There has been much discussion about the temporary repeal and reinstatement of the federal estate tax.
And, for your own information, here is a brief summary of some of the current proposals.
There are three major bills in Congress:
Senate Bill 722:
1) Makes permanent the 2009 $3.5 million exemption and top 45% tax rate
2) Reunifies the estate and gift tax exemption (the gift tax exemption is $1 million in 2009)
3) Indexes the exemption for inflation
4) Allows for exemption portability (i.e., allows the transfer of a decedent's unused exemption to his or her surviving spouse)
House Bill 2032:
1) Makes permanent the exemption level at $2 million
2) Establishes top tax rates of 45% for estates valued between $2 million and $5 million, 50% for estates valued at $5 to $10 million, and 55% for estates valued over $10 million
3) Reunifies the estate and gift tax exemption
4) Indexes the exemption for inflation
5) Allows for exemption portability
6) Restores the state death tax credit
House Bill 436:
1) Makes permanent the 2009 $3.5 million exemption and top 45% tax rate
2) Reunifies the estate and gift tax exemption
3) Limits the valuation discount for family limited partnerships (FLPs)
4) Provides strict valuation rules for the transfer of non-business assets
And, the Congressional Budget Office has modeled these four options for Congress:
1) Makes permanent the exemption level at $5 million
2) Establishes the tax rate to equal the top rate on capital gains (currently 15% in 2010 and 20% thereafter)
3) Indexes the exemption for inflation
4) Disallows the deduction for state death taxes
Makes the same changes as Option 1, but a two-tiered rate would be used -- the first $25 million of taxable assets would be subject to the top capital gains rate, then taxable transfers above $25 million would be taxed at 30% (and the $25 million threshold would be indexed for inflation)
Makes permanent the 2009 $3.5 million exemption and top 45% tax rate
1) Repeals the estate tax in 2010
2) Retains the $1 million gift tax exemption
3) Institutes a carryover basis regime
This article was provided by Forefield and distributed by Lawrence Sprung.
There has been much discussion about the temporary repeal and reinstatement of the federal estate tax.
There are two fundamental ways that you can profit from owning bonds: from the interest that bonds pay, or from any increase in the bond's price. Many people who invest in bonds because they want a steady stream of income are surprised to learn that bond prices can fluctuate, just as they do with any security traded in the secondary market. If you sell a bond before its maturity date, you may get more than its face value; you could also receive less if you must sell when bond prices are down. The closer the bond is to its maturity date, the closer to its face value the price is likely to be. Though the ups and downs of the bond market are not usually as dramatic as the movements of the stock market, they can still have a significant impact on your overall return. If you're considering investing in bonds, either directly or through a mutual fund or exchange-traded fund, it's important to understand how bonds behave and what can affect your investment in them.
The price-yield seesaw and interest rates
Just as a bond's price can fluctuate, so can its yield--its overall percentage rate of return on your investment at any given time. A typical bond's coupon rate--the annual interest rate it pays--is fixed. However, the yield isn't, because the yield percentage depends not only on a bond's coupon rate but also on changes in its price. Both bond prices and yields go up and down, but there's an important rule to remember about the relationship between the two: They move in opposite directions, much like a seesaw. When a bond's price goes up, its yield goes down, even though the coupon rate hasn't changed. The opposite is true as well: When a bond's price drops, its yield goes up. That's true not only for individual bonds but also the bond market as a whole. When bond prices rise, yields in general fall, and vice versa.
What moves the seesaw?
In some cases, a bond's price is affected by something that is unique to its issuer--for example, a change in the bond's rating. However, other factors have an impact on all bonds. The twin factors that affect a bond's price are inflation and changing interest rates. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.
If inflation means higher prices, why do bond prices drop?
The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes. Let's say a five-year bond pays $400 every six months. Inflation means that $400 will buy less five years from now. When investors worry that a bond's yield won't keep up with the rising costs of inflation, the price of the bond drops because there is less investor demand for it.
Why watch the Fed?
Inflation also affects interest rates. If you've heard a news commentator talk about the Federal Reserve Board raising or lowering interest rates, you may not have paid much attention unless you were about to buy a house or take out a loan. However, the Fed's decisions on interest rates can also have an impact on the market value of your bonds.
The Fed takes an active role in trying to prevent inflation from spiraling out of control. When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. Why? To try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy. When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well. That's because bond issuers must pay a competitive interest rate to get people to buy their bonds. New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. Prices of existing bonds fall. That's why bond prices can drop even though the economy may be growing. An overheated economy can lead to inflation, and investors begin to worry that the Fed may have to raise interest rates, which would hurt bond prices even though yields are higher.
Falling interest rates: good news, bad news
Just the opposite happens when interest rates are falling. When rates are dropping, bonds issued today will typically pay a lower interest rate than similar bonds issued when rates were higher. Those older bonds with higher yields become more valuable to investors, who are willing to pay a higher price to get that greater income stream. As a result, prices for existing bonds with higher interest rates tend to rise.
Example: Jane buys a newly issued 10-year corporate bond that has a 4% coupon rate--that is, its annual payments equal 4% of the bond's principal. Three years later, she wants to sell the bond. However, interest rates have risen; corporate bonds being issued now are paying interest rates of 6%. As a result, investors won't pay Jane as much for her bond, since they could buy a newer bond that would pay them more interest. If interest rates later begin to fall, the value of Jane's bond would rise again--especially if interest rates fall below 4%. When interest rates begin to drop, it's often because the Fed believes the economy has begun to slow. That may or may not be good for bonds. The good news: Bond prices may go up.
However, a slowing economy also increases the chance that some borrowers may default on their bonds. Also, when interest rates fall, some bond issuers may redeem existing debt and issue new bonds at a lower interest rate, just as you might refinance a mortgage. If you plan to reinvest any of your bond income, it may be a challenge to generate the same amount of income without adjusting your investment strategy.
All bond investments are not alike
Inflation and interest rate changes don't affect all bonds equally. Under normal conditions, short-term interest rates may feel the effects of any Fed action almost immediately, but longer-term bonds likely will see the greatest price changes. Also, a bond mutual fund may be affected somewhat differently than an individual bond. For example, a bond fund's manager may be able to alter the fund's holdings to minimize the impact of rate changes. Your financial professional may do something similar if you hold individual bonds.
Focus on your goals, not on interest rates alone
Though it's useful to understand generally how bond prices are influenced by interest rates and inflation, it probably doesn't make sense to obsess over what the Fed's next decision will be. Interest rate cycles tend to occur over months and even years. Also, the relationship between interest rates, inflation, and bond prices is complex, and can be affected by factors other than the ones outlined here. Your bond investments need to be tailored to your individual
financial goals, and take into account your other investments. A financial professional can help you design your portfolio to accommodate changing economic circumstances.
The inflation/interest rate cycle at a glance
- Inflation goes up.
- Bondholders worry that the interest they're paid won't buy as much in the future because inflation is driving costs higher.
- The Fed may decide to raise interest rates to try to control inflation. To get investors to lend money by purchasing bonds, bond issuers must pay higher interest rates.
- When interest rates go up, bond prices go down.
- Higher interest rates make borrowing money more expensive. Economic growth tends to slow, which means less spending.
- With less demand for goods and services, inflation levels off or falls.
- With lower inflation, bond investors are less worried about the future purchasing power of the interest they
- receive. Therefore, they may be willing to accept lower interest rates on bonds, and prices of older bonds with higher interest rates tend to rise.
- Interest rates in general fall, fueling economic growth and potentially a new round of inflation.
This article was provided by Forefield and distributed by Lawrence Sprung.
College cost trends
Every October, the College Board releases its Trends in College Pricing report that highlights college cost increases and trends. While costs can vary significantly by region and individual college, the College Board publishes average cost figures, which are based on its survey of 3,500 colleges across the country.
Here are highlights from its latest report:
• At four-year public colleges for in-state students, tuition, fees, and room and board increased by 5.9% from last year, with the total cost for 2009/2010 averaging $19,388
• At four-year public colleges for out-of-state students, tuition, fees, and room and board increased by 6.0% from last year, with the total cost for 2009/2010 averaging $30,196
• At four-year private colleges, tuition, fees, and room and board increased by 4.3% from last year, with the total cost for 2009/2010 averaging $39,028
“Total average cost” includes tuition and fees, room and board, books and supplies, transportation, and a small amount for miscellaneous expenses.
To read the Trends in College Pricing report, visit www.trends-collegeboard.com.
Student aid trends
The College Board is quick to point out that the average "sticker price" cost figure is not necessarily representative of what most students pay. That's because almost two-thirds of undergraduate students receive grants that reduce the actual price of college. The largest provider of grant aid is individual colleges, followed by the federal government, private sources and employers, and state governments.
For the 2009/2010 year, the College Board estimates that students at public colleges will receive an average of $5,400 in grant aid from all sources and federal tax benefits, and students at private colleges will receive an average of $14,400 in grant aid from all sources and federal tax benefits. Federal tax benefits include the American Opportunity tax credit (formerly called the Hope credit), the Lifetime Learning tax credit, and the deduction for qualified higher education expenses.
Every year, the College Board also releases a sister report to Trends in College Pricing, called Trends in Student Aid, that examines student financial aid in more detail. To read this report, visit http://www.trends-collegeboard.com/.
This article was provided by Forefield and distributed by Lawrence Sprung.
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.
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.
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.
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.
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.
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.
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