I love getting and answering questions. Often, it’s too late, a reader already did something, and enough time has passed that there’s little to be done. When I’m contacted first and can save a reader from a potential mistake, that’s a good day for me.

I found this one particularly intriguing. First, the question from my reader at JoeTaxpayer.com:

Thanks for all of the great information you have provided! I have a question that I’m hoping you can shed some light on. My father passed and left his IRA to my brother and me, each of us inheriting a 50% share of the account. My brother is proposing to sign over his share to my name, and then have me cash out his 50% amount because I’m in a much lower income income tax bracket and live in Florida with no state income tax. Then he suggests that I write him a check for the amount I receive, after proper taxes are withheld according to MY residency and tax bracket. My question is, is this even legal? What are the implications of doing this? He says his tax attorney says it’s completely legal, but something doesn’t seem right about it to me, I somehow feel like this is backdoor way at tax evasion. Thanks for your help!

My response – sorry for your loss. Forgive me, I’m forgetting the exact word here. The meaning is that when one looks at the whole picture, what do they see?

a) disclaim IRA inheritance – no problem
b) withdraw more than RMD at your rate – no problem
c) gift (up to $14,000 per year with no paperwork required) – no problem

Three separate transactions each being fine, but when strung together are in fact, tax evasion. I am not a lawyer, nor a CPA. I am self-educated in this field and an author with passion. I’ve read enough to know that in the case of an audit, these events clearly come together with the intent to defraud. In fact, (a) the disclaimer, while legal, wasn’t a true disclaimer, it came with strings and an expectation that you’d give the money back. The advice I’d give a family member, friend, or reader is to avoid such transactions. Your Spidey-senses told you this can’t be the right thing to do, and it really isn’t. I’m afraid your brother will inject “but Joe said ‘audit’ and we’d never get audited.” I have a 14 year old and my advice to her has always been if you are wondering what the odds are are of being caught, you know you’re doing something wrong. On a lighter note, the attorney is actually proposing tax evasion, and should be disbarred. I’d say jailed as well, but I don’t wish to pay for this guy’s room and board.

This was my response, and I was confident of its accuracy. But the word I was missing was driving me crazy. Fortunately, an online request at the Usenet group I frequent and am a moderator, misc.taxes.moderated, resulted in a response. Step Transaction Doctrine. Indeed, I got it right, the definition at USLegal.com shows “In short, the tax liability should be determined by viewing the transaction as a whole, disregarding one or more non substantive, intervening transactions taken to achieve the final result.” To put it into layman’s words – “They think they are taking a series of legal steps that, if done all at once, would result in underpayment of tax. The idea is that the IRS has the ability to ignore the middle steps and look just at the result.”

Simply put, these three transactions combined as suggested form one larger transaction that is tax evasion. As I wrote the response to my reader, what I found remarkable is the suggestion from the Tax Attorney whom you’d expect to be knowledgeable on such matters. It took me a few hours to track down the right principle that applies in this matter, shouldn’t a legitimate tax attorney know this as well? In my post “Let’s Kill All the Lawyers,” it seemed a lawyer stepped out of his area of expertise, but in this case, this was something a tax attorney should get right, period.

The tax deadline, April 15th is nearly here and if you’ve not caught my Last Minute Tax Tips if You’re Still Working on Your Tax Return, it’s a good time to do so.

Here, I focus on the Roth IRA, and its cousins, the Roth 401(k) and the Traditional IRA. As you work on your return, consider whether you’d like to make a deposit to your IRA for 2012. Even though 2012 is over, you have until April 15th to deposit to your IRA.

For 2012 the phaseout range for deducting an IRA contribution when you are covered by a retirement plan at work are as follows:

• For single filers: $58,000 to $68,000
• For head of household filers: $58,000 to $68,000
• For married couples filing jointly: $92,000 to $112,000
• For married couples filing separately: $0 to $10,000

The Roth IRA income phase-out ranges are as follows:

• For single filers: $110,000 to $125,000
• For head of household filers: $110,000 to $125,000
• For married couples filing jointly: $173,000 to $183,000
• For married couples filing separately: $0 to $10,000

If you are beyond the range to deposit to a Roth, you can still deposit money to a traditional IRA but with no deduction. You may have the opportunity to convert it to Roth with no tax due if you have no pre-tax traditional IRA money or with prorated tax due based on the ratio of money that’s pre tax vs post tax.

You may deposit $5000 or if you were 50 or older in 2012, $6000 as long as you had earned income above this amount.

Normally, when you convert any retirement money to a Roth IRA, the tax is calculated and due for that tax year. 2010 was a special year. It was in 2010 that the Roth conversion cap of $100K adjusted gross income was lifted and the stampede to convert to Roth began. As an added incentive to convert, the taxpayer had an option – to claim the entire converted amount as income in 2010 or to take half in 2011 and half in 2012. If you converted in 2010, and took the two year option, consider this a friendly reminder that you should report that second half this year. If this doesn’t impact you, well, as Emily Litella used to say, ‘never mind.’

There are times the news is so exciting I’d like to queue up the musical piece Thus Spoke Zarathustra, you may know it as the theme from 2001; A Space Odyssey.
You know already that we’ve gone Over The Cliff and Back Again. But, chances are good you didn’t know that H.R.8, “An Act to extend certain tax relief provisions enacted in 2001 and 2003, and to provide for ex- pedited consideration of a bill providing for comprehensive tax reform, and for other purposes” had a hidden gem, the ability to convert funds from your traditional 401(k) to your Roth 401(k) when you wish.

The conversion isn’t right for everyone, but it opens up the opportunity to maximize your Roth savings like never before. First, the Roth 401(k) has only been available since 2006, compared to the traditional 401(k) being launched in the early ’80s. This means most 401(k) money is currently of the pretax variety even if many folk wish it weren’t.

Even if you started with the Roth 401(k) when it was introduced, your employer match is still pretax money. So, for those who wish to end their career with a 401(k) that will have no tax on withdrawal, now’s the time to start the conversion process. Before we queue the music again, let’s look at the situations that might make the Roth 401(k) conversion a compelling move:

• You are young, and in a bracket sure to go up in the next few years. A series of partial conversions each year to fill your present bracket can help minimize your lifetime tax bill.
• For whatever reason, you have losses that would otherwise offset ordinary income pushing you down into a lower bracket. Why not use some of it to offset a Roth Conversion?
• You’re well off. Enough that the estate tax will impact what you leave to your loved ones. A conversion now will reduce the tax your estate will need to pay and give your beneficiaries an inherited plan with no further taxes due.
• Your traditional pension plan(s)  will already put you in a high bracket at retirement, by biting the bullet now, you keep your retirement accounts from making this worse.
• And last – you wish to avoid The Phantom Tax Rate Zone – the strange situation where your Social Security gets taxed based on other income and a $1000 IRA (or 401(k)) withdrawal can raise your tax by 46.25% even though you are in the 15% bracket.

Fade to black, roll the credits…. the Roth IRA and Roth 401(k) aren’t for everyone, nor is the conversion a windfall for all. These are just another tool in our financial toolbox. The key is to be aware of what’s available to you and use it wisely.

Happy New Year!

The title I was using as I wrote the first draft of this article was “Poop Happens.” It was recommended to me by my puppy as he heard me tell my wife the story of  IRA paperwork gone bad. Sorry, I’m getting ahead of myself.

Early this year, a friend of a friend passed away. Wayne was too young, a heart attack that he didn’t survive. A 58 year old man, he would miss his daughter’s upcoming wedding. He left a nice insurance policy for his ex-wife, they had divorced on the best of terms. But, I later found out that when it came to his IRA, the broker saw the beneficiary form still had his “wife” listed, and they changed the account title into her name.

This is how things could have gotten messy. An inherited IRA must have RMDs (required minimum distributions) taken out starting in the year after the owner has passed or the entire balance withdrawn by the fifth year. The one exception is a spouse inherits the IRA. She is permitted to transfer the account into her name and treat it as if it were always hers. This means no RMDs are due until the year she turns 70-1/2, and she may make Roth conversions any time she wishes. If she keeps the account titled as a beneficiary IRA, she’s subject to RMDs, not allowed to convert to Roth, but she also can take larger withdrawals and not be subject to any penalty if she’s under 59-1/2.

In this circumstance, the woman was no longer the wife of the man who passed away, she had no option to transfer the IRA to her name, but more important, she’d be subject to a 50% penalty for any RMD required but not taken.

The lesson here is two-fold — When there is a change in your family situation, a birth, death, marriage, or divorce of you or any of your loved ones, take a moment to review your accounts beneficiaries on life insurance, retirement accounts, and any other account that include such designations. Second, the broker shared fault here, as even though the beneficiary form showed wife, the death certificate clearly showed that she and Wayne were divorced when he passed on.

This situation was caught in time to avoid any issue, fortunately. Hopefully, reading about mistakes such as this can help you avoid similar ones.

When writing on such an important and misunderstood topic such as IRAs and Conversions to Roth, I believe that authors need to spell out very clearly what they mean. If the reader misunderstands the intent of an article due to some ambiguous writing, the author may just as well have gotten his facts wrong. In an article I’ll share with you today, I’m not 100% sure of the author’s intent, I only know the right way to do the math, and that I tried to help clarify his discussion.

The article How To Convert A Non-Deductible IRA Into A Roth IRA recently appeared at Investopedia. It started with some great info, introducing the idea of the Roth IRA, Traditional IRA, and Tradition IRA with post tax money. But then this section had me wondering:

John Doe, a 30% taxpayer, has a Traditional IRA worth $200,000 on Dec. 31, 2012, of which $100,000 is non-deductible contributions. Doe wants to convert $100,000 of this IRA to Roth. Because Doe has $100,000 of non-deductible contributions in this Traditional IRA, you would think that he could convert the $100,000 of non-deductible contributions tax-free. Unfortunately, the IRS has a special formula that must be followed if you own an IRA with normal contributions.

Here’s how it works:
Tax-free Percentage = Total Non-deductible Contributions divided by
(Sum of year-end value of all IRA accounts + Conversion Amount) = $100,000/($200,000 + $100,000) = $100,000/$300,000
Tax-Free amount of Conversion = 33.3% (or $33,333)
Therefore, if John converts $100,000 to the Roth, he will have $33,333 ($100,000 x 33.3%) that is not-taxed and $66,667 ($100,000 x 66.7%) that will be taxed at his 30% tax rate.

Now, I’ll ignore the fact that there is no 30% bracket. Not all states recognize the Traditional IRA pre-tax status, so when I talk IRAs, it’s usually from a federal-only tax perspective. Let’s move on. The author states Doe wants to convert $100K of an IRA worth $200K. $100K is post-tax (“non-deducted”) money. Absent any further growth, this conversion takes place in 2013, as the author is looking back at Dec 31, 2012 in hindsight. On Dec 31, 2013, he has $100K in a Roth and $100K in the Traditional IRA. The amount that he owes tax on is $50K, as half his IRA is attributed to post-tax deposits. I’ll even agree his equation was correct but the numbers are $100K/($100K+$100K) or $100K/$200K so the tax free conversion is 50%. The author has added the converted amount to all IRA balances which includes the converted amount in the new Roth.

Unfortunately, when I tried to kindly point this out, the author rejected my clarification, and held firm. “The IRS and JK Lasser’s Tax Guide use the specific formula that’s mentioned above.” Well, right, that equation is correct, but the Traditional IRA ended the year with $100K, not $200K. It would stand to reason that if preconversion, your IRA is half post tax, half the conversion will be taxed at your marginal rate.

Mistakes happen. I’ve caught professionals with simple typos that change the meaning of articles. More often than not, they’ll correct their article and jot me a note thanking me for my obsession. I’m not insulted when they don’t but am a bit dismayed that such an error remain uncorrected and a search for advice on the topic will lead a reader to an incorrect calculation. Unfortunately, no one else has commented to point out the error. The punchline remains – do your research when it comes to any financial decisions you make. Better to spend a bit more time and find two or three sources that confirm your understanding than to go with the first explanation you find, as there’s a chance it may be wrong.

Early on, we discussed the Roth IRA Conversion, and soon after, the Roth IRA Recharacterization.

It’s important that you know the deadline to recharacterize any conversion you made in 2011 is fast approaching. Monday October 15th is the deadline, and if for whatever reason you with to take a do-over on any or all of the money you converted, it’s time to move fast. You don’t need any particular reason to do so, the forms to do this don’t ask why, just what (assets to recharacterize) and where (which accounts are involved).

I’ll offer the two top reasons you might want to do this – The value of the stock or fund you converted has dropped, why pay tax on $25000 when the investment is now worth only, say, $20,000? Or, you prefer not to take the ta hit just yet. A large conversion can result in a large tax bill, and you may not have the money to cover the bill you realized you created for yourself this past April.

Remember, you can wait 30 days and convert again. You’ll then have until next October to decide if your really meant it this time.

Last week’s Phantom Tax Zone Article was well received. It showed how the phasing in of Social Security taxation can create a phantom 46.25% for a single retiree with $34K in pension income or 401(k) / Traditional IRA withdrawals. Crazy stuff, but knowledge is power, and some planning is in order. Today, let’s look at the same phenomenon as it impacts a married couple filing a joint return. For this chart, we assume a Social Security benefit of $40K combined, as compared to the $20K benefit used for the single. They have their standard deduction of $11,600 and two exemptions of $3,700 each. (Please note, this chart was created using 2011 tax rates, its shape and impact are similar for 2012.) Then, to create the chart, I simply enter a $1000 Traditional IRA (or 401(k)) withdrawal, and note the tax, increasing $1000 each time, and observing how much the tax due rises for that $1000 increased withdrawal. While the couple is still subject to the standard marginal rates, 10%, 15%, 25%, you see here that impact as social security is pulled in to the equation.

Let’s recap the rules for Social Security Taxation;

• file a federal tax return as an “individual” and your combined income*is
  • between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits.
  • more than $34,000, up to 85 percent of your benefits may be taxable.
• file a joint return, and you and your spouse have a combined income*that is
  • between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits
  • more than $44,000, up to 85 percent of your benefits may be taxable.
• are married and file a separate tax return, you probably will pay taxes on your benefits.

*Note – Your adjusted gross income+ Nontaxable interest+ ½ of your Social Security benefits= Your “combined income”

You can see from these rules that there’s a huge marriage penalty in that the phase in for marrieds is not twice that of singles. The result is that while at first glance you might observe that the shape of the curve for the single’s taxation looks far worse, especially with that 46.25% rate applying to a full $5,000 of income, yet the couple’s rate only hits 45% for $1,000. The thing to look at closely is the income levels across the chart’s bottom. For the couple, the 27.75% rate you see is the result of the 85% taxation of their social security while they are still in the 15% bracket. While they would otherwise expect to see their 15% last until $69,000 of taxable income, they actually exceed the 15% bracket once they pass $19,000 in gross (not net of deductions/exemptions) income. Ouch.

In an upcoming article, some ideas on how to mitigate the impact of this tax.

In my last article, I wrote about Topping off your bracket with a Roth Conversion. Even as I posted it, I realized I missed a pretty large issue. You see, your Social Security benefits may be taxable if you:

• file a federal tax return as an “individual” and your combined income*is
  • between $25,000 and $34,000, you may have to pay income tax on up to 50 percent of your benefits.
  • more than $34,000, up to 85 percent of your benefits may be taxable.
• file a joint return, and you and your spouse have a combined income*that is
  • between $32,000 and $44,000, you may have to pay income tax on up to 50 percent of your benefits
  • more than $44,000, up to 85 percent of your benefits may be taxable.
• are married and file a separate tax return, you probably will pay taxes on your benefits.

*Note – Your adjusted gross income+ Nontaxable interest+ ½ of your Social Security benefits= Your “combined income”

It took less than an hour for a reader to point this out, so it’s time for a deeper dive on how you might be retired, collecting Social Security and never quite see a 15% marginal rate. It’s tough to explain any algebra problem that has more than two variables. I can solve them easy enough, but verbalizing is tough. So, today we’re going to assume a single retiree is collecting $20,000 per year in Social Security benefits. And for simplicity’s sake, no deductions other than the standard $5,800, and of course, the $3,700 exemption. Here’s where it gets good – I pull up a copy of TurboTax (disclaimer – I am a paid blogger at their site, but am not being paid for this article, I actually just love their software) and enter an IRA withdrawal amount. I do this in $1000 increments, and for each thousand increase in IRA withdrawal, I note the increase in Federal Tax. If the tax table tell you that your marginal rate is 15%, but you see your tax go up by 22.5%, 27.75%, or an insane 46.25%, you’ve entered what I call the Phantom Tax Rate Zone.

When you look at the marginal rate table, a single person is expecting their bracket to be at 15% right up till a taxable $34,500. It’s the nature of the phase-in of the tax on your Social Security benefit that makes your tax rise far more than this on the next incremental dollar withdrawn.

The question is whether you can use this to plan your retirement withdrawals a bit better. First, sit down and look at the numbers. If you are single and are actually going to collect $20,000 in Social Security benefits, the chart above applies to you. If not, you’ll need to run some calculations of your own, and see where your phantom rates kick in. Next, how much do you have saved in pre-tax retirement accounts? For the above example, say it’s $500K. That works out well, as the $20,000 Social Security benefit is approximately what a $50,000 earner would get at full retirement age, and the $500K nest egg should offer you a $20,000 per year withdrawal for a total $40K per year retirement income. Now, that $20K/yr withdrawal does hit the phantom 22.5% level, but no worse. It would take $800K or more, and a $32K/yr withdrawal  to push you into the much higher 46.25% rate. Here’s where it gets interesting. By delaying your Social Security start date, your benefit increases by 8% per year delayed. During this time, you’d take larger withdrawals from your 401(k) or IRA accounts, and, if you don’t actually need the extra funds, use the Roth Conversion to pull more money out of the accounts. Note, the numbers shown here is using 2011 rates as that’s the current software I’m using. When you add your exemption, standard deduction, and the $34,500, you’re at a gross $44,000 withdrawal and remain in the 15% bracket. 5 years of this withdrawal/conversion combination and you’ve drawn down your pretax account by over $100,000, and increased your Social Security benefit by 40%.

I look forward to feedback on this, as I feel that the phantom tax rate, due to Social security being taxed at what I believe is a low threshold, is one of the most under-reported bits of financial news. It’s also a sad irony that one can work and remain in the 15% bracket, yet, if they save pre-tax and invested wisely, are doomed to pay 27.75% & 46.25% on a portion of their withdrawals. There are ways to avoid this, but only by planning ahead.

On Monday, I’ll reproduce the chart but for Married Filing Joint. Thank you to all those who have read this article.

Today, let’s look at one of the strategies where a Roth conversion makes good sense. You are single, retired, and currently taking your required minimum distributions. You find that your taxable income puts you at a marginal 15%. Back to the tax table -

After deductions, your income is in the high $20K range. You’re looking at the required minimum distributions, in Publication 590, and see how at 75 you need to withdraw 4.4%, but by age 85, the percent you must withdraw creeps up to 6.8%, and hopefully, your account has grown as well. Ideally, you’d like to pay 15% on as much of your lifetime income as you can, and this method is a simple way to do that. During the year, convert a portion of your IRA to a Roth. A bit more than to hit the line from 15 to 25%, for 2012, we’re looking at $35,350. So if you think your taxable income will be $27,000, convert $10,000 of your IRA to Roth. In March, when you’re doing your taxes, you’ll have an exact number, and whatever amount you exceeded the $35,350 you will recharacterize back to the Traditional IRA. A bit of paperwork each year, but as time passes, you’ll see the Roth account growing and the Traditional IRA diminishing a bit so your RMDs won’t push you into the next bracket. Also, once the Roth is 5 years old, you are able to withdraw from that with no penalty or tax on any or all withdrawals, so if in any year, you have a large expense, you won’t have to withdraw from the Traditional IRA and get hit with a higher tax bill.

Any questions regarding this strategy? Please ask!