Disclaimer: Information contained below was accurate as of the date of publication. Due to frequent tax law changes, information may no longer be accurate. For the latest tax information, please contact a member CPA.

TWO MAJOR CHANGES TO TAX-FREE ROTH ACCOUNTS

by Andrew D. Schwartz, CPA

From a tax perspective, saving for retirement used to be a heck of a lot simpler.  You'd deduct the money contributed into your employer sponsored retirement plan or IRA, and then would pay taxes on money withdrawn from those accounts down the road. 

Everything changed back in 1998 with the introduction of Roth IRAs. You now have the option of foregoing a tax break today in exchange for tax-free growth within your Roth account.  As long as certain conditions are met, you'll owe no taxes on money withdrawn from your Roth IRA. 

The government even went one step further.  The 1997 Tax Act provided a provision allowing people to convert their existing IRAs to a Roth IRA.  Yes they would owe taxes on the amount converted, but the IRA account would then grow tax-free from that point forward.  The only catch was that you could only convert your IRAs in a year that your income does not exceed $100,000. Please note that the same $100,000 threshold applies to single individuals as well as to married couples, and has not increased for inflation since being implemented back in 1998. 

This year, there have been two major changes to tax-free Roth accounts.  One change was introduced in 2006 as part of the recent Tax Act, while the second change, enacted as part of the 2001 Tax Act, finally took effect on January 1st.

Income Limitation For Roth Conversions Disappears in 2010

The Tax Increase Prevention and Reconciliation Act, signed into law on May 17, 2006, eliminates the income limitation for people looking to convert their IRAs to a Roth IRA, effective in 2010.  If you convert your IRAs in 2010, the new rules give you the option of paying all the taxes in one year, or spreading the tax bill over the following two years.

So what should you do?  If you plan to take advantage of this opportunity in 2010, keep in mind that you can only convert money held within an IRA account.  So now's the time to complete the paperwork to roll those old 401(k) or 403(b) accounts still being held at a former employer into an IRA account.  (Just be aware that money held in a qualified plan such as a 401(k) or 403(b) might be more protected from your creditors than money held within an IRA.)

You also have the opportunity to build up your IRA accounts over the next five years.  With a maximum IRA contribution of $4,000 per year through 2007, increasing to $5,000 for the three subsequent years, you can add $23,000 into your IRA over the next five years, increasing the money available to be converted.

Anyone 50 or older can make catch-up contributions of an extra $1,000 per year, adding an additional $5,000 into your IRA accounts by 2010.

Even if you're covered under a retirement plan at work, you have the option of contributing to your IRA account each year.  The amount you contribute might not be tax deductible, but that's okay, since you won't be taxed again on those non-deductible contributions when you convert your IRAs.

If you're married, your spouse can also contribute to an IRA each year.  The only requirement is that your earned income, including wages and net self-employment income, exceed the total amount of your combined IRA contributions.

Does it make sense to convert your IRAs to a Roth IRA?  Before deciding, you need to consider a variety of factors.  Check out our Roth Conversion Quiz created when Roth IRAs were first introduced back in 1997.

Roth Planning Opportunity For High Income Taxpayers

Through 2010, there is an opportunity available to high income taxpayers looking to take advantage of these new Roth conversion rules.  Let's look at the basics:

• Starting in 2010, anyone can convert their IRAs to a Roth IRA since the $100,000 income limitation has been eliminated.

• If you work and are covered under an employer sponsored retirement plan, or are self-employed and contribute to your own SEP, SIMPLE or other retirement plan, your IRA contributions aren't tax deductible if your 2006 Adjusted Gross Income (AGI) exceeds $60,000 if single or $85,000 if married.

• If you work and are covered under a retirement plan during the year, and your spouse either doesn't work or works but isn't covered under a retirement plan during the year, your spouse's IRA contributions aren't tax deductible if your combined AGI exceeds $160,000.

• You're not eligible to contribute to a Roth IRA in any year that your AGI exceeds $110,000 if single or $160,000 if married.

Here's the plan.  For this example, let's assume your income each year exceeds the applicable thresholds so you're not eligible to make tax deductible contributions into your traditional IRA or to contribute to a Roth IRA.

Starting in 2006, contribute the maximum to your IRA each year, and then convert your IRA to a Roth IRA in 2010.  Assuming you have no other IRA accounts, you'll only be taxed on the portion of the 2010 value of this account that exceeds the $23,000 you invested over the years, since those IRA contributions weren't previously tax deductible.

Essentially, even though your income was too high to contribute to a Roth IRA over the years, by making non-deductible IRA contributions between 2006 and 2010, and then converting your IRA in 2010, you ended up contributing to your Roth IRA each of those years. 

The New Roth 401(k) or 403(b)

The second big change, introduced as part of the 2001 Tax Act, finally went into effect this year.  As of January 1, 2006, employers can amend their retirement plans to allow their staff to designate their salary deferrals as Roth contributions.

While contributions made into your current 401(k) or 403(b) plan reduce your taxable earnings, you'll be taxed on money withdrawn from these retirement savings accounts down the road.  With a Roth account, you forego a tax savings today, but the money invested within the account grows tax-free - provided you're at least 59 1/2 and the account has been open for at least five years before any money is withdrawn. 

Like many other of today's tax breaks, this opportunity is scheduled to sunset on December 31, 2010.  That means you only have five years to contribute to a Roth 401(k) or 403(b) plan at work unless this rule is extended.  Now's the time to find out if your employer amended their retirement plan to offer you access to these tax-free retirement savings accounts.

Deciding whether a Roth 401(k) or 403(b) is the right choice is a tough decision.  More information about this twist to these already popular retirement savings plans is available at our October 2005 Newsletter (2nd article).

Major Changes = Tough Decisions

Thanks to these major changes to Roth accounts, most taxpayers are now faced with two tough decisions.  While the tax-free growth provided by Roth accounts is very attractive, taking advantage of these two new rules will cost you additional taxes in the short run.

By converting your IRAs to a Roth IRA, you'll owe income taxes on the amount converted.  And by going with a Roth 401(k) or 403(b) at work, you forego a current year tax break.

Are these prudent steps to take?  You'll only know for sure when it's time for you to withdraw money from these accounts and can see whether tax rates have risen over the years, and whether Roth distributions have remained completely tax-free as promised in the 2001 Tax Act.

TOP

FIRST QUARTER SALES FIGURES FOR HYBRID VEHICLES ANNOUNCED

by Andrew D. Schwartz, CPA

The numbers are in.  Toyota and Lexus outpaced their rivals by selling a combined 41,779 hybrid vehicles during the first quarter of 2006.  Honda sold 9,072 hybrids and Ford and Mercury sold a combined 6,192 hybrids during the first three months of 2006.

Why are these sales figures important?  Effective January 1, 2006, you're eligible for a new tax credit of up to $3,400 if you purchase a hybrid vehicle.  The catch is this credit begins to phase out for each manufacturer upon selling 60,000 hybrids, as follows:

• The full credit is allowed through the end of the quarter following the quarter during which the manufacturer sells its 60,000th hybrid vehicle subsequent to January 1, 2006.

• The credit is cut in half for the subsequent two quarters.

• The credit is then cut to twenty-five percent of the original credit for the subsequent two quarters.

• No credit is allowed for vehicles purchased from that manufacturer thereafter.

The hybrid car tax credit is currently set to expire on December 31, 2010.  Even so, if you're thinking about purchasing a Toyota or Lexus, don't delay!  Based on the sales figures for the first quarter of 2006, the allowable credit for their hybrids is on track to be cut in half on October 1, 2006 and then will be fully phased out on September 30, 2007.

The New Hybrid Vehicle Tax Credit

Prior to January 1, 2006, a person who purchased a hybrid was eligible to claim the $2,000 "Clean Fuel" deduction.  The Energy Tax Incentives Act of 2005 enacted a more valuable tax credit for hybrid purchasers.   Here are the hybrids currently eligible for this new tax credit:

Eligible Vehicles

To qualify for this tax credit, the hybrid you purchase must be a new vehicle.  According to the IRS, "the original use of the vehicle must begin with you", so used vehicles don't qualify. 

You must also purchase the hybrid instead of leasing one.  "If a qualifying vehicle is leased to a consumer, the leasing company may claim the credit," explains the IRS.

And the final condition to qualify for this tax credit is that you use your hybrid predominantly within the United States. 

Form 8910

To claim this new tax credit, you need to complete and attach a Form 8910 to your tax return.  Consider reading through the instructions to this form prior to purchasing a new hybrid.

While the form seems simple enough to complete, don't overlook that the Alternative Minimum Tax (AMT) might cause you to completely lose out on this new tax break.  And with more and more people paying this tax each year, working through a tax projection is the best way to determine if you'll be hit by the AMT the year you purchase your hybrid vehicle.

TOP

TAX AND FINANCIAL PLANNING CALENDAR FOR AUGUST, 2006

TOP

2005 & 2006 TAX FACTS

• For 2005, the standard deduction for a single individual is $5,000 and for a married couple is $10,000. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes (or sales taxes), real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses.
• For 2005, the personal exemption is $3,200. Individuals will claim a personal deduction for themselves, their spouse, and their dependents. 
  
• The maximum earnings subject to social security taxes is $94,200 for 2006, up from $90,000 in 2005.
  
• The standard mileage rate is $.485 per business mile as of September 1, 2005 (after being $.405 per mile through August 31, 2005), and will then be $.445 per mile for 2006.
  
• The maximum annual contribution into a 401(k) plan or a 403(b) plan is $15,000 for 2006.  And if you'll be 50 or older by December 31, 2006, you can contribute an extra $5,000 into your 401(k) or 403(b) account this year.
• The maximum annual contribution to your IRA is $4,000 for 2006.  And if you turn 50 by December 31st, you can contribute an extra $1,000 for 2006.  You have until April 15, 2007 to make your 2006 IRA contributions. 

TOP

copyright - 2006 - CPANiche, LLC