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ON THE MONEY: Making contributions to Roth IRAs

October 30, 2018 GMT

So, you have decided to open a Roth IRA at a financial institution of your choosing and you intend to make a contribution in 2018 of an amount that cannot be larger than $6,500 if you are beyond age 50 or $5,500 if you are younger. Now what? Two things to remember, first, you will make no reference to this contribution on your 2018 tax return, and by April 15, 2019 your financial institution will send you a form 5498, documenting the amount of the contribution, as well as the value of the account as of Dec. 31, 2018. This activity is certainly straightforward.

By way of review, here are the income limits for a Roth contribution in 2018: for single filers, the maximum modified adjusted gross income is $135,000, with a reduced amount of contribution available if your MAGI is more than $120,000. If you are married and file jointly, the phase out starts at $189,000 and no contribution is available if your MAGI is greater than $199,000. Remember that both spouses may contribute up to the maximum to a Roth if their income is not beyond these limits, even if they are older than 70.

What if you make a Roth IRA contribution during 2018, but your income skyrockets at year end and you wind up with total income greater than the maximum allowable for a Roth contribution? What then? In this case, if you correct the error by April 17, 2019, your financial institution will refund your money and send you a 1099-R form, but with the proper codes to indicate that this distribution is not taxable. If you had already filed your tax return by the time you made the correction, you could still correct the error by October 2019 by filing an amended return.

If you so choose, you could direct your financial institution to treat the excess contribution amount as a 2019 Roth contribution. Even though the result would be as if you never made the contribution, you must pay income tax on any gains that were credited to your account during the year. If your excess contribution is not corrected in time, there is a 6 percent tax penalty levied each year that the excess contribution remains in the account. Take it from me; the actual calculation of the taxable amount is quite complicated.

If you are considering converting some or part of your traditional IRA to a Roth, the most important thing to remember is that it is a taxable event. A corollary of that is: do you have enough monies that are not in a qualified plan to pay the taxes that will be due when you file your 2018 tax return? The taxes themselves will be based on ordinary tax rates, and the increased income you must report may thrust you into a higher tax bracket. If you are receiving Social Security benefits, the increased income may subject a larger percentage of your Social Security benefits to taxation.

If you choose to pay the taxes out of your conversion amounts and you are younger than 59½, you must pay a 10 percent penalty on the monies that you withdraw to pay the tax. If this is your plan, then don’t convert.

However, if your income is lower than usual; or, your IRA values are depressed; or, you have losses and other deductions to offset some of the income taxes due upon conversion; and, you are in good health and longevity runs in your family, a Roth conversion could be a sound strategy for you.

If you have a 401(k) from a former employer and are interested in a Roth conversion, you can convert your 401(k) values into a Roth IRA directly, but taxes are still due.

The flow of paperwork to document your conversion is: you will receive a 1099-R before tax time next year, disclosing the amount of the conversion and the fact that it is all taxable. This form has codes delineating the type and taxability of any distribution. The codes themselves are shown in box 7 of the 1099-R form, and with a conversion, the code will be either “7” if you are older than 59½, or “2” if you are younger. If you are younger than 59½, the converted amounts are not subject to the 10 percent early distribution penalty. In addition, you will receive a form 5498 in 2017 documenting the amount of the conversion, and the account values at year end, 2016.

In 2017 and before, it was possible to convert monies from a traditional IRA to a Roth and later change your mind (if the tax bite were too onerous), but the new tax law does not allow a taxpayer to reverse the conversion of a traditional IRA to a Roth beginning in 2018.