Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) Becomes Law

If you read our article on advantages of Roth IRA, you know that tax-free growth of earnings, tax-free distributions and flexible withdrawal rules are just some of the great benefits of having a Roth IRA. Furthermore, the fact that no minimum required distributions are required once you turn 70 and 1/2 years old is another advantage. You might therefore have tried converting your Traditional IRA or SEP/Simple IRA to a Roth IRA but may not meet the modified adjusted gross limit (MAGI) rule. The MAGI rule states that if your adjusted gross income exceeds $100,000 a year for 2008, you will not qualify for Roth IRA conversion. Also, if your status is ‘married but filing separately’, you will not qualify for Roth IRA conversion. There is where the Tax Increase Prevention & Reconciliation Act of 2005 (TIPRA) comes into play.

TIPRA Is Signed into Law

Prez. Bush signed TIPRA into law on May 17th, 2006. It includes a provision that allows conversion of Traditional IRAs to Roth IRAs. It also includes a provision that eliminates the $100,000 modified adjusted gross income limit starting January 1st, 2010. Also, investors who convert into Roth IRAs in 2010 can spread their taxes owed over 2 years, 2011 and 2012. This is treated more like an interest-free loan from the IRS that will not be paid until 2011 and 2012. After this, any gains you make on your Roth IRA investments will accrue taxes on a deferred basis and any distributions will be tax-free if you meet the Roth IRA hardship withdrawal rules.

So you ask, what can you do to take full advantage of TIPRA? We suggest contributing as much as you can to your Traditional IRA, SEP/Simple IRA or your 401k/403b plan so that you can convert these funds to a Roth IRA in 2010 without having to face the $100,000 modified adjusted gross income limit. What if you do not have any 401k or Traditional IRA plan? Your next best bet would be a non deductible IRA.

Non Deductible IRA?

If your modified adjusted gross income (MAGI) exceeds $100,000 and prevents you from making Roth IRA contributions, a non deductible IRA would be your next best option. If you are less than 70 and 1/2 years old in the year you are making the contribution, you can contribute $4000 to a non deductible IRA ($5000 if you are 50 years or older); or you and your spouse could contribute $8000 ($10,000 if both of you are 50 years or older) under the ‘married and filing joint’ clause. For example, consider Jane and John who are both 50 years old and are making $10,000 a year contributions to a non deductible IRA (under the ‘married and filing joint’ clause). They do this till they are 65 years of age. Here’s the math:

Annual Contributions = $10,000
50 – 65 years of age = $10,000 x 15 years = $150,000
Annual Rate of Return = 6%
Total Nest Egg @ 65 years = $246,725.28 (this factors in compounding interest)

At this point, Jane and John could convert their non deductible IRA into a Roth IRA. Therefore, they will owe taxes only on ($246,725.28 – $150,000) = $96,725.28. What’s more, they will not have to worry about taking minimum required distributions once they reach 70 and 1/2 years old because that clause does not apply to Roth IRAs.

Tax Planning

If you want to convert your Traditional IRA or 401k to a Roth IRA in 2010, be sure to set aside extra money for the taxes owed on the Roth IRA conversion. Here’s a way to estimate taxes owed. Say your Traditional IRA is currently worth $50,000 (as of January 1st, 2008). By 2010 at an annual rate of return of 6%, your Traditional IRA will be worth 56,180. You will then have to declare this amount as income for the tax years 2011 and 2012 and owe taxes. Say you’re in the 18% tax bracket, your tax liability of $10,112.40 will be spread over 2 years. After this point, you or your future beneficiaries will never have to pay taxes on qualified Roth IRA distributions ever again, no matter how much your nest egg grows. On the other hand, you will actually face a larger tax bill if you let your money stay in the Traditional IRA tax-deferred. Here is a comparison.

Roth IRA Conversion in 2010
Traditional IRA
Year
Before Tax Value*
Taxes Due
After Tax Value
Before Tax Value
Taxes Due**
After Tax Value
2008 $50,000 $50,000
2009 $53,000 $53,000
2010 $56,180 $56,180
2011 $59,550.80 $5056.20 $54,494.60 $59,550.80 $10,719.15 $48,831.65
2012 $63,123.85 $5056.20 $58,067.65 $63,123.85 $11,362.30 $51,761.55
2013 $66,911.28 $61,551.71 $66,911.28 $12,044.03 $54,867.25
2014 $70,925.96 $65,244.81 $70,925.96 $12,766.68 $58,159.28
2015 $75,181.51 $69,159.50 $75,181.51 $13,532.68 $61,648.83
2016 $79,692.40 $73,309.07 $79,692.40 $14,344.63 $65,347.77
2017 $84,473.95 $77,707.61 $84,473.95 $15,205.31 $69,268.64
2018 $89,542.38 $82,370.07 $89,542.38 $16,117.63 $73,424.75
2019 $94,914.93 $87,312.28 $94,914.93 $17,084.69 $77,830.24
2020 100,609.82 $92,551.01 $100,609.82 $18,109.76 $82,500.06
* Assuming a 6% Annual Rate of Return
** Before Tax Value x 18% Tax Rate

The ‘Before Tax Value’ column starts off with $50,000 in the year 2008, growing at an annual return of 6%. It is therefore the same for both the Roth IRA & Traditional IRA, through to 2020. However, the ‘After Tax Value’ in 2020 is greater with the Roth IRA conversion ($92,551.01) while it is only $82,500.06 for Traditional IRA. This is what we mean when we say you will be faced with a larger tax bill if you let your money stay in a tax-deferred Traditional IRA.

The Future

What’s the long term outlook of the Tax Increase Prevention & Reconciliation Act of 2005? It was primarily designed to be a short term fund raiser for the US Treasury because billions of dollars will be paid to the government in 2011 and 2012 due to Roth IRA conversions. For the long term though, the US Treasury will lose billions of dollars in tax revenue when distributions from these Roth IRAs will not be taxable.

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