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How to Take Advantage of an IRS Loophole

  • Mary Hunt Debt-Proof Living
  • 2010 2 Feb
  • COMMENTS
How to Take Advantage of an IRS Loophole

 


It's not often that the IRS offers tax-paying U.S. citizens a gift, but that's what we get when the IRS allows us to defer taxes on the money we contribute to qualified retirement accounts. Of course, these gifts come with strings attached known as "restrictions" and "deferred taxes."

One of these gifts is called an Individual Retirement Account, or IRA. With an IRA, you deposit untaxed dollars that grow until you withdraw them in retirement. There is a catch, and a pretty big one: The taxes you didn't pay were only deferred, not forgiven. As you withdraw the money, you must pay taxes on it including federal, state and local, depending on where you live.

In 1998, a new kind of IRA, called a Roth IRA, was introduced. With a Roth IRA, you have to pay the taxes first, which means you contribute after-tax dollars (currently up to $5,000 per year or $6,000 if you are 50 or older). You don't get that deferred tax break on the front end, but the entire account becomes non-taxable, even the growth. This is huge, especially for young people who are looking at many years of investment growth.

In the past, you could change your mind mid-stream and convert a traditional IRA to a Roth IRA, but with restrictions. For example, if your modified adjusted gross income was more than $100,000, you couldn't do it. In 2010, however, this restriction has been lifted. Anyone can convert any IRA of any size to a Roth IRA. There is one small problem, however. Since the money in a traditional IRA has not been taxed, Uncle Sam will require you to pay those federal taxes (and any state and local taxes, too) when you make the switch.

Now, before you assume you cannot afford to take advantage of what I see as a great opportunity because of the taxes, there's more good news. For 2010 only, you can opt to have the taxable income from your conversion reported in two equal installments in 2011 and 2012. That gives you until 2013 to pay the taxes, as your 2012 taxes will not be due until April 15, 2013. You must make the conversion in 2010 to take advantage of paying the taxes in installments. Being able to put off the tax bill, and paying it over two years, should lighten the burden.

If you have a traditional IRA or a 401(k) account that can be converted to a Roth IRA, be sure to talk with your tax professional about details that pertain to your specific tax situation.

You will want to time your conversion to your best advantage. For many taxpayers, it makes sense to convert as early in 2010 as possible to gain as much as possible from the tax-free growth that a Roth IRA offers. However, if you're unsure of what your income will be and what tax bracket you'll be in, it might make sense to wait until the second half of 2010 to get a better handle on the tax consequences.

February 8, 2010

Copyright © 2010 Mary Hunt. All rights reserved. Permission to reprint required.

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