With much ado about taxpayers' lack of fiscal readiness for retirement, stakeholders are taking steps to encourage taxpayers to increase their retirement savings. Congress and the IRS are part of this effort, and have made changes by relaxing some of the rules and increasing the available options for retirement savings. In this article, we highlight some of the recent changes that have been put into effect to date and give you a look at what's to come.

Expanded Eligibility for Roth IRA Conversions
The option of converting Traditional, SEP and SIMPLE IRA assets to a Roth IRA is an attractive one for many taxpayers, especially those who feel they may be in a higher tax bracket when they retire. This option is attractive mainly because earnings in Traditional, SEP or SIMPLE IRAs are accrued on a tax-deferred basis, and taxable amounts are treated as ordinary income when distributed. For Roth IRAs, earnings are tax-deferred, but are tax-free if certain requirements are met. (For additional reading, see Tax Treatment Of Roth IRA Distributions.)

Note: SIMPLE IRA assets cannot be converted to a Roth IRA until at least two years after the first deposit has been made to the SIMPLE IRA.

Generally, converting assets to a Roth IRA allows the taxpayer to include the amount in his or her income for the year of conversion, and withdraw the amounts tax-free during retirement - which could, in effect, lower the amount of taxes paid by individuals who would be in higher tax brackets during retirement. However, many taxpayers were unable to enjoy the benefits of converting their assets because they were excluded automatically by the eligibility requirements. Prior to 2010, a taxpayer was eligible for a Roth IRA conversion, only if his or her modified adjusted gross income (MAGI) was not more than $100,000 for the year and/or the taxpayer's tax filing status was not married filing separately.

On May 17, 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Under TIPRA, the $100,000 MAGI limit and the requirement that married individuals file a joint tax return no longer applies effective for tax years beginning January 1, 2010. In addition, individuals who convert in 2010 may spread the income from the conversion over 2011 and 2012.

Example 1

John converted $100,000 from his traditional IRA to his Roth IRA in 2010, all of which is taxable. Unless John elects otherwise, he may include $50,000 on his 2011 tax return and $50,000 on his tax return for 2012.

Tax Planning Tip
In addition to the opportunity to complete a Roth IRA conversion in 2010 and after, this change may present an opportunity for individuals who are ineligible to make regular contributions to Roth IRAs due to MAGI caps. Such individuals could make non-deductible contributions to their traditional IRAs and convert the amount to their Roth IRAs in 2010 or after. The conversion of these nondeductible amounts would be nontaxable. However, certain things must be considered, including the following:

  • Any earnings on the amount would be taxable, but could be spread over 2011 and 2012 as explained above, provided the conversion occurs in 2010.
  • If the IRA owner has other Traditional, SEP or SIMPLE IRA funds, the amount converted would include a pro-rated amount of taxable and non-taxable assets.
Example 2
Assume that John has two IRAs, with balances as follows:
IRA No.1: $100,000, all pretax assets
IRA No.2: $25,000, all post-tax assets

If John converted the balance in IRA No.2 to his Roth IRA, John would need to include $20,000 in income. This is regardless of whether the $25,000 is converted from either or both of his Traditional IRAs.
John would need to file IRS Form 8606, which would not only help to calculate the taxable amount of the conversion, but would notify the IRS of the amount that\'s taxable.

A financial assessment may be required to determine whether converting to a Roth IRA would make good financial sense for the individual. It may seem like a good idea to pay taxes on the amount now, and accrue earnings on a tax-free basis (if qualified); however, that is usually ideal for someone who would be in a higher tax bracket when distributions are projected to be made from the Roth IRA. Further, projections usually make assumptions about growth rate of earnings that may not be realized, and there are other factors that may need to be taken into consideration. (For more information, read Tax-Saving Advice For IRA Holders and IRA Contributions: Deductions and Tax Credits.)

Non-Taxable Combat Pay Now Eligible for IRA Contributions
Generally, in addition to meeting certain other requirements, compensation must be taxable in order for it to be used to make an IRA contribution. However, effective for tax years beginning January 1, 2004, an exception is being made for military personnel who receive nontaxable combat pay while serving in combat zones. This exception was put into effect under the Heroes Earned Retirement Opportunities (HERO) Act, which President Bush signed into law on May 29, 2006. (For more insight, see Benefits For Members Of The Armed Forces.)

IRS Allows IRA Contributions Through Direct Deposit of Tax Refunds
The IRS now allow taxpayers to direct their tax refund to up to three accounts, via direct deposit. The receiving accounts now include traditional and Roth IRAs. This split refund program became effective in January 2007. Individuals who want to direct their tax refund to more than one account are required to complete IRS Form 8888. In instances where the deposit will be made to only one account, the instructions should be provided on the individual's tax return

FDIC Insurance Limits for IRAs and Other Retirement Accounts Increase
On March 14, 2005, the Federal Deposit Insurance Corporation (FDIC) issued a press release wherein they announced FDIC coverage for self-directed retirement accounts, including Traditional IRAs, Roth IRAs, self-directed qualified plan accounts and 457 plans held at an insured institution, have been increased from $100,000 to $250,000. These retirement accounts will be provided with separate coverage from other accounts, which will still be protected up to $100,000. (To learn more, read 9 Tips For Safeguarding Your Accounts.)

These are just a few of the changes that create retirement saving opportunities for taxpayers. Individuals can take advantage of these opportunities to improve their nest eggs, and increase their financial security during retirement.