Funding a Roth
Eager banks make opening an account easy
You can start a Roth IRA two ways, depending on your current retirement savings. After confirming your eligibility, you can either:
• Open a new account and fund it with a check, direct transfer from your bank account, or with cash; or,
• “Convert” an existing IRA or retirement plan to a Roth.
Starting from scratch is relatively easy. The only thing you need to remember is to stay within the annual contribution limits. In 2012, the limit is $5,000 for most people and $6,000 for those 50 and older.
Roth IRA conversions are easy to set up as well. Just be aware that a conversion has tax consequences in the year you move the money. That’s because the money you contribute to a retirement plan or traditional IRA is typically deducted from your income taxes. Since a Roth can only be funded with after-tax money, you’d have to pay taxes in the year of the conversion for any amount transferred. For instance, if you have $10,000 in a 401(k) with a former employer and convert it to Roth, the $10,000 is added to your taxable income for the year (since the contributions were deducted from your taxes in earlier years). Make sure you have a clear understanding of the tax implications before moving your money.
“Meet Ira Smith”
Let’s take a hypothetical example. Ira Smith makes $50,000 a year managing a donut shop. This year, however, he sells his old Perry Como albums on eBay for $15,000. His annual income increases to $65,000. It’s a nice bump, but not enough to propel him out of the 10 percent tax bracket. He’d also like to convert to a Roth IRA the $10,000 he had in a 401(k) from his previous career as a hand model. If he does, his income rises to $75,000 and puts him in a 15 percent tax bracket.
What should he do?
Unless he expects tax rates to shoot up next year, Ira should wait. Since he doesn’t have any more albums to sell, his income next year is likely to go back down to $50,000. Doing the Roth IRA conversion next year will increase his taxable income to $60,000, which is still within the 10 percent bracket. Waiting a year saves Ira $500 in taxes (it’s $1,500 in additional taxes at 15 percent, and only $1,000 at 10 percent).
And, of course, whenever you make the conversion and regardless of your tax rate, be sure you have the money to pay the increased taxes that year. The immediate consequences of being hit with an unmanageable tax bill likely far outweigh the long-term benefits of a conversion.
How to convert
You can perform a conversion two ways:
• Have your retirement plan send you a check for the balance of the account. You then have 60 days to put the money into a Roth before being assessed a penalty.
• Have your retirement plan transfer the money directly to your Roth IRA.
Banks and brokerage firms are eager to get your business, and most will hold your hand through the entire process. And who doesn’t like holding hands?