Not eligible for Roth IRA - conversion?

[Lusitan]

Hi All,

I took a first crack at my taxes this year (TurboTax) and was rudely awakened to the fact that my wife and I did not qualify to make any Roth IRA contributions in 2005 due to the income limits.

However, I made Roth IRA contributions into our accounts in early 2005. I haven't started doing all the research yet on what steps I need to take now - apparently I need to do some kind of conversion of those contributions into a standard IRA ...

I have a few questions if anyone has gone through this process before or just happens to know ...

It looks like I will have to convert the contributions for both of our Roth IRA accounts in 2005 out of the Roths and into standard IRAs. And based on what I've read about the income limits and the fact that I do participate in a 401(k), we will not be able to deduct any of those contributions into the standard IRAs.

But logistically how do I do this? Since I made the 2005 Roth IRA contributions sometime early in 2005, I have gains on those contributions. Do I need to:

(a) pull the 4k+gains out of the Roth and only put 4k into the IRA, cashing out those gains,

(b) just pull the 4k out of the Roth and put it into the standard IRA, not worrying about any gains that the 4K may have earned in the Roth, or

(c) pull the 4k+gains out and invest that into the IRAs?

I've got a sinking feeling in my stomach that this is going to be a major hassle ...

Anyone go through this before and have any advice to share?

Thanks!

P.S> And I've already gone and made 2006 contributions into Roth IRAs this year, and although our incomes are in transition (which is how I got caught off guard in 2005) I still don't know where we will come out so I guess I will just hold off on doing anything with those contributions for now ... ugh.

 

[Martha]

Lusitan, this happened to us a number of years ago. We had the Roth at Vanguard. They gave us a bunch of forms we had to fill out which took care of eliminating the Roth. It was fairly painless, but I can't remember all the ins and outs. Where is your Roth held at? I would talk to them about what to do.

Here is a web site that talks about recharacterizing your ROTH as a traditional, but nondeductible IRA: http://www.fairmark.com/rothira/excess.htm

 

[cute fuzzy bunny]

Ugh. I did that once. I had to pull out the money and decided that since I couldnt get any deductions for putting it into a traditional IRA I'd just take the cash and invest it in my taxable. Vanguard sent me a form with the numbers on it, I just had to plug those into turbotax. I think I had to pay a very small penalty for excessive contribution to a roth or some similar named thing.

 

[Martha]

The penalty is due only if you don't get this resolved by the date your taxes are due, without extensions. So get 'er done.

 

[Lusitan]

Thanks for the responses guys.

Our IRAs are with Vanguard, so I'll contact them about making the changes.

I'm guessing our contributions to a standard IRA will not be tax-deductible either, since I have a 401(k) plan at work that I contribute to. But I was still thinking to put the money into an IRA - is there any downside to doing so?

The benefits of putting that money from my Roth into a non-deductible IRA would be:

(1) tax-deferred growth - no need to worry about taxes on that account until I start withdrawals

(2) the convenience-factor of having the funds in a definite "retirement" account (not a real benefit, more like an emotional one I guess)

Any drawbacks? Assuming that I make the same investment (probably a Vangard target retirement fund) and no account-maintenance cost difference, is there any reason why it would be worse to pull this money from the Roth and put it into a non-deductible IRA instead of a regular taxable account? (Apart from the flexibility it would give to keep the money in regular account?)

Any any reason to recharacterize this money from the Roth into a separate IRA instead of putting it into my existing regular IRA? I'm thinking that somewhere down the road I might want to be able to distinguish between the two ...

 

[Nords]

Our IRAs are with Vanguard, so I'll contact them about making the changes.

Give 'em plenty of time to get it right, and it might take them three or four tries. This is a very busy time of year and the first string isn't necessarily answering the phone.

I'm guessing our contributions to a standard IRA will not be tax-deductible either, since I have a 401(k) plan at work that I contribute to. But I was still thinking to put the money into an IRA - is there any downside to doing so?
The benefits of putting that money from my Roth into a non-deductible IRA would be:
(1) tax-deferred growth - no need to worry about taxes on that account until I start withdrawals
(2) the convenience-factor of having the funds in a definite "retirement" account (not a real benefit, more like an emotional one I guess)
Any drawbacks? Assuming that I make the same investment (probably a Vangard target retirement fund) and no account-maintenance cost difference, is there any reason why it would be worse to pull this money from the Roth and put it into a non-deductible IRA instead of a regular taxable account? (Apart from the flexibility it would give to keep the money in regular account?)

No downside at all. The tax-deferral eventually comes due but the compounding beats paying annual taxes. There may also come a day in your life when your income drops low enough to make it worth partially converting the conventional IRA to a Roth, hopefully in the 10-15% tax bracket, to escape RMDs & further taxes altogether.

If you need the money before 59 1/2 you can always use a penalty-free 72(t).

Any any reason to recharacterize this money from the Roth into a separate IRA instead of putting it into my existing regular IRA? I'm thinking that somewhere down the road I might want to be able to distinguish between the two ...

No reason one way or the other. Your contributions will be tracked on IRS form 8606 no matter how many accounts you have. If Vanguard doesn't charge you for "extra" accounts then you could pretty much do whichever strikes your fancy.

 

[Lusitan]

Thanks Nords. Good point about getting started early on this too ... oh, how I love tax time ...

Cheers

 

[kaneohe]

Lusitan,

I've done a number of recharacterizations through Charles Schwab and they've been relatively painless and fast.  I would think Vanguard would be similar but you might want to ask them for a timeline and followup to make sure things are proceeding.

"Your contributions will be tracked on IRS form 8606 no matter how many accounts you have. "----Nords hints  but does not explicitly state that YOU have to file this form 8606 with your Federal 1040.  I think there is a small penalty for not doing this but you would want to do it anyway so that the non-deductible contribution does not get taxed again when you withdraw the funds in the future.

Next year you will get a Form 5498 from Vanguard showing an IRA distribution----you will need to report this IRA distribution on
the first page of the 1040 (line 15a this year but may be different in 2006)  .   If you recharacterize into a non-deductible IRA there won't be any tax consequences since you enter 0 (zero) as the taxable amount in line 15b.

"Any drawbacks? Assuming that I make the same investment (probably a Vangard target retirement fund) and no account-maintenance cost difference, is there any reason why it would be worse to pull this money from the Roth and put it into a non-deductible IRA instead of a regular taxable account? "

An interesting question.   Nords has described the benefit of long term compounding and tax deferral.     I have seen one argument on the other side---that a taxable account could conceivably be taxed at lower rates (capital gains) vs ordinary income rates for the IRA.    You would have to do the spreadsheet calculation to see how it works out---seems like it depends so much on the assumptions made that either answer might apply.   One extreme example is if you are very successful in growing your tax deferred accounts and don't take distributions until forced to----conceivably you might then be in the same tax bracket as when working but will be taxed at ordinary income rates on the IRA distributions.

 

[kaudrey]

Hi Lusitan,

The question of whether to fund a non-deductible IRA is interesting - I just went through the same thought process. I rolled over a 401(k) to an IRA, so I had the same issue - do I start putting $4K in it a year?

You have already been given both sides, and I really think it's partly a guess. Yes, the money grows tax deferred, but when you pull it out, you pay taxes on it as income. The alternative is a LTBH strategy in your taxable account that will trigger cap gains taxes, which in theory will be lower than income taxes. But that party depends on what your income will be in retirement.

With my government pension kicking in at 57 (5 years after I plan to retire), I believe that my income tax bracket won't be very low, in which case my IRA withdrawals will cost more in taxes.

That, and the fact that I want 5 years of living expenses in my taxable account to live on from age 52 to 57, has led me to the decision NOT to put any more money in the IRA.

Just one person's perspective. Good luck either way!
Karen

 

[Lusitan]

Thanks Karen and Kaneohe - more good points.

It's hard to judge whether/where we'll be at all, let alone financially, in ~30 years when I plan to withdrawal from the IRAs ... as you said, it's at best an educated guess.

I'm kicking myself for not only having to do this for 2005, but for already having gone and made the Roth IRA contributions for 2006 ... I'm afraid I'll be going through the same thing next year. I realize it's a "problem" that I'm fortunate to have, but I just hate the paperwork and hassle of it ... hopefully it won't be too bad. I'm just a wimp when it comes to paperwork I suppose - but you've all given me the moral support I need - thanks!