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Converting or Rolling Over Traditional IRAs to Roth IRAs

What is it?

Depending upon your annual income and federal income tax filing status, you may be able to transfer all or a portion of your traditional IRA funds to a Roth IRA. This can be accomplished in one of two ways: You can convert your traditional IRA to a Roth IRA, or you can roll over funds from your traditional IRA to a Roth IRA.

In the case of a conversion, you notify the trustee or custodian of your traditional IRA that you wish to convert your traditional IRA to a Roth IRA. The account is then renamed as a Roth IRA, and your funds never actually leave the account. In the case of a rollover, you actually transfer the funds from your traditional IRA to a Roth IRA. The income tax consequences of the two methods are identical.

The fact that you qualify to convert or roll over funds from your traditional IRA to a Roth IRA doesn't necessarily mean that you should. There are a number of factors that you need to consider.

Tip: Your employer may also allow you to make after-tax "Roth" contributions to your 401(k) or 403(b) plan. Qualified distributions of these contributions and related earnings may be income tax free (and penalty free) at the federal level. This may be a factor in your decision of whether to convert funds from a traditional IRA to a Roth IRA. However, be sure to discuss your situation with a qualified professional before making any decisions.

When can it be used?

You have a traditional IRA

It probably goes without saying, but you can't convert or roll over funds from a traditional IRA to a Roth IRA unless you already have a traditional IRA.

Tip: In addition to traditional IRAs, SEP-IRAs, SAR-SEP IRAs, and SIMPLE IRAs (those that have existed for at least two years) are eligible to be converted to a Roth IRA. Further, a rollover IRA (i.e., a traditional IRA containing funds rolled over from an employer-sponsored plan) is also eligible to be converted to a Roth IRA. The rules that apply to conversions from traditional IRAs, as discussed in this article, also apply to SEP, SAR-SEP, and SIMPLE conversions.

Your modified adjusted gross income is less than or equal to $100,000

If you have funds in a traditional IRA, you can convert or roll over all or a portion of those funds to a Roth IRA if you file your federal income tax return as a single taxpayer and if your modified adjusted gross income (MAGI) for the year is less than or equal to $100,000. If you're married and file your return as married filing jointly, the combined MAGI of you and your spouse for the year must be less than or equal to $100,000. Amounts that must be included in your taxable income as a result of conversion or rollover to a Roth IRA are not considered when determining if your annual income exceeds this $100,000 threshold.

Tip: If you want to convert or roll over funds from a traditional IRA to a Roth IRA, but your MAGI for the year is over the $100,000 threshold, consider methods of deferring income to bring your income for the year below the threshold. Another tip: If your annual income is close to the $100,000 threshold, it might be better to wait until the end of the year to make sure you will qualify. Unexpected income in the form of a year-end bonus or lottery winnings could push you over the $100,000 threshold.

Tip: The Tax Increase Prevention and Reconciliation Act of 2005 eliminates the $100,000 ceiling for converting a traditional IRA to a Roth IRA for tax years after 2009.

You do not file your federal income tax return as married filing separately

If your federal income tax filing status for the year is married filing separately, you cannot convert or roll over funds from a traditional IRA to a Roth IRA for that year. However, if you and your spouse file separate federal returns and lived apart at all times during the tax year, you are treated as a single taxpayer for purposes of determining your eligibility to convert or roll over funds.

Tip: For tax years after 2009, married individuals who file separate returns will be able to convert funds from a traditional IRA to a Roth IRA.

Rollovers must follow IRA rollover rules

As mentioned, one of the two ways to transfer funds from a traditional IRA to a Roth IRA is to withdraw the funds from your traditional IRA, and then roll those funds over into a Roth IRA in your name. If you choose this method to transfer funds, you must comply with federal rules governing IRA rollovers. For example, if you roll over funds from a traditional IRA to a Roth IRA, the funds must be deposited in the Roth IRA within 60 days after you receive the distribution from the traditional IRA. If you do not meet the 60-day deadline, you may be subject to tax consequences and a penalty. There is no limit on the number of rollovers from traditional IRAs to Roth IRAs that you can do in a year.

Tip: The 60-day deadline can be waived in certain circumstances. You may be eligible for an automatic waiver if you sent your rollover assets to a financial institution within the 60-day period, but the financial institution makes an error and fails to complete your rollover before the deadline. However, to be eligible to use this automatic waiver, your rollover must be completed within one year from the beginning of the 60-day period. The IRS also has the discretion to grant a waiver of the 60-day deadline in certain circumstances.

Strengths

Qualified distributions from Roth IRAs are tax free

A withdrawal from a Roth IRA (including both contributions and investment earnings) is completely tax free (and penalty free) if made at least five years after you first establish any Roth IRA, and if one of the following applies:

  • You have reached age 59½ at the time of the withdrawal
  • The withdrawal was made due to qualifying disability
  • The withdrawal was made to pay for first-time homebuyer expenses ($10,000 lifetime limit)
  • The withdrawal is made by your beneficiary or estate after your death

Tip: The five-year holding period begins on January 1 of the tax year in which you make your first contribution to any Roth IRA. Each taxpayer has only one five-year holding period for this purpose.

If none of these conditions is met, only the portion of a Roth IRA withdrawal that represents investment earnings will be subject to federal income tax. The portion of a Roth IRA withdrawal that represents your contributions (including amounts converted to or rolled over from a traditional IRA) is never taxable, since those dollars were already taxed. Roth IRA withdrawals are treated as coming from your contributions first and investment earnings last.

Caution: If you convert or roll over funds from a traditional IRA to a Roth IRA, special penalty provisions may apply if you subsequently withdraw funds from the Roth IRA within five years of the conversion (and prior to age 59½).

Roth IRAs are not subject to the lifetime required minimum distribution (RMD) rules

Federal law requires you to take annual minimum withdrawals (required minimum distributions, or RMDs) from your traditional IRAs beginning no later than April 1 of the year following the year in which you reach age 70½. These withdrawals are calculated to dispose of all of the money in the traditional IRA over a given period of time. Because Roth IRAs are not subject to the lifetime RMD rules, you are not required to make any withdrawals from your Roth IRAs during your life. This can be a significant advantage in terms of your estate planning and may be a good reason to consider converting funds.

Caution: The Worker, Retiree, and Employer Recovery Act of 2008 waives required minimum distributions for the 2009 calendar year.


Converting or rolling over funds may reduce your taxable estate and your countable assets

If you use non-IRA funds to pay the conversion tax that results from converting or rolling over funds from a traditional IRA to a Roth IRA, the funds that you use to pay the tax are removed from your taxable estate, potentially reducing your future estate tax liability. Also, the funds that you use to pay the tax are no longer part of your countable assets for purposes of determining your children's eligibility for financial aid. In contrast, if you use IRA funds to pay the conversion tax, there generally is no effect on financial aid eligibility.

Qualified distributions from Roth IRAs are not included when determining the taxable portion of Social Security benefits

Converting or rolling over your funds from a traditional IRA to a Roth IRA could be beneficial when it comes time to begin receiving your Social Security benefits. The portion of your Social Security benefits that is taxable (if any) depends on your MAGI and federal income tax filing status in a given year. Under current law, qualified distributions from Roth IRAs are not included when determining the taxable portion of an individual's Social Security benefits. However, some people believe that the law may eventually change to include qualified distributions from Roth IRAs in this calculation.

Tradeoffs

You have to pay tax now on the funds that you convert or roll over

When you convert or roll over funds from a traditional IRA to a Roth IRA, the funds that you transfer are subject to federal income tax (to the extent that those funds represent investment earnings and tax-deductible contributions made to the traditional IRA). Even if it makes overall financial sense to convert funds from a traditional IRA to a Roth IRA, paying tax on your IRA funds now may not be desirable.

Tip: Special rules apply to conversions made in 2010. The amount that must be included in income as a result of the conversion will be able to be averaged over the next two years. That is, no resulting income need be reported on the individual's 2010 tax return. Instead, half of the income may be reported in 2011, and the remaining half in 2012.

Using IRA funds to pay conversion tax has significant drawbacks

If using other IRA dollars is the only way that you can pay the conversion tax that results from converting or rolling over funds from a traditional IRA to a Roth IRA, the benefits of converting or rolling over funds are substantially reduced. Using IRA dollars to pay the tax reduces the amount of funds in your IRAs, potentially jeopardizing your retirement goals. In addition, the IRA funds used to pay the tax may themselves be subject to federal income tax and a premature distribution tax. If possible, paying the conversion tax with non-IRA funds is generally more advisable.

Special penalty provisions may apply to withdrawals from Roth IRAs that contain funds converted from traditional IRAs

If you're under age 59½ and take a nonqualified distribution from a Roth IRA, the 10 percent premature distribution tax generally applies only to that portion of the distribution that represents investment earnings. However, if you convert or roll over funds from a traditional IRA to a Roth IRA and then take a premature distribution from that Roth IRA within five years, the 10 percent premature distribution tax will apply to the entire amount of the distribution (to the extent that the distribution consists of funds that were taxed at the time of conversion).

Tip: The five-year holding period begins on January 1 of the tax year in which you converted or rolled over the funds from the traditional IRA to the Roth IRA. When applying this special rule, a separate five-year holding period applies each time you convert or roll over funds from a traditional IRA to a Roth IRA.

Taxable income resulting from conversion can increase taxable portion of Social Security benefits being received

If you're currently receiving Social Security benefits or soon will be, consider the possible tax consequences of converting or rolling over funds from a traditional IRA to a Roth IRA. When you convert or roll over funds, those funds are generally considered taxable income to you for the year in which you transfer them. Remember that the portion of your Social Security benefits that is taxable (if any) depends on your income and tax filing status for the year. This means that converting funds to a Roth IRA may increase the taxable portion of your Social Security benefits for that year.

Risk of future change in the law

One of the main reasons to consider converting or rolling over funds from a traditional IRA to a Roth IRA is that qualified distributions from Roth IRAs are completely tax free. Under current law, this is the federal tax treatment given to Roth IRAs. Some experts, however, are skeptical that this will always remain the case, given the uncertain status of Social Security and the projected lost federal revenue attributable to Roth IRAs.

States may differ in their treatment of Roth IRAs

Although most states follow the federal tax treatment of Roth IRAs, you should check with a tax professional regarding the tax treatment of Roth IRAs in your particular state.

Creditor protection

Federal law provides protection for up to $1,095,000 (as of 4/1/07) of your aggregate Roth and traditional IRA assets if you declare bankruptcy. (Amounts rolled over to the IRA from an employer qualified plan or 403(b) plan, plus any earnings on the rollover, aren't subject to this dollar cap and are fully protected.) The laws of your particular state may provide additional bankruptcy protection, and may provide protection from the claims of your creditors in cases outside of bankruptcy. In some states the creditor protection available to Roth IRAs may be less than that available to traditional IRAs.

How to do it

Calculate the tax that will result from converting or rolling over funds from your traditional IRAs to Roth IRAs

All or a portion of the funds that you convert or roll over from your traditional IRA to a Roth IRA will be subject to federal income tax in the year that you shift the funds. Consult a tax professional for an accurate calculation of the income tax liability that will result. This will help you decide if converting funds makes sense for you.

Decide where the dollars will come from to pay the resulting tax

Decide if you will use IRA funds or non-IRA funds to pay the conversion tax that will result from converting or rolling over funds, and make sure that you understand the tax consequences of either choice. For example, if you plan to sell stock to pay the tax, realize that your sale of stock will have tax consequences of its own. If you plan to use IRA funds to pay the tax, be aware that this may trigger additional income tax liability (and possibly a penalty). Again, consult a tax professional.

Decide whether to convert or roll over

If you have decided to transfer funds from your traditional IRA to a Roth IRA, your next step is to decide whether to convert your traditional IRA to a Roth IRA, or to roll over your traditional IRA funds to a Roth IRA. The income tax consequences are the same either way, so the question is: Do you want your IRA to stay at the same institution with the same custodian/trustee, or would you prefer to move your IRA dollars to another institution and have a different custodian/trustee?

If converting, contact the custodian of your traditional IRA

The custodian/trustee of your traditional IRA will provide you the paperwork you need to convert your traditional IRA to a Roth IRA with that same institution.

If rolling over, establish a Roth IRA and roll over your traditional IRA

First, you need to establish a Roth IRA in your name, if you don't already have one. Once you have a Roth IRA, you can have the funds in your traditional IRA transferred directly to your Roth IRA. The custodian of your Roth IRA can give you the paperwork that you need to do this. If you prefer, you can instead contact the custodian of your traditional IRA, have the funds in your traditional IRA distributed to you, and then roll those funds over into your Roth IRA within 60 days of the distribution.

Tax considerations

You include funds that are converted or rolled over from a traditional IRA to a Roth IRA in income

When you convert or roll over funds from a traditional IRA to a Roth IRA, those funds are subject to federal income tax in the year that you transfer them (to the extent that the funds consist of deductible contributions and investment earnings). If you have made only deductible contributions to your traditional IRAs, then the entire amount of any funds that you convert or roll over to a Roth IRA will be taxable. If, however, you have ever made nondeductible (after-tax) contributions to your traditional IRAs, then those contribution amounts will not be taxable when converted or rolled over to a Roth IRA (since they have already been taxed). In effect, the income tax consequences of converting funds are the same as those that apply when you make a withdrawal from a traditional IRA.

Tip: Amounts that must be included in your taxable income as a result of converting funds from a traditional IRA to a Roth IRA are not considered when determining if you qualify to convert funds in the first place.

Application of the 10 percent premature distribution tax

The 10 percent premature distribution tax does not apply at the time that you convert or roll over funds from a traditional IRA to a Roth IRA, even if you convert the funds before reaching age 59½. However, if you convert or roll over funds from a traditional IRA to a Roth IRA and withdraw any portion of those funds from the Roth IRA within five years (and prior to age 59½), the withdrawal will be subject to the 10 percent premature distribution tax (to the extent those funds were taxed at the time of the conversion).

Caution: Remember that withdrawals from Roth IRAs are treated as coming from contributions first and investment earnings second. Contributions are considered to consist first of regular contributions (i.e., contributions other than rollover contributions), and then of amounts converted or rolled over from a traditional IRA (on a first in, first out basis).

Tip: All of your Roth IRAs are aggregated for this purpose.

Example(s): John is age 40. John contributed $3,000 to his Roth IRA in 2006. In 2007, John converted $10,000 from his traditional IRA to his Roth IRA, and included this $10,000 in his 2007 gross income. He made no further contributions to his Roth IRA. In 2009, his Roth IRA has grown to $14,000, of which John withdraws $4,000. None of the exceptions to the 10 percent premature distribution tax apply to John. John's $4,000 withdrawal is considered to consist first of his $3,000 regular contribution made in 2006. John owes no premature distribution tax on this $3,000. The remaining $1,000 of John's $4,000 withdrawal is considered to consist of funds he converted from his traditional IRA, and is subject to the 10 percent premature distribution tax.

You can't convert or roll over RMDs into a Roth IRA

After age 70½, you are required to begin taking annual minimum withdrawals from your traditional IRAs (RMDs). You cannot roll over or convert these RMD amounts to a Roth IRA.

Special rules apply to conversions made in 2010

For Roth conversions made in 2010 only, the amount includible in gross income as a result of the conversion will be averaged over the following two years, unless the taxpayer elects otherwise. That is, no resulting income will be reported on the individual's 2010 federal income tax return. Half the resulting income will be reported on the taxpayer's tax return for 2011, and the remaining half will be reported on the taxpayer's tax return for 2012.

Caution: Income inclusion will be accelerated if converted amounts are distributed before 2012. In that case, the amount included in income in the year of distribution is increased by the amount distributed, and the amount included in income in 2012 (or 2011 if the distribution takes place in 2010) is the lesser of: (1) half of the amount includible in income as a result of the conversion, and (2) the remaining portion of such amount not already included in income.

Example(s): [From Joint Explanatory Statement of the Committee of Conference] Taxpayer A has a traditional IRA with a value of $100, consisting of deductible contributions and earnings. A does not have a Roth IRA. A converts the traditional IRA to a Roth IRA in 2010, and, as a result of the conversion, $100 is includible in gross income. Unless A elects otherwise, $50 of the income resulting from the conversion is included in income in 2011, and $50 in 2012. Later in 2010, A takes a $20 distribution, which is not a qualified distribution and all of which, under the ordering rules, is attributable to amounts includible in gross income as a result of the conversion. Under the accelerated inclusion rule, $20 is included in income in 2010. The amount included in income in 2011 is the lesser of: (1) $50 (half of the income resulting from the conversion), or (2) $70 (the remaining income from the conversion), in other words -- $50. The amount included in income in 2012 is the lesser of: (1) $50 (half of the income resulting from the conversion), or (2) the remaining income from the conversion, i.e., $100 - $70 ($20 included in income in 2010 and $50 included in income in 2011), in other words -- $30.


Questions & Answers

Should you convert or roll over funds from your traditional IRA to a Roth IRA?

Before you even begin to think about converting or rolling over funds from a traditional IRA to a Roth IRA, be sure that you understand what the Roth IRA is and how it works. If the Roth IRA seems like an appropriate retirement savings vehicle, make sure that you qualify to convert funds from a traditional IRA to a Roth IRA. If you qualify, be sure to consider the income tax consequences of converting funds, and how you will pay the resulting tax. Think about the following scenarios and factors before you act.

Scenario 1: You don't qualify to convert funds because your MAGI for the year exceeds the $100,000 threshold.

Scenario 2: You'll pay the resulting "conversion" tax with non-IRA funds, you have 10 years or more before you will be taking distributions from the Roth IRA, and you will be in the same or a higher tax bracket when you start taking those distributions. Converting funds probably makes overall sense.

Scenario 3: You'll pay the conversion tax with IRA funds, you need to take substantial distributions from the Roth IRA within a few years (5 years or less), and you will be under age 59½, or in a lower tax bracket when you begin taking distributions. You probably shouldn't convert funds to a Roth IRA.

Can you convert or roll over only a portion of the funds in your traditional IRAs to Roth IRAs?

Yes. If you qualify to convert funds, you can convert or roll over whatever amount you want from your traditional IRAs to a Roth IRA. All or a portion of the funds that you convert or roll over to the Roth IRA will be subject to federal income tax. If you have ever made nondeductible (after-tax) contributions to your traditional IRAs, you have to calculate what portion of the funds that you convert represents nondeductible contributions. Because those amounts were already taxed, they will not be taxed again when converted to a Roth IRA.

How do you calculate the portion of your conversion that represents nondeductible contributions?

If you have made only deductible contributions to your traditional IRAs, the full amount that you convert or roll over from your traditional IRAs to a Roth IRA will be subject to federal income tax, since no portion of the funds represents nondeductible contributions. If you have ever made nondeductible contributions to your traditional IRAs, you calculate and report the taxable and nontaxable portions of the funds that you convert or roll over using IRS Form 8606. Basically, you calculate the ratio of all of your nondeductible contributions to the total balance of all of your traditional IRAs, including simplified employee pension plan IRAs and savings incentive match plan for employees (SIMPLE) IRAs. That ratio is then applied to any withdrawal that you make from any of your traditional IRAs, including a conversion or rollover to a Roth IRA. So, if 50 percent of the total balance of all of your traditional IRAs represents nondeductible contributions, half of the funds that you convert to a Roth IRA would be taxable, and half would not.

Can you convert or roll over funds from your traditional IRAs to a Roth IRA if you're already receiving RMDs from your traditional IRAs?

Unlike traditional IRAs, you can contribute to a Roth IRA after age 70½, so the fact that you're receiving RMDs from your traditional IRAs doesn't by itself disqualify you from converting funds to a Roth IRA. You cannot, however, convert or roll over an RMD itself into a Roth IRA.

Tip: RMDs from traditional IRAs don't count in determining whether your MAGI for the year exceeds the $100,000 threshold for converting funds to a Roth IRA.

Can you "undo" or recharacterize a traditional IRA to Roth IRA conversion?

You may be able to undo or recharacterize a Roth IRA conversion by making a trustee-to-trustee transfer of the contribution (plus any related earnings) from the Roth IRA back to the traditional IRA within certain deadlines. You may want to consider undoing a Roth conversion if your income for the year of the conversion ends up exceeding the Roth IRA eligibility limit. Additionally, if your IRA investments experience a significant decline after the conversion date, you may be able to minimize your tax hit by reversing (recharacterizing) your conversion. Generally, the deadline for recharacterizing an IRA contribution or Roth IRA conversion is the due date of your federal income tax return (including extensions) for the year of the original contribution.

When you withdraw funds from a Roth IRA, in what order are the funds considered withdrawn?

Withdrawals from Roth IRAs are considered made in the following order:

  • Regular Roth IRA contributions (i.e., contributions other than rollover or conversion contributions).
  • Rollover or conversion contributions, in the order made (i.e., first in, first out). If any rollover or conversion included nondeductible contributions, the withdrawal is considered made first from funds that were subject to federal income tax at the time of the rollover or conversion.
  • Any investment earnings.

All Roth IRAs you maintain are aggregated (i.e., treated as a single Roth IRA) for purposes of classifying withdrawals.

This article was provided by Forefield and distributed by Lawrence Sprung.

The ABCs of 529 Plans

If you're already saving for college, you've probably heard about 529 plans. 529 plans are revolutionizing the way parents and grandparents save for college, similar to the way 401(k) plans revolutionized retirement savings. Americans are pouring billions of dollars into 529 plans, and contributions are expected to increase dramatically in the coming decade. Where did these plans come from, and what makes them so attractive?

The history of 529 plans

Congress created Section 529 plans in 1996 in a piece of legislation that had little to do with saving for college--the Small Business Job Protection Act. The law on 529 plans was later refined in 1997 by the Taxpayer Relief Act, in 2001 by the Economic Growth and Tax Relief Reconciliation Act, and in 2006 by the Pension Protection Act. In this short period, 529 plans have emerged as one of the top ways to save for college.

Section 529 plans are officially known as qualified tuition programs under federal law. The reason "529 plan" is commonly used is because 529 is the section of the Internal Revenue Code that governs their operation.

What exactly is a 529 plan?

A 529 plan is a college savings vehicle that has federal tax advantages. There are two types of 529 plans: college savings plans and prepaid tuition plans. Though college savings plans and prepaid tuition plans share the same federal tax advantages, there are important differences between them.

College savings plans

College savings plans let you save money for college in an individual investment account. These plans are run by the states, which typically designate an experienced financial institution to manage their plan. To open an account, you fill out an application, choose a beneficiary, and start contributing money. However, you can't hand pick your own investments as you would with a Coverdell ESA, custodial account, or trust. Instead, you typically choose one or more portfolios offered by the plan--the underlying investments of which are exclusively chosen and managed by the plan's professional money manager. After this, you simply decide when, and how much, to contribute.

With early college savings plans, plan managers commonly invested your money based only on the age of your beneficiary (known as an age-based portfolio). Under this model, when a child is young, most of the portfolio's assets are allocated to aggressive investments. Then, as a child grows, the portfolio's assets are gradually and automatically shifted to less volatile investments to preserve principal. The idea is to take advantage of the stock market's potential for high returns when a child is still many years away from college, while recognizing the need to lessen the risk of these investments in later years.

Though the age-based portfolio model is certainly logical (indeed, many parents were already trying to invest this way on their own), offering only this type of portfolio made college savings plans seem a bit inflexible. After all, with other college savings options like Coverdell ESAs, custodial accounts, mutual funds, and trusts, you can invest in practically anything (thereby taking into account your risk tolerance), and you have complete freedom to sell an investment that's performing poorly (though in some cases the proceeds must still be used for education purposes, or for the child's benefit in general).

Now, college savings plans are older and wiser. Today, more plans offer a wide array of portfolio choices. So, in addition to choosing an age-based portfolio, you may also be able to direct your 529 plan contributions to one or more "static portfolios," where the asset allocation in each portfolio remains the same over time. These static portfolios usually range from aggressive to conservative, so you can match your risk tolerance. But keep in mind that college savings plans don't guarantee your return. If the portfolio doesn't perform as well as you expected, you may lose money.

When it's time for college, the beneficiary of your account can use the funds at any college in this country and abroad (as long as the school is accredited by the U.S. Department of Education).

Prepaid tuition plans

Prepaid tuition plans let you save money for college, too. But prepaid tuition plans work differently than college savings plans. Prepaid tuition plans may be sponsored by states (on behalf of public colleges) or by private colleges.

A prepaid tuition plan lets you prepay tuition expenses now for use in the future. The plan's money manager pools your contributions with those from other investors into one general fund. The fund assets are then invested to meet the plan's future obligations (some plans may guarantee you a minimum rate of return). At a minimum, the plan hopes to earn an annual return at least equal to the annual rate of college inflation for the most expensive college in the plan.

The most common type of prepaid tuition plan is a contract plan. With a contract plan, in exchange for your up-front cash payment (or series of payments), the plan promises to cover a predetermined amount of future tuition expenses at a particular college in the plan. For example, if your up-front cash payment buys you three years' worth of tuition expenses at College ABC today, the plan might promise to cover two and a half years of tuition expenses in the future when your beneficiary goes to college. Plans have different criteria for determining how much they'll pay out in the future. And if your beneficiary attends a school that isn't in the prepaid plan, you'll typically receive a lesser amount according to a predetermined formula.

The other type of prepaid tuition plan is a unit plan. Here, you purchase units or credits that represent a percentage (typically 1 percent) of the average yearly tuition costs at the plan's participating colleges. Instead of having a predetermined value, these units or credits fluctuate in value each year according to the average tuition increases for that year. You then redeem your units or credits in the future to pay tuition costs; many plans also let you use them for room and board, books, and other supplies.

A final note to keep in mind: Make sure you understand what will happen if a plan's investment returns can't keep pace with tuition increases at the colleges participating in the plan. Will your tuition guarantee be in jeopardy? Will your future purchases be limited or more expensive?

What's so special about 529 plans?

Section 529 plans--both college savings plans and prepaid tuition plans--offer a combination of features that have made them attractive to college investors:

  • Federal and state tax-deferred growth: The money you contribute to a 529 plan grows tax deferred each year.
  • Federal tax-free earnings if the money is used for college: If you withdraw money to pay for college (known under federal law as a qualified withdrawal), the earnings are not subject to federal income tax, similar to the treatment of Coverdell ESA earnings.
  • Favorable federal gift tax treatment: Contributions to a 529 plan are considered completed, present-interest gifts for gift tax purposes. This means that contributions qualify for the $13,000 annual gift tax exclusion. And with a special election, you can contribute a lump sum of $65,000 to a 529 plan, treat the gift as if it were made over a five-year period, and completely avoid gift tax.
  • Favorable federal estate tax treatment: Your plan contributions aren't considered part of your estate for federal tax purposes. You still retain control of the account as the account owner but you don't pay a federal estate tax on the value of the account. But if you spread today's gift over five years and you die within the five years, a portion of the gift will be included in your estate.
  • State tax advantages: States can also add their own tax advantages to 529 plans. For example, some states exempt qualified withdrawals from income tax or offer an annual tax deduction for your contributions. A few states even provide matching scholarships or matching contributions.
  • Availability: Section 529 plans are open to anyone, regardless of income level. And you don't need to be a parent to set up an account. By contrast, your income must be below a certain level if you want to contribute to a Coverdell ESA or qualify for tax-exempt interest on U.S. education savings bonds (Series EE bonds, which may also be called Patriot bonds, and Series I bonds).
  • High contribution limits: The total amount you can contribute to a 529 plan is generally high. Most plans have limits of $300,000 and up. Coupled with the tax-deferred growth of your principal and the income tax-free treatment of qualified withdrawals, it's easy to see how valuable your money can be in a 529 plan.
  • Professional money management: For college investors who are too busy, too inexperienced, or too reluctant to choose their own investments, 529 plans offer professional money management.
  • College savings plan variety: In many cases, you're not limited to the college savings plan in your own state. You can shop around for the plan with the best money manager, performance record, investment options, fees, state tax benefits, and customer service. (You can't generally shop around with prepaid tuition plans, though.)
  • Rollovers: You can take an existing 529 plan account (college savings plan or prepaid tuition plan) and roll it over to a new 529 plan once every 12 months without paying a penalty. This lets you leave a plan that's performing poorly and join a plan with a better track record or more investment options (assuming the new plan allows nonresidents to join).
  • Simplicity: It's relatively easy to open a 529 account, and most plans offer automatic payroll deduction or electronic funds transfer from your bank account to make saving for college even easier.
  • Innovation: Section 529 plans are a creature of federal law, but the states are the ones that interpret and execute them. As Congress periodically revises the law on 529 plans, states will continue to refine and enhance their plans (and their tax laws) in order to make them as attractive as possible to college investors from all over the country.

What are the drawbacks of 529 plans?

No college savings option is perfect, and 529 plans aren't, either. Here are some of the drawbacks:

  • Investment options: 529 plans offer little control over your specific investments. With a college savings plan, you may be able to choose among a variety of investment portfolios when you open your account, but you can't direct the portfolio's underlying investments. With a prepaid tuition plan, you don't pick anything--the plan's money manager is responsible for investing your contributions.
  • Investment guarantees: College savings plans don't guarantee your investment return. You can lose some or all of the money you have contributed. And even though prepaid tuition plans typically guarantee your investment return, some plans sometimes announce modifications to the benefits they'll pay out due to projected actuarial deficits.
  • Investment flexibility: If you're unhappy with your portfolio's investment performance in your college savings plan, you typically can direct future contributions to a new portfolio (assuming your plan allows it), but it may be more difficult to redirect your existing contributions. Some plans may allow you to make changes to your existing investment portfolio once per calendar year or upon a change in the beneficiary. (For 2009 only, states may permit 529 college savings plan investors to change the investment options for their existing contributions twice per year instead of once per year.) But in either case, it depends on the rules of the plan. However, you do have one option that's allowed by federal law and not subject to plan rules. You can do a "same beneficiary" rollover (a rollover without a change of beneficiary) to another 529 plan (a college savings plan or a prepaid tuition plan) once every 12 months, without penalty. This gives you the opportunity to shop around for the investment options you prefer.
  •  Nonqualified withdrawals: If you want to use the money in your 529 plan for something other than college, it'll cost you. With a college savings plan, you'll pay a 10 percent federal penalty on the earnings part of any withdrawal that is not used for college expenses (a state penalty may also apply). You'll pay income taxes on the earnings, too. With a prepaid tuition plan, you must either cancel your contract to get a refund or take whatever predetermined amount the plan will give you for a nonqualified withdrawal (some plans may make you forfeit your earnings entirely; others may give you a nominal amount of interest).
  • Fees and expenses: There are typically fees and expenses associated with 529 plans. College savings plans may charge an annual maintenance fee, administrative fees, and an investment fee based on a percentage of your account's total value. Prepaid tuition plans may charge an enrollment fee and various administrative fees.


This article was provided by Forefield and distributed by Lawrence Sprung.

IRS Allows Additional Time to Roll Over 2009 RMDs from IRAs and Employer-Sponsored Plans

On December 23, 2008, President Bush signed The Worker, Retiree, and Employer Recovery Act of 2008 into law. The law waived required minimum distributions (RMDs) for 2009 from IRAs and employer sponsored defined contribution plans (including 401(k), profit-sharing, stock bonus, 403(b), and 457(b) plans).

In many cases, because the law was passed so late in 2008, and because many inpiduals and plan sponsors were confused about how to comply with the new rules, IRA owners and plan participants received RMDs they weren't required to take, and which they didn't want. Inpiduals who received such RMDs were allowed to roll them into an IRA or eligible retirement plan (even though RMDs aren't usually eligible to be rolled over). Some inpiduals failed to complete their rollovers within 60 days, or weren't aware of their ability to roll over the funds. In some cases, employees who received RMDs as part of substantially equal periodic payments, which are also generally ineligible for rollover, were uncertain whether a rollover was allowed.

In Notice 2009-82, the IRS provides relief to plan participants and IRA owners who have already received an unwanted 2009 RMD, and for whom the 60-day rollover period has expired. Under the Notice, these inpiduals will generally have until November 30, 2009, to complete a rollover. This relief applies to IRA owners, plan participants, and spouse beneficiaries. (Note: this special rule does not apply to RMDs received in 2009 for 2008.) For employer-sponsored plans, the relief applies to any payment that is equal to the 2009 RMD, and to any substantially equal periodic payments the employee received during 2009 that included RMDs.

The Notice cautions that the one-rollover-per-year rule still applies to IRAs. Under this rule, which applies separately to each IRA, only one rollover from a particular IRA can be made to any other IRA in a 12-month period. Roth conversions do not count as a rollover for purposes of this rule.

The Notice also provides additional guidance to taxpayers and plan sponsors in the form of Q&As, including the following:


The deadline for an employee or a beneficiary that had until the end of 2009 to choose between receiving RMDs under the 5-year or the life expectancy rule is extended until the end of 2010.


In plans that permit a nonspouse beneficiary to directly roll over a deceased participant's account balance, the nonspouse designated beneficiary has until the end of 2010 to make the direct rollover and use the life expectancy rule with respect to an employee who died in 2008.
In general, the rollover can be back to the same plan that made the distribution (if the plan permits such rollovers).


The 2009 RMD waiver does not apply to substantially equal periodic payments taken in order to avoid the 10 percent early distribution tax on distributions prior to age 59½, even if the inpidual is using the "RMD method" to calculate those payments.


You can find a copy of Notice 2009-82 here.

This article was provided by Forefield and distributed by Lawrence Sprung.

Taking Advantage of Employer-Sponsored Retirement Plans

Employer-sponsored qualified retirement plans such as 401(k)s are some of the most powerful retirement savings tools available. If your employer offers such a plan and you're not participating in it, you should be. Once you're participating in a plan, try to take full advantage of it.

Understand your employer-sponsored plan

Before you can take advantage of your employer's plan, you need to understand how these plans work. Read everything you can about the plan and talk to your employer's benefits officer. You can also talk to a financial planner, a tax advisor, and other professionals. Recognize the key features that many employer-sponsored plans share:

  • Your employer automatically deducts your contributions from your paycheck. You may never even miss the money--out of sight, out of mind.
  • You decide what portion of your salary to contribute, up to the legal limit. And you can usually change your contribution amount on certain dates during the year.
  • With 401(k), 403(b), 457(b), SARSEPs, and SIMPLE plans, you contribute to the plan on a pretax basis. Your contributions come off the top of your salary before your employer withholds income taxes.
  • Your 401(k) or 403(b) plan may let you make after-tax Roth contributions--there's no up-front tax benefit but qualified distributions are entirely tax free.
  • Your employer may match all or part of your contribution up to a certain level. You typically become vested in these employer dollars through years of service with the company.
  • Your funds grow tax deferred in the plan. You don't pay taxes on investment earnings until you withdraw your money from the plan.
  • You'll pay income taxes and possibly an early withdrawal penalty if you withdraw your money from the plan.
  • You may be able to borrow a portion of your vested balance (up to $50,000) at a reasonable interest rate.
  • Your creditors cannot reach your plan funds to satisfy your debts.

Contribute as much as possible

The more you can save for retirement, the better your chances of retiring comfortably. If you can, max out your contribution up to the legal limit. If you need to free up money to do that, try to cut certain expenses.

Why put your retirement dollars in your employer's plan instead of somewhere else? One reason is that your pretax contributions to your employer's plan lower your taxable income for the year. This means you save money in taxes when you contribute to the plan--a big advantage if you're in a high tax bracket. For example, if you earn $100,000 a year and contribute $10,000 to a 401(k) plan, you'll pay income taxes on $90,000 instead of $100,000. (Roth contributions don't lower your current taxable income but qualified distributions of your contributions and earnings--that is, distributions made after you satisfy a five-year holding period and reach age 59½, become disabled, or die--are tax free.)

Another reason is the power of tax-deferred growth. Your investment earnings compound year after year and aren't taxable as long as they remain in the plan. Over the long term, this gives you the opportunity to build an impressive sum in your employer's plan. You should end up with a much larger balance than somebody who invests the same amount in taxable investments at the same rate of return.

For example, you participate in your employer's tax-deferred plan (Account A). You also have a taxable investment account (Account B). Each account earns 8 percent per year. You're in the 28 percent tax bracket and contribute $10,000 to each account at the end of every year. You pay the yearly income taxes on Account B's earnings using funds from that same account. At the end of 30 years, Account A is worth $1,132,832, while Account B is worth only $757,970. That's a difference of over $370,000. (Note: This example is for illustrative purposes only and does not represent a specific investment.)

Capture the full employer match

If you can't max out your 401(k) or other plan, you should at least try to contribute up to the limit your employer will match. Employer contributions are basically free money once you're vested in them (check with your employer to find out when vesting happens). By capturing the full benefit of your employer's match, you'll be surprised how much faster your balance grows. If you don't take advantage of your employer's generosity, you could be passing up a significant return on your money.

For example, you earn $30,000 a year and work for an employer that has a matching 401(k) plan. The match is 50 cents on the dollar up to 6 percent of your salary. Each year, you contribute 6 percent of your salary ($1,800) to the plan and receive a matching contribution of $900 from your employer.

Evaluate your investment choices carefully

Most employer-sponsored plans give you a selection of mutual funds or other investments to choose from. Make your choices carefully. The right investment mix for your employer's plan could be one of your keys to a comfortable retirement. That's because over the long term, varying rates of return can make a big difference in the size of your balance.

Research the investments available to you. How have they performed over the long term? Have they held their own during down markets? How much risk will they expose you to? Which ones are best suited for long-term goals like retirement? You may also want to get advice from a financial professional (either your own, or one provided through your plan). He or she can help you pick the right investments based on your personal goals, your attitude toward risk, how long you have until retirement, and other factors. Your financial professional can also help you coordinate your plan investments with your overall investment portfolio.

Finally, you may be able to change your investment allocations or move money between the plan's investments on specific dates during the year (e.g., at the start of every month or every quarter).

Know your options when you leave your employer

When you leave your job, your vested balance in your former employer's retirement plan is yours to keep. You have several options at that point, including:

  • ·Taking a lump-sum distribution. This is often a bad idea, because you'll pay income taxes and possibly a penalty on the amount you withdraw. Plus, you're giving up continued tax-deferred growth.
  • Leaving your funds in the old plan, growing tax deferred (your old plan may not permit this if your balance is less than $5,000, or if you've reached the plan's normal retirement age--typically age 65). This may be a good idea if you're happy with the plan's investments or you need time to decide what to do with your money.
  • Rolling your funds over to an IRA or a new employer's plan if the plan accepts rollovers.

This is often a smart move because there will be no income taxes or penalties if you do the rollover properly (your old plan will withhold 20 percent for income taxes if you receive the funds before rolling them over). Plus, your funds will keep growing tax deferred in the IRA or new plan.

This article was provided by Forefield and distributed by Lawrence Sprung.

Group Term Life Insurance

Group term life insurance is simply term insurance issued to people who belong to a group that has a common interest or association, such as an employer, a trade, or a school affiliation. Premiums increase annually or in "bands" of three- or five-year periods. Group term life insurance offers pure financial protection against premature death (there is no cash value component with term insurance, as there is with permanent insurance). For an employer, group term life insurance is a convenient way to offer employees easy-to-buy, affordable life insurance coverage.
Employers often provide a flat amount of coverage, such as $10,000 per employee. Many employers offer coverage that is a multiple of an employee's earnings, such as two times his or her annual salary.

Eligibility information

As an employer, you can choose to include all of your employees in a group term life insurance plan, or select only a class of employees, such as managers. You can also exclude certain employees from coverage. For instance, you could require employees to work a minimum number of hours per week, such as 20, before they would qualify for coverage. You could also exclude employees based on the number of months worked per year, such as requiring at least five months of work in order to obtain coverage. Or, employees may have to have been employed for a certain period of time before they are eligible to participate.

A business can start group coverage with as few as 2 employees, though most employers begin thinking about offering coverage when they have 10 or more employees. The number of employees may determine whether an insurer will offer immediate coverage without evidence of insurability. Plans that limit coverage to $50,000 or less usually skip any medical underwriting requirements; amounts over $50,000 may require individuals to answer medical questions and satisfy underwriting standards to be accepted.

Bells and whistles

Some group term policies may offer supplemental coverage (for a spouse) or dependent coverage (for children). These coverage amounts often carry limitations. For instance, the spousal coverage may be limited to 50 percent of the employee's amount, while dependent coverage may be a flat amount, such as $2,000.
Some policies also offer an accelerated death benefit that allows an employee with a terminal illness to collect a percentage of his or her coverage in advance. When employees leave your firm or retire, they may also be able to keep the coverage as personally owned term insurance, or convert the group term to permanent life insurance. Available options vary among insurers, so be sure to ask about features that are important for your business needs and for your employees.

What's in it for the employees?

Essentially, group term coverage can represent free life insurance for an employee. But because many employers limit group term coverage to $50,000, employees should often think of this coverage as supplemental to their own personal life insurance plans, not as their main source of protection.

Employers often stop at $50,000 of coverage for tax reasons. The cost to provide coverage of up to the $50,000 limit is deductible by the employer but not includable in the income of the employee. Also, an employee's beneficiary will not pay federal income taxes on the death benefits. A state may, however, require income taxes on the death benefits.

Employers that pay for more than $50,000 of group term coverage must include the "economic value" of the cost of the excess insurance as taxable income to the employee (reported on their W-2s as "additional compensation"). One way around these limitations is for an employer to pay for the first $50,000 of coverage and allow employees to pay for any optional coverage in excess of this amount.

What's in it for the employer?

As the employer, you can offer different coverage amounts for different classes of employees. For example, you might buy $50,000 of coverage for your customer service personnel, but buy coverage for your engineers equal to three times their annual salaries. The downside is that if you do "discriminate" among different classes of employees, the economic value of the cost of the first $50,000 of coverage may be taxable to your key employees (i.e., certain officers, highly compensated individuals, and owners with 5 percent or more ownership).

As mentioned, you may pay all or part of the cost of group life coverage, and many employers pass on the costs of any additional features to their employees. The good news, from a federal income tax standpoint, is that group term life premiums paid by an employer are tax deductible by the business, even if your plan is discriminatory.
Also note that the way your business is organized will affect your business tax benefits. Owners of more than 2 percent of an S corporation, partners, and sole proprietors are not considered employees, so premiums paid for their group term insurance are generally not tax deductible. In a corporation that is not an S corporation, premiums paid for all employees (including owner-employees) are generally tax deductible.

Cost concerns

Typically, you can expect to pay a set amount per $1,000 of coverage per employee (e.g., $.10 per $1,000 per month). Premium costs depend on the coverage amounts you want to provide and whether medical underwriting is required. Premium costs will also depend on the number of employees, their ages, their genders, and the type of business you operate. For instance, a commercial fishing fleet will probably pay more in premiums than a bookstore.

For any type of business, though, you can expect costs to rise as your employee population ages. In general, the larger the group of employees, the lower the premium charged. And just like many group health plans, an insurer may also charge higher life insurance premiums for smokers than for nonsmokers.

This article was provided by Forefield and distributed by Lawrence Sprung.

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