Beverly,Great article on Roth IRAs amid the new tax law. You covered the traditional IRA to Roth IRA conversion thoroughly except for an interesting "tax loophole" created with the 2002 saver's tax credit. This tax loophole is available to those under 65 years of age with earned income of less than $50,000, and who contribute up to $2,000 ($4,000 married) to a retirement account (IRA, Roth IRA, etc.). You are probably familiar with the saver's tax credit, which allows for up to 50% of the $2,000 (or $4,000) retirement contribution to be used as a tax CREDIT.Let me explain how it can be used. I retired at age 55 about five years ago with all of my company retirement money placed in a traditional IRA. My wife teaches at the local college a couple nights a week and earns about $8,000 per year, which allows us to contribute up to $7,000 per year into a Roth IRA. This makes us eligible for the $2,000 saver's tax credit (50% of $4,000 max), since we have an earned income less than $30,000. Since we actually have virtually no taxable earned income after deductions, this allows us to convert about $30,000 in my traditional IRA to a Roth IRA and use the $2,000 saver's credit to offset almost all tax consequences of the conversion. As long as the saver's tax credit is in effect, I could possibly convert over $200,000 in my IRA to a Roth IRA with no taxable consequences before I reach 65. I have done this conversion in 2002 and 2003. Let me know if you have any other insights on this subject. Regards,Ray E.
I'm always amazed at how creative some
readers are, and your point is an excellent one. Since you've essentially provided the example, allow me to provide the background for other readers.
The saver's credit was implemented last year to encourage taxpayers in the lower income tax brackets to save more money. Those who qualify for the new saver's credit are eligible to receive a credit for up to $1,000. (Remember, a credit is like a coupon -- every dollar of a credit lessens the tax you owe by $1. That's different from a deduction, which simply lowers your taxable income -- meaning you have less money to tax. So a $1,000 credit is better than a $1,000 deduction.)
Only the first $2,000 of your annual contribution is eligible for the saver's credit -- that's $4,000 for married couples filing jointly. The amount of the credit depends on how much you contribute and your adjusted gross income. The credit is figured as a percentage of your contribution, but only up to $2,000 per person. The maximum credit is 50% of a taxpayer's contribution, up to that first $2,000. (Hence the $1,000 maximum credit -- if a taxpayer contributes just $500, though, his or her credit would be just $250.) As income rises, the credit drops to 20% or 10% of the maximum contribution.
Married couples filing jointly receive the full amount of the credit -- 50% of their contribution (up to the first $2,000) if their AGI is $30,000 or less. Singles get the full credit if their AGI is $15,000 or below. The credit drops to 20% of the first $2,000 of each person's contribution beyond that, and falls to 10% once AGI goes past $32,500 for married couples and $16,250 for singles. The credit expires once income goes beyond $50,000 for married couples and $25,000 for singles.
This credit can be used by anyone who contributes to a retirement plan and meets the income requirements -- including retirees, the unemployed and youngsters new to the workforce (although the credit isn't available to anyone under the age of 18, full-time students or anyone who is claimed as an exemption on someone else's return).
Virtually all contributions to retirement plans are eligible for the credit (provided, of course, you meet the income limitations). The 10%, 20% or 50% tax credit can be for contributions to all of the following -- a traditional IRA; Roth IRA; 401(k) plan; 403(b) plan (the plan used by most nonprofits and academia); 457 plan (used by governments), savings incentive match plans for employees (or SIMPLE plans, for small businesses and the self-employed); and salary reduction simplified employee pension (SEP) plans.
So some taxpayers can indeed use Ray's strategy: Use the saver's credit to offset the tax you would otherwise owe on the amount you convert from a traditional IRA to a Roth.
For taxpayers on the brink of credit eligibility, though, the news isn't so good. Because the credit doesn't phase in and out like many others do (instead, the credit plummets from 50% to 20%, for instance, when a married couple's income hits $30,001), the steep drop-offs will cause many taxpayers some consternation. Consider this example, from Tax Analysts, a nonprofit publisher of tax research and analysis: A married couple with income of $30,000 contributes $2,000 to a retirement plan. (For simplicity's sake we're assuming they claim the standard deduction and have no children.) After the saver's credit, the couple's income tax liability would be about $700 for 2003. But if one spouse earns an extra dollar, the couple's income tax liability after the credit would increase to about $1,300 -- a $600 increase in taxes for just $1 more in income.
The folks at Tax Analysts also point out that while the credit seems generous, many of those eligible actually earn so little that they don't pay income tax. And since the credit is nonrefundable -- meaning it will only offset your taxes, and at the most reduce your liability to zero -- those taxpayers won't get any benefit, even if they continue to save. According to the IRS, 57 million returns have incomes low enough to qualify for the 50% credit. But only 20% of those returns could benefit from the credit if they contributed to a retirement plan.