The Federal deficit is rising and Congress is trying to cut the budget, however it is inevitable that taxes will increase sometime in the future. In a recent article in Fortune Magazine, it talks about a quirk in the tax code that allows high income earners an opportunity to build savings and shelter more of their income from future taxes. Has Congress gone mad?
The Roth IRA, a tax-sheltered savings plan, has limitations to keep high income earners from participating in a Roth. For 2011, single tax filers can make only the maximum Roth IRA contribution if their modified adjusted gross income is less than $107,000; once their income hits $122,000, they can’t contribute at all. For married couples filing jointly, allowable contributions begin to phase out when their combined income reaches $169,000.
High income earners were not eligible for a Roth IRA because of the income limitation; however anyone can open a traditional IRA. A traditional IRA allows tax-deferred savings as long as you earned income equal or greater than your contribution, and you must be under the age of 70 1/2. You may contribute up to$5,000 ($6,000, if over 50) per year (2011). If you are not covered by an employer sponsored retirement plan, your contribution is fully tax deductible. If you are covered by employer sponsored plan, your deductible amount depends on your income.
The major difference between the traditional IRA and the Roth IRA is how it is taxed. The traditional IRA distributions are taxed when it is withdrawn as ordinary income. The Roth IRA distributions are federally tax free if you had your Roth for at least five years and you are over the age of 59 ½. If you are under 59 ½ and had your Roth for at least five years and your distribution is due to death or disability or for a first time home purchase ($10,000 lifetime maximum).
The rules are meant to keep the high income earners from taking advantage of the Roth IRA until now! Prior to 2010, Roth conversions were allowed for single or married taxpayers with modified adjusted gross incomes below $100,000. There is no dollar limit on the amount of traditional IRAs you can convert, but you will have to pay taxes on the amount converted. Why would someone want to do this? They believe they will be in a higher tax bracket when they receive the distributions.
Since most people use a traditional or Roth IRA for retirement savings, you expect to be in a lower tax bracket. Are there exceptions? Yes! You are an executive of a public company with a very rich retirement package with stock, annuity and pension. High earners who expect to be in a high tax bracket are good candidates for this conversion. In addition, you may believe that the existing tax brackets will be increased due to the continuing federal deficit. Whatever your reason, this may be your last chance to take advantage of this quirk.
Why is the government being so nice to rich people? Do you think the government likes rich people more than the rest of us? Do you think they did it on purpose to help out their rich friends who contribute to their political campaigns? Maybe the answer is simpler! They allowed this loophole so the people with money would convert and pay the taxes now in order to avoid taxes later. The federal government reaps the increased taxes now and everyone is happy. Sounds like a win/win! What do you think? Are you going to take advantage of this loophole?
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