Individual Retirement Accounts may be simple, but they continue to befuddle investors. My recent column on IRAs prompted lots of questions. In fact, I get almost as many e-mails from IRA columns as when I trash annuities.
Here are some more IRA questions:
Q: What are the tax consequences for moving cash from a nondeductible IRA to a Roth IRA?
A: Before reading last week's column, I'm sure most readers had never spent even a nanosecond contemplating the merits of a nondeductible IRA. Until the Roth IRA came along, my husband and I used to feel like freaks for investing in a nondeductible IRA, which had been our only option. Our accountant used to tell us that we were his only clients who owned one of these IRAs.
But as I mentioned previously, the nondeductible IRA is enjoying sudden attention from those who make too much money to qualify for the more attractive Roth IRA. Thanks to recent legislation, these high-income earners will be able to move money that has accumulated in a nondeductible IRA into a Roth beginning in 2010. So now is an excellent time for these folks to start stockpiling money in nondeductible IRAs.
People who invest in a nondeductible IRA will have to pay tax when they eventually convert their account into a Roth. The tax hit, however, won't be as punitive as you might assume. In paying the tax, you exclude the nondeductible contributions that you've made.
If a 50-year-old puts $5,000 into a nondeductible IRA for four years for a total of $20,000 - and the account grows to $25,000, he or she would only owe income taxes on the $5,000. The math will be different, however, if you have more than one nondeductible IRA.
Suppose you also have an old nondeductible IRA that you haven't touched in years that has generated a lot of growth. Even if you only want to convert your newer IRA to a Roth, you must still average in the earnings of any nondeductible IRA accounts. So if earnings represent 20 percent of the new IRA and 60 percent of the old one, you'd have to pay taxes on 40 percent of the account.
Nobody asked about the tax consequences of inheriting a nondeductible IRA - an even more obscure topic - but it's important to understand the handling directions so you can shrink that looming tax bill. When you inherit a traditional IRA, you should determine if it's a deductible or a nondeductible account. Figuring this out isn't an easy as you might think, but it's worth the hassle.
If you inherit a nondeductible IRA, you won't have to pay federal taxes on the cost basis, which represents all the prior contributions. Suppose a father, for instance, plowed $30,000 into a nondeductible IRA and it ultimately grew to $45,000. The son or daughter would owe taxes only on the $15,000. In contrast, if Dad had left a deductible IRA, the heir would face a tax liability on $45,000.
You, however, can't expect the IRS to alert you to this, and even most tax preparers don't think about it. So how can you tell if you've inherited a nondeductible IRA? One way is to see if the benefactor filed IRS Form 8606 with his or her federal taxes, which shows the amount of a nondeductible IRA contribution. You can also check IRA statements and old federal tax returns to see if tax deductions were claimed for contributions. If they were, the money was intended for a deductible IRA. FYI, one reason why Roth IRAs are so wonderful is because those who inherit these accounts will pay zero taxes on any withdrawals.
Q: I've been told that my wife must stop contributing to her IRA because she's no longer working. Is this true?
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