the new law. Their voluntary contributions will be considered a retirement savings account and therefore the total account (both the already taxed principal plus any untaxed interest) can be transferred to a traditional IRA and then to a Roth IRA. Timing for Roth Distributions
The rules for making withdrawals from a Roth IRA remain unchanged. Generally, tax-free distributions can begin five years after a Roth can be established, and the taxpayer must be over the age of 59.5. Someone that is planning on withdrawing from a Roth but does not have an existing Roth should start one as soon as possible to start the clock on the five-year requirement.
You are eligible to make Roth IRA contributions this year if:
What to do now?
Maximize IRA contributions: If you are not eligible to make Roth contributions now but would like to have a Roth account, start maximizing traditional IRA contributions this year. You must have earned income to fund a traditional IRA (or be the nonworking spouse of an individual with earned income). There are no income limits to be eligible for making contributions to a traditional IRA. Understand that your IRA may have both taxed and untaxed money: Any amount withdrawn from an IRA will contain a percentage of previously taxed dollars as well as interest and, in some cases, contributions that have never been subject to income tax. You will need to pay the tax on the money that's never been taxed before moving it to a Roth IRA.Another Really Nice Tax Law Change
For example, say you made $10,000 of nondeductible IRA contributions over the years and the total balance in your IRA, including all IRA contributions and earnings, is $100,000. Of the $100,000, 90 percent has not been taxed and only 10 percent has already been taxed before it was invested in the IRA. If you want to convert $10,000 of those funds to a Roth IRA, you will need to pay tax on 90 percent, or $9,000, and the other 10 percent, or $1,000, will be tax free.
By the way, it doesn't matter if the $100,000 is invested in one IRA account or 10 different IRA accounts. The tax law considers all of your IRAs as one. You must include the balances of all your IRAs even if they are in separate accounts. The nice thing about contributing money to voluntary contributions (CSRS employees only) is that you may contribute up to 10 percent of your lifetime earnings (after tax money) to a voluntary contributions account. In some situations, where the voluntary contributions account was established recently, there may be little or no interest earned and therefore, no "untaxed" money in this account.
The HERO Act allows retroactive IRA contributions to both traditional and Roth IRAs for those service members and their spouses, if applicable, who are serving in combat zones. The HERO Act allows IRA contributions for years 2004 and 2005. These IRA retroactive contributions can be made as late as May 29, 2009. Even those service members with nontaxable combat pay are eligible. The funds can come from anybody, including friends and relatives.
Before the HERO Act, military members receiving combat pay were required to have a certain amount of income before IRA contributions could be made. Many service members whose income was not high enough were restricted or limited in making IRA contributions under the old law. Combat pay still is not subject to income tax. In Summary
In less than four months, tax laws have been changed that benefit all levels of taxpayers. While it is not certain that all of the topics discussed will be extended to the Thrift Savings Plan, it is very reasonable to assume they will be. If all of the changes discussed this week and last week are not entirely clear, please do yourself a favor and seek guidance so that you can take full advantage of these very generous opportunities.
Tammy Flanagan is the senior benefits director for the National Institute of Transition Planning Inc., which conducts federal retirement planning workshops and seminars. She has spent 25 years helping federal employees take charge of their retirement by understanding their benefits.
August 25, 2006