Roth IRA proponents are often heard to remark that one of the benefits of a Roth IRA is that first-time home buyers can withdraw up to $10,000 penalty free to use toward the purchase of their first home.  Those who are considering such a move should be made aware that the government’s definition of “first-time home buyer” also includes anyone who hasn’t owned a home in two years or more.  So, even if you’ve owned a home before, you can withdraw up to $10,000 from your Roth IRA to help meet qualified home acquisition costs.  And, the “first-time home buyer” doesn’t even have to be the owner of the Roth IRA; it can be the owner’s spouse, child, father, mother, grandfather, and grandchildren. 

$10,000 and only $10,000

Of course, the fact that the Roth IRA distribution can be used by so many different people does not mean that each person can get $10,000.  The limit of the distribution is $10,000 for the lifetime of the account owner.  Married couples who each own a Roth can take $10,000 each from their account.  I suppose that’s good news for someone who is an only child, and each parent owns a Roth; not such good news for a family with eleven children and just one Roth.

Qualified Acquisition Costs

The distributed funds must be used for expenses directly related to home acquisition: costs related to buying or building a home, plus any usual and reasonable settlement, financing, and closing costs.  You can’t use the funds to pay toward a home you already own and expect to do so penalty-free.  Mortgage repayment is not a “qualified acquisition expense”.  You can’t use the funds to buy furniture or for home repairs.    The Roth IRA funds distributed must be used before the close of the 120^th day after the distribution. 

Distribution Ordering Rules

First-in-first-out does not apply to disbursements from a Roth IRA.  In most cases, money is deposited into a Roth, interest is earned, more money is deposited, etc.  The money does not come out in the order that it was added to the account.  The first money to come out of a Roth IRA is taken from your contributions, regardless of when the contributions were made.  Next out would be money that you converted from a traditional IRA, lastly money that was earned.  

The key to using Roth IRA funds for home acquisition is to plan early.  Make sure the funds will be used within the 120 day time allotment, are used for a qualified acquisition expense, and make sure the funds taken will not be penalized or taxed.  If funds will be taxed, be sure you know how the taxes will be paid.

The tax cuts that were implemented by the George W. Bush administration are set to expire at the end of 2010.  The daily sound bites and media buzz lead one to believe that only the top tax brackets will be affected if these cuts expire.  That is not the case at all: if the tax cuts expire, all tax-paying Americans will be affected, some more than others.

The six tax brackets implemented under Bush were 10%, 15%, 25%, 28%, 33%, and 35%.  According to the Internal Revenue Service, less than 1% of taxpayers pay the 35% rate and less than 33%of taxpayers pay the 33% rate. Currently, most taxpayers are paying a marginal rate of 15% or 25%. 

If the Bush cuts expire, the six marginal tax rates will be replaced with 5 rates: 15%, 28%, 31%, 36%, and 39.6%.  The new rates translate to a tax bump from a few hundred to a few thousand dollars for most taxpayers. Regardless of your tax bracket, the expiration of the Bush cuts means that Americans will face higher tax rates, more taxes on investment income, fewer tax breaks for families, and a tougher estate tax.

Avoid Higher Taxes on Your Retirement Funds

Investors who have money in a traditional IRA will certainly pay more taxes on withdrawals in 2011 than in 2010.  So, why wait to until 2011 or beyond to start withdrawing funds?  In 2010, traditional IRA owners can roll their IRA over to a Roth IRA without income limits and other restrictions.

Now is the Time to Convert

There are three main reasons to convert a traditional IRA to a Roth IRA in 2010:

1. Investors can “lock in” the current tax rates and not risk the possible tax increase
2. There is a three-year window on paying the taxes due
3. Income limits are removed

Positive Side-effect

The removal of income limits to a Roth IRA provides a side effect that hasn’t gotten much press: national deficit reduction.  To convert from a traditional IRA to a Roth IRA entails paying taxes now that would not have been paid for years to come.  Investors who pay the conversion taxes now are able to permanently free their retirement income from taxation. The combination of benefits provided by conversion is so compelling that Americans are converting in large numbers, and will continue to do so through the end of the year.  The “pre-payment” of hundreds of billions of dollars in taxes will help reduce the federal deficit and get the American economy back on track.

Paying for a college education continues to be a challenge.  Not only is there tuition to consider, but the cost of books, lab fees, travel expenses, housing and meals, and a spending allowance.   Most families will seek some sort of financial aid to help cover the costs.  Since financial aid is need-based, families who have saved and invested well over the years to pay for college may find that they don’t qualify for financial aid when the time comes: they make too much money, or they have too much savings.  In that instance, financial aid will go to families who did not plan quite so well.  There is a way, however for a family to save the money they need for college and still qualify for financial aid:  start a Roth IRA.

Roth IRA as a College Fund

If you start making Roth IRA contributions when your child is small, a significant sum can accrue by the time the child is ready for college.  Since you’ve already paid the taxes on contributions you made to a Roth IRA, your funds can be left in the Roth account, earning interest tax-free.  You can use your Roth IRA to pay for all of your school-related expenses, as long as they are “qualified education expenses.”  Qualified education expenses include books, tuition, fees, supplies, and tuition that are paid to a properly accredited institution.  For room & board, you’re on your own: you can’t pay living expenses with your Roth IRA funds.  You can also use the funds to pay for yourself, your spouse, your children, your spouse’s children, your grandchildren, or your spouse’s grandchild. 

Financial Aid Considerations

Financial aid formulas usually do not take retirement savings into account, so any funds in the Roth will not be considered when applying for financial aid.  Other college savings options, like a Coverdale Education Savings Account or a state 529 savings account are considered for financial aid purposes.  A parent who has saved for college using a Roth IRA (all other things being equal) is much more likely to qualify for financial aid than a parent who saved using a Coverdale.

Of course, things are rarely as simple as they seem, and there is one flaw in using a Roth as a college savings vehicle: withdrawals from the account may be considered unearned income.  A boost in a family’s income affects their ability to qualify for financial aid.  Individuals should consult with their financial planner to develop a strategy for using Roth funds to pay for college.

The Federal Reserve has gotten much press lately from its’ announcement that consumers slashed their credit card debt by more than 7 billion dollars in May 2010.  That sounds like good news; at first glance, perhaps the economy is not as bad as it seems.  After all, 7 billion dollars is a lot of money for consumers to fork over to pay down credit card debt.  If only it were true.

Closer analysis of the facts reveals a less auspicious outlook.  The reason that credit card balances are declining isn’t because consumers are paying them off, it’s because banks are writing off delinquent balances as the borrowers default.  During the first quarter of 2010, credit card balances declined by 19.5 billion dollars; 18.7 billion dollars was written off by the banks.  Since the end of 2008, balances have dropped by over 127 billion dollars, much of that being written off by the banks.

Debts Don’t Go Away

Banks write off debt because they are required to do so by the Federal Reserve.  To do otherwise would distort a bank’s balance sheet by showing a large receivables asset that was actually not an asset at all, because it is uncollectable.

Debtors who have had balances written off are not out of the woods regarding payment of the debt.  Banks routinely sell written-off receivables for pennies on the dollar to collection agencies, who continue to try to collect the debt.  When a collection agency buys a debt, they become the owner of the debt and assume all rights of ownership, including the right to sue for payment.  Collection agencies can sue for payment up to the statute of limitations of the home state.

Your Roth IRA May Be At Risk

The Employee Retirement Security Income Act (ERISA) completely protects employer-sponsored plans from creditors (except former spouses and the IRS).  IRA’s are not covered by ERISA.  In a bankruptcy proceeding, the first one million dollars of an IRA can be exempt from creditors (depending on the source of the funds) but for anything short of bankruptcy, state law prevails.  There is no consistency in state laws regarding the vulnerability of IRA funds.

Most states exempt 100 percent of the funds while they are in the account; that is the case in New York, New Jersey, and Connecticut.  Laws vary regarding whether withdrawals are covered, and whether protections extend to heirs and former spouses.  Other states limit how much of the account is exempt; Nevada caps the account at five hundred thousand dollars, while other states – like California – exempt only what is “reasonably necessary” to support the account owner and dependents.  The “reasonably necessary” wording is problematic because it is open to interpretation and an invitation to lawyers to sue.

Put the Roth in a Trust

Financial advisors suggest that placing the Roth account into a trust can protect the account from creditors.  The time to take this action is before there is any sign of creditor problems on the horizon; otherwise the action could be deemed a fraudulent conveyance and be reversed.   As usual, such decisions are complex, and applicable laws will vary from state to state.  Individuals concerned about protecting their Roth from attacks by creditors should seek qualified advice.

Since Roth IRA’s were initiated in 1998, upper-income individuals have been unable to fully take advantage of the Roth’s ability to earn income tax-free.  2010 provides an opportunity for individuals with incomes over $100,000 to convert their traditional IRA to a Roth IRA.  Of course, the ability to convert brings with it a downside: not only are taxes due on the funds withdrawn from the IRA, the funds are also added to one’s annual income, and can put some into a higher tax bracket. 

Converting a traditional IRA to a Roth is a good idea for many, but the tax hit can be severe.  The tax hit is made worse when one is bumped into a higher tax bracket; why make the conversion if you’re going to pay a huge tax bill as a result?  Wasn’t the whole idea behind setting up and IRA in the first place to take a tax deduction today, when your tax rate is high, and withdraw the funds at retirement, when your tax rate would be lower?

Charitable Giving Offset

One way that individuals can avoid being bumped into a higher tax bracket by converting their traditional IRA to a Roth is through charitable giving.  Gifts can be deducted from income; generally, deductions are allowed up to 30% of Adjusted Gross Income for gifts of appreciable securities; 50% for cash donations.  Any income increase caused by converting traditional IRA funds is offset by the amount of the charitable contribution.

Donations can be made to any charity recognized by the IRS.  For those who need to make a large donation but can’t decide where to donate the money, a charitable gift account can be set up with a donor-advised fund provider.  Contributing to such a fund enables you to receive an immediate tax deduction but take your time deciding which charity gets the money. 

Donations not only benefit the charity, but the donor is able to:

• Convert more IRA funds to a Roth IRA while reducing the tax cost of the conversion
• Benefit from the potential future tax-free growth of a Roth IRA
• Support charitable causes

As with any tax-planning strategy, there could be additional considerations that apply to your particular situation.  Always consult with your tax advisor, so that your over-all personal goals are taken into consideration. 

2010 is the year to act.  Tax laws continue to change, and are once again under review by Congress and the Obama administration.  Those who have been considering making the change to a Roth are advised to consult with their tax advisor soon.

Have you ever done something that you later wished you hadn’t done?  As children, we could invoke the powerful “take-back” rule to reverse a poor decision.  As adults, we rarely have the luxury of a “take-back”.  When the economy is uncertain, the tax code is the size of a telephone book, and financial advisors sometimes misinterpret the rules, it’s easy to make a financial mistake.

IRA’s Now Have a “Take-back” Rule

IRA’s have a built-in take-back rule.  You can switch your IRA contribution from one type of IRA to another, or undo a conversion.  You can go from Roth to traditional or from traditional to Roth, subject to some restrictions.  You can use this rule to recover from a failed conversion, or simply because you changed your mind. You can even use this rule to reduce your taxes by reversing a conversion following stock market losses.

When to Use the Rule

Keep these uses in mind; you never know when you may need them:

• Failed conversion:  Let’s say that you converted a regular IRA to a Roth in February.  Later in the year, it becomes apparent that your income will exceed the allowed limit.  You can set up a new traditional IRA to replace the Roth, and it will be treated as if the original conversion was simply a rollover to a new traditional IRA.

• Unable to pay the taxes:  If you make the conversion and find that you can’t pay the taxes, or that the increased income will jeopardize your Social Security or other entitlement, you can set up a traditional IRA to replace the Roth IRA, and the unwanted conversion disappears.

• Stock market losses after conversion:  If you converted your traditional IRA when the stock market was doing well, then you paid a lot of taxes on the converted funds.  If the market then took a dive and you lost money, you can reverse the conversion, and then do a new conversion later.  You will pay fewer taxes on the conversion. 

• Regular contribution to traditional IRA. If you make a contribution to a traditional IRA and then wish you had contributed that money to a Roth IRA instead, you can substitute a Roth IRA for the traditional IRA as the recipient of that contribution.  This also works in reverse; you can change your Roth contribution to a traditional IRA contribution.

It’s rare that the IRS will let you reverse a decision; they are quick to add interest and penalties when someone makes a mistake.  In this instance, though, the ability to recharacterize an IRA is built into the tax code.  Thanks to Congress for realizing that in an uncertain economy, taxpayers need a “take-back” rule.

Many investors have a false sense of security when it comes to keeping track of contributions to their Roth IRA.  It is assumed that the brokerage or bank is keeping adequate records, and that copies of the records will be readily available if they are needed.

Such is not always the case.  As a CPA recently wrote:  

‘I’ve prepared too many tax returns where no one knows what their basis is – in their retirement funds, or in their taxable accounts. Brokers are not always very helpful. They don’t necessarily keep records forever, either. (and) with all these investment house mergers, past data does not always carry over to the new firm…I see a lot of people get “double taxed” as a result. Particularly when it comes to IRAs that have basis in them’

Keep Your Own Records

Typically, one keeps financial records for seven years, for tax purposes.  In the case of tax-deferred investments, it is recommended that records be kept until seven years after the investment has been liquidated.  If the Roth IRA is to be passed on to heirs, that means keeping the account records beyond death.

The primary reason to keep the records that long is the issue of basis.  Basis is what you have contributed to the account, as opposed to what you have earned on the account.  In a Roth IRA, the basis is not taxed upon withdrawal.  Depending on the purpose and timing of a withdrawal, earnings may or may not be taxed.  Either way, it will be necessary to know your basis.

5 Reasons to Keep Your Own Records

There are five compelling reasons to consider keeping your own Roth records.  They are:

1.  Tax laws are subject to change: it’s good to have proof of your IRA contributions and conversions.  Keep the conversion tax forms indefinitely.

2.  If you change custodians: when you change custodians you could lose all cost basis information held by the original custodian

 3.  Inheritance taxes:  Basis changes from generation to generation.  Having a complete account records provides a chronology of the account.

 4.  Support legal action: in these days of corporate bailouts and bankruptcies, contributions could be lost and then recovered in a lawsuit.  

 5.  Differing state tax laws: sometimes state tax law differs from federal law.  Just because withdrawals are untaxed at the federal level does not mean they will be untaxed by your state.  

 CPA’s recommend that you keep your records in a fire-resistant box.  When you have reviewed your monthly statements, file them away, and keep the box in a safe place.

Discussion continues as to the better retirement vehicle: a traditional IRA or a Roth IRA.  Much of the disagreement centers around future tax rates; will they go up, or will they go down?  And, how will changes in the tax code affect IRA’s of either type?  Economists can’t seem to agree.  The following axiom regarding economists holds true in this situation:

• For every economist’s opinion, there exists an equal and opposite economist’s opinion.

Two Schools of Thought

The adversaries in this discussion fall into two camps: those who believe that you should invest in a Roth IRA because taxes will certainly go up, and those who believe that the future is uncertain, so take what you can get now.  Let’s have a look at their arguments.

Taxes Will Go Up, So Invest in a Roth

Proponents of the “taxes will go up” position state that in the future, tax rates will almost certainly go up.  Currently, they say, there are multiple financial crises to be concerned with: health care, increased unemployment benefits, hard-hit pension funds, under-funded social security, and an expensive war.  Somehow, all of this must be paid for, so it is inevitable that taxes will go up.

If tax rates go up, investors who have contributed funds to a traditional IRA with the hope that their tax rate will be lower when they retire are in for a big disappointment.  They may, in fact, be paying more tax on their future withdrawals instead of less tax.

The solution, according to this camp, is to pay the tax on your contributions now while rates are low.  Then, when the money is withdrawn, there will then be no tax due at all on the withdrawals.   Having a Roth, they say, removes any uncertainly about what future tax rates will be, because there will be no tax on withdrawals at all.  With a traditional IRA, you have no choice but to start making withdrawals at age 70 ½ and pay whatever the prevailing tax rate is.

The Future is Uncertain, So Take What You Can Get Today

The proponents of the “uncertain future” position say that knows one knows what the future will bring, so take what you can get today, i.e., an income deduction for your contributions to a regular IRA.  The thinking here is similar to the “eat, drink, and be merry, for tomorrow we die” philosophy in its fatalism: the only thing we can be certain about is today.

Income taxes could increase, or not.  Capital gains tax could increase, or not.  The US could institute a national sales tax, of a VAT tax, or a flat-rate tax.  Or not.  Who knows?  Everyone’s crystal ball seems to be broken.

It’s the uncertainty of future tax policy that prompts this camp to preach in favor of the traditional IRA.  Take the tax deduction today.  Let tomorrow take care of itself.

The Middle Ground

The truth is that future changes in the tax code could increase or decrease the value of either type of account, say those who assume the middle ground.  Middle-of-the-roaders recommend investing in several different retirement vehicles, according to one’s personal circumstances and attitude toward risk.

Who knows what the future will hold?  No one, but everyone has an opinion.  Just ask any economist.

Many investors with traditional IRA’s have been unable to convert to a Roth IRA due to income limits and other restrictions.  However, those limits have been lifted in 2010, so investors who have waited for “just the right time” to convert will be able to do so in 2010.

The Time is Right to Convert

There are three compelling reasons to convert a traditional IRA to a Roth IRA in 2010:

1.  The decline in the stock market in 2007 and 2008 means that earnings on a traditional IRA were lower than normal, and consequently less tax will be due at the time of conversion.

• Taxes are due on a Roth conversion because investors were able to deduct the contributions from their taxable income when they were first deposited. The investor’s tax bill at the time of conversion also depends on several other factors, including their income, their federal tax bracket and their state tax rate.

2.  There is a three-year window on paying the taxes due

3.  Income limits are removed

Proceed Cautiously

Converting to a Roth IRA can be beneficial if it is done correctly and with the help of a financial advisor.  Here are a few areas of concern:

• Pay attention to how conversion taxes are calculated, and be aware of your tax bracket.
• Don’t use IRA funds to pay the conversion taxes.  Money that is converted is exempt from penalties, but money withheld to pay taxes isn’t.
• Whatever money you withdraw from your IRA increases your income, and with the increase in income you may experience an increase in Medicare premiums; you could also affect your Social Security income.

The Benefits of a Roth IRA

There are other benefits to converting your traditional IRA to a Roth IRA, including:

• All withdrawals are tax free if you are at least 59 ½ and your account is at least five years old.
• There are no mandatory minimum distributions.
• There is no age limit on contributions.
• There are qualifying exceptions that allow a withdrawal without paying penalties, including medical and educational expenses, disability, and buying a first home.
• Investors gain more control over how funds are invested by choosing the self-directed option
• IRA funds bypass probate to the direct benefit of heirs.

The decision whether to convert to a Roth IRA is a personal decision, and should be done in consultation with family members and a trusted financial advisor.  There is no “one size fits all” answer to the conversion conundrum.  All factors should be considered, including today’s tax rates, anticipated future tax rates, how the conversion taxes will be paid, the size of our estate, and our overall estate plan.

Anyone wanting to get a good understanding of retirement plans should have lots of time on their hands, some good reading glasses, and some aspirin.  The number of retirement plans available is overwhelming; there are individual retirement plans (IRA’s), and employer-sponsored retirement plans (Defined Benefit, Defined Contribution, 401K’s, Profit-Sharing plans, ESOP plans, Simple plans, Money-Purchase pension plans, and SEPs.)

Let’s take a look at the two Individual Retirement Plans (IRA’s), and see how they compare.

Traditional Individual Retirement Plan (IRA)

Regular IRA’s were created in 1975, and are no longer offered. Traditional IRA’s have been around since 1986.  They have always been a popular investment product, because the contributions made (up to $5,000 in 2010; $6,000 if you are over 50) are deductible from your income for tax purposes.  If you earn $85,000 in 2010 and contribute $5,000 to your IRA, your taxable income drops to $80,000.  The $5,000 drop saves you not only the tax on the $5,000 ($1,400 @ 28%), it drops you to a 25% marginal rate which can save you up to $14,000 in taxes, depending on your filing status and other factors.

Traditional IRA’s are a good tactical maneuver if you want to drop into a lower tax bracket.  Since no taxes have been paid on the deposit, you will have to pay taxes when the money is withdrawn.   Withdrawals must be made starting at age 70 ½.  When withdrawn, the money is taxed as if it was ordinary income.  Most retirees are in a lower tax bracket at retirement age, so the theory is that the withdrawal will be taxed at a lower rate than if taxes were paid prior to deposit.

Roth IRA

Roth IRA’s were established in 1997.  The tax structure of a Roth is substantially different from that of the Traditional IRA.  Taxes on contributions made to a Roth are paid prior to depositing the money.  Consequently, the account owner has better access to his account funds, and the investment of funds can be done either by an account custodian or the account owner (self-directed).  Further advantages of a Roth IRA over a Traditional IRA are:

• Direct contributions can be withdrawn tax-free at any time
• Up to $10,000 in earnings can be withdrawn for the purchase of the account owner’s first home
• Assets can be passed on to heirs
• There are no age-based distribution rules.  Funds can be withdrawn once the account is five years old.

Growth is Not Guaranteed

Both the Traditional IRA and the Roth IRA are investment-based retirement accounts.  The key word here is “investment”.  Investment’s don’t always earn money, even when they are invested in blue-chip, stable companies.  Markets and economies can crash, and your investment could suffer.

Each person’s circumstances will vary, and it is difficult to choose wisely unless all of the circumstances are known.  Choosing an IRA account is always a wise decision; which one is best for you is between you and your financial advisor.