The SIMPLE IRA checklist in our Business Tools is intended to aid in keeping such plans in compliance with tax rules. To open this PDF, you may need to download a free version of Acrobat Reader.
If you own a small business, you have a wide variety of retirement plans you can use to save for the future. From traditional employer-provided pension plan, through simplified qualfied plans such as SIMPLE plans all the way through Roth IRAs, explore the options that will help you meet your retirement-funding needs.
Employer-provided pension plan benefits from previous jobs may be a source of your retirement income. And you may have benefits coming to you under an employer-provided plan.
But as a small business, you may not have any employer-provided pensions or retirement plans to rely on. That doesn't mean, however, that you have to forego participation in retirement plans. In fact, there are numerous options available to self-employed individuals. Among the most effective, and popular, retirement savings vehicles are:
As a general rule, you trade off simplicity in plan set-up and administration for the ability to make substantial contributions to the plan. For example, in 2013, the maximum contribution to a SIMPLE-IRA is $12,000, while that for a defined contribution plan is higher. So, if you have the income and you want to accumulate money for retirement rapidly, the hassle of a defined benefit plan may be worth it. On the other hand, if rapid savings is not a priority, but flexibility is, then one of the other options might be a better. Even if you choose not to establish one of the new plans designed for small business owners, you owe it to yourself (and to your future) to aggressively fund individual retirement accounts.
It is important for you to understand the "how's" of your particular pension plan:
There are two categories of pension plans: qualified plans and nonqualified plans.
The Advantages of Qualified Plans
Qualified plans meet the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code and qualify for four significant tax benefits.
Qualified retirement plans are also divisible into the following broad categories:
Nonqualified Plans
Nonqualifed plans do not meet the ERISA guidelines and the requirements of the Internal Revenue Code. There is no preferential tax treatment granted to a non-qualified plan. Nonqualified plans are usually designed to provide deferred compensation exclusively for one or more executives.
Distributions to plan participants or beneficiaries, if the terms of the plan permit, can be made in several ways. The typical types of distribution choices are:
Lump sum. As the name implies, this form of payout distributes the entire vested balance in one payment.
Distribution Events
Distributions can be made at termination of employment for any reason including death, dismissal, disability or retirement. Distributions may also be allowed for medical expenses in excess of 7.5 percent of adjusted gross income. Profit-sharing plans allow withdrawals only after age 59 1/2.
Distribution Timing
Distributions from all qualified plans must begin no later than April 1 of the calendar year following the year that the participant attains age 70 1/2, or the calendar year in which the employee retires. Special rules apply if the distribution is made to a 5 percent owner of the business.
Distribution Amounts
Each year's minimum distribution is calculated by dividing the balance of the account at the beginning of the year by the life expectancy of the owner or joint life expectancies of the owner and a designated beneficiary. Life expectancy is determined using the annuity unisex life expectancy tables in the Internal Revenue Regulations.
Generally, amounts distributed by a qualified plan, minus any nondeductible contributions made by the employee over the years, are taxable to the recipient as ordinary income in the year received.
Pension distributions are subject to federal income tax withholding, although the rate varies based on the type of distribution. Additional taxes may be required for premature distribution (10 percent penalty), or failure to make minimum distributions (50 percent penalty).
Tax-Free Rollovers
The main exception to taxing distributions from a qualified plan is if you make a tax-free rollover. A rollover is a tax-free transfer of cash or other assets from one retirement account to another if made within 60 days of receipt.
Cash-Out Rollovers
Mandatory cash-out distributions of more than $1,000, but less than $5,000, that are made from a retirement plan (including governmental and church plans) must be paid in a direct rollover to an individual retirement plan unless the distributee elects to have the amount rolled over to another retirement plan or to receive the distribution directly. A mandatory cash-out distribution is a distribution that:
However, a distribution to a surviving spouse or alternate payee does not count as a mandatory distribution. The plan administrator must notify a distributee in writing when a distribution will be paid in a direct rollover to an IRA.
A Keogh Plan is a qualified defined-benefit or a defined-contribution retirement plan set up by a self-employed person or partnership. (The term "Keogh" is used less and less frequently, so the remainder of this article will refer to Keogh plans as "qualified plans.")
The plan must meet the same:
as any qualified retirement plan covering corporate employees.
Simply put, it is more difficult and expensive to establish, and you cannot withdraw funds at any time, but the trade-off is that you can contribute more money each year.
The good news is you're not required to have any employees to establish a qualified plan. However, if there are employees, they must be allowed to participate in the plan. You do not have to be self-employed on a full-time basis to become eligible to open a qualified plan. An individual who has another job during the day but decides to supplement his or her income by turning his or her weekend hobby into a business is eligible to open a qualified plan based on the net earnings derived from the part-time self-employment.
The qualified plan must be in writing and approved by the IRS. Further, the terms and conditions of the plan must be communicated to the employees, and the plan's provisions must be stated in the plan.
You will usually need the help of a professional to establish the plan. You can set up a trust or custodial account to invest the funds or buy a contract from an insurance company.
You must abide by the limits on how much can be contributed to a qualified plan each year. The contribution limit depends upon
For 2013, the annual contribution limit for a defined-contribution plan is $51,000. The annual limits for a defined-benefit plan are based on a formula derived to ensure that the annual benefit limitation (for 2013, $205,000) is not exceeded. The services of a professional are required to compute these amounts.
If you are self-employed, you can make contributions for yourself only if you have net earnings (compensation) from self-employment in the trade or business for which the plan was set up. These net earnings must be from your personal services, not from your investments. If you have a net loss from self-employment, you cannot make contributions for yourself for the year, even if you can contribute for common-law employees based on their compensation.
Plans can be set up to allow participants to make nondeductible contributions into the plan in addition to the employer's contributions. Even though these employee contributions are not tax deductible, the earnings on them are tax-free until distribution. If you make contributions that are higher than the limits, you are considered to have made a nondeductible contribution which may also be subject to a 10 percent excise tax penalty.
Distributions from qualified plans are taxed as ordinary income or in the same manner as distributions from any other qualified plan. Certain transactions are prohibited if made between the plan and a "disqualified person." A disqualified person can be:
An excise tax penalty of 100 percent is charged on prohibited transactions. The disqualified person taking part in the transaction who must pay the tax, not the company or the qualified plan.
The plan administrator or employer must prepare and file certain annual returns and reports with the Internal Revenue Service relating to the plan, including Form 5500, Annual Return/Report of Employee Benefit Plan. The required annual communications must be provided to all plan participants and those who are eligible to participate in the plan.
Be sure to read more information about qualified plans in the context of employee benefits before pursuing this retirement option.
One great way to ensure a steady stream of income from an "employer-paid" plan is—you guessed it—to start one yourself.
In recent years, numerous law changes have made creating and funding a plan an achievable goal for many small business owners. The Simplified Employee Match (SIMPLE) plan and the Simplified Employee Pension (SEP) plan are often the best retirement plans for small business owners like you to consider.
SIMPLE plans are designed for small businesses. The SIMPLE plan is not subject to the nondiscrimination rules or other complex requirements applicable to qualified plans.
If you have more than 100 employees who received more than $5,000 in compensation during the preceding year, you cannot adopt a SIMPLE plan. If you have any other plan, you can not also have a SIMPLE plan.
So, if you've already established another plan, you'd have to terminate it or convert it to a SIMPLE. If a SIMPLE plan is adopted, it must be open to every employee who is reasonably expected to receive at least $5,000 in compensation during the current year and received at least $5,000 in compensation from the employer during any two preceding years. Self-employed individuals are also eligible to establish a SIMPLE plan.
SIMPLE plans may be structured as an IRA or as a 401(k) plan, but there are special contributions limits for SIMPLE plans. Employees can make up to $12,000 of elective contributions in 2013. However, you must make a matching contributions, up to 3 percent of each employee's pay.
Thus, the total amount that can go into an SIMPLE plan is $24,000 per year ($12,000 by the employee and the match of $12,000 by the employer). Contrast this amount with the 2013 limits of $5,500 for an IRA and $17,500 for a 401(k).
Rather than match each employee's contribution up to $12,000 or 3 percent of his or her income, whichever is lower, you can opt to make a blanket contribution of 2 percent of each participating employee's pay regardless of whether they make any elective contributions. These are the only contributions permitted. In addition, all contributions to an employee's SIMPLE account must be nonforfeitable. That means that the employees vest immediately in contributions you make.
Assets in the account are not taxed until they are distributed to an employee. However, you can claim a deduction for the contribution in the year in which it is made.
Distributions from a SIMPLE account are generally taxed like distributions from an IRA. To save your employees some money, participants may roll over distributions from one SIMPLE account to another free of tax. In addition, a participant may roll over a distribution from a SIMPLE account to an IRA without penalty if the individual has participated in the SIMPLE plan for two years. However, distributions may not be rolled over tax-free to another type of qualified plan.
Participants who take early withdrawals from a SIMPLE account before age 59.5 are generally subject to the 10 percent early withdrawal penalty. However, employees who withdraw contributions during the two-year period beginning on the date that they first began participating in the SIMPLE plan will be assessed a 25 percent penalty tax.
Be sure to research SIMPLE plans in the context of employee benefits before pursuing this retirement option much further.
The SIMPLE IRA checklist in our Business Tools is intended to aid in keeping such plans in compliance with tax rules. To open this PDF, you may need to download a free version of Acrobat Reader.
A simplified employee pension (SEP) is simply a written arrangement that allows an employer to make contributions toward his or her own and employees' retirement without becoming involved in more complex retirement plans. The contributions are made to special IRAs (SEP-IRA) set up for each individual qualifying employee.
An employer can use IRS Form 5305-SEP to satisfy the written arrangement requirement for a SEP. A SEP can be established at any time during the year. Contributions to the SEP for a given year must be made by the due date of the income tax return, including any extensions, for that tax year. Distributions or withdrawals from a SEP-IRA are subject to the same rules that apply to regular IRAs. Special rules do apply for SEPs in the context of employee benefits.
If you have a SEP plan in place, you don't have to make any contributions to the plan in any given year. But, if you do make contributions for a year, the contributions must be based on a written allocation formula (e.g., "2 percent of each employee's pay") and must not discriminate in favor of highly compensated employees.
For 2013, the SEP rules permit an employer to contribute, and deduct, an annual maximum of 25 percent of the employee's compensation or $51,000, whichever is less, to each participating employee's account. For the business owner, however, the contribution limit is lower.
Leslie, a participant in a SEP sponsored by her employer, earns $70,000 in compensation from the employer. Her employer may contribute up to $17,500 (the lesser of 25% × $70,000 or $51,000) to her SEP for the 2013 tax year. The amount contributed by the employer is not taxable income to Leslie in the year that it is contributed. Thus, the employer's contribution is not included in wages on her Form W-2, although the amount is reported as non-taxable income.
The annual limits on your contributions for your employee's SEP-IRA accounts also apply to contributions you make to your own SEP-IRA. Your contribution cannot exceed $51,000 or 25% of your net earnings.
Net earnings from self-employment is your gross income from your trade or business (provided your personal services are a material income-producing factor) minus allowable business deductions. Allowable deductions include contributions to SEP and qualified plans for common-law employees and the deduction allowed for one-half of your self-employment tax. Net earnings from self-employment do not include items excluded from gross income (or their related deductions) other than foreign earned income and foreign housing cost amounts.
As usual, special rules apply when figuring your maximum deductible contribution. These limitation are necessary because of the interplay of the allowable deductions for one-half of the self-employment tax and the deduction for SEP contributions.
You can compute your percentage for other rates by taking the employees' rate, expressed as a decimal, and dividing it by that rate plus one. The maximum effective applicable percentage limit for self-employed individuals is 20 percent.
If your employees were receiving the maximum contribution of 25 percent of pay, you would have to use 20 percent. If your employees receive 15 percent, your percentage would be 13.0435. Similarly, if your employees' rate was 10.5 percent, you could compute the owner's rate by dividing 0.105 by 1.105 to arrive at .0950, or 9.5 percent.
Prior to 1997, an employer could establish a Salary Reduction Arrangement SEP (SARSEP) under which employees could elect to make contributions out of their own pay, up to a certain dollar limit per year, per employee. This choice is called an elective deferral.
Although new SARSEPs can no longer be set up, you may continue to make contributions to a SARSEP that was established before 1997. In 2013, individuals participating in a SARSEP may elect to contribute up to the smaller of $17,500 or 100 percent of their compensation to the plan. Participants in a SARSEP plan who are age 50 and older may contribute an additional $5,500 in 2013.
Download the SEP IRA checklist Business Tool to help you keeping your plans in compliance with tax rules. You many need to download a free copy of Acrobat Reader to view and print this PDF.
Individual Retirement Accounts (IRAs) function as personal tax-qualified retirement savings plans. Many small business owners opt for IRAs because they are fairly easy to set up and to maintain. Plus, they offer extreme flexibility.
You'll want to investigate the two main types of IRAs: traditional and Roth.
IRAs are set up as trusts or custodial accounts for the exclusive benefit of an individual and his or her beneficiaries. You can set up an IRA simply by choosing a bank, mutual fund, brokerage house or other financial institution to act as trustee or custodian. The institution will give you the necessary forms to complete.
While not as popular an option, you can purchase an individual retirement annuity contract from a life insurance company. But know that an individual cannot be his own trustee.
The shifting of funds from one IRA trustee/custodian directly to another trustee/custodian is called a transfer, not a rollover because nothing was paid over to you. A transfer is tax-free and requires no waiting periods between transfers.
A rollover, in contrast, is a tax-free distribution to you of assets from one retirement plan that you then contribute to a different retirement plan.
Under certain circumstances, you may either roll over assets withdrawn from one IRA into another, or roll over a distribution from a qualified retirement plan into an IRA. If the distribution from a qualified plan is made directly to you, the payer must withhold 20 percent of it for taxes. You can avoid the withholding by having the payer transfer the funds directly to the trustee/custodian of your IRA.
A rollover must be made within 60 days of receipt of the distribution. You cannot deduct the rollover contribution, but you must report it on your tax return. Rollovers not completed within 60 days are treated as taxable distributions. On top of the regular income tax, you may also have to pay a 10 percent excise tax penalty on the premature distribution and another 15 percent excise tax penalty on an excess distribution.
A rollover from one IRA to another enables you to change your investment strategy and enhance your rate of return. This type of rollover may be made only once a year. This rule applies separately to each IRA you own. And if property other than cash is received, that same property must be rolled over. Except for an IRA received by a surviving spouse, an inherited IRA cannot be rolled over into, or receive a rollover from, another IRA.
Which type of IRA is the right choice for you? While that depends upon many factors, this table highlights some of the key differences.
| Question | Answer | |
| Traditional IRA | Roth IRA | |
| Is there an upper-age limit on opening an IRA? | You must not have reached age 70½ by the end of the year you open a traditional IRA. | There is no upper age limit on opening a Roth IRA. |
| Am I required to start taking distributions when I reach a certain age? | Yes. You have to start taking minimum distributions by April 1 of the year following the year you reach age 70½. | No. If you are the original owner of a Roth IRA, you never have to start taking distributions. There are no minimum distribution requirements, regardless of your age. |
| What is the maximum amount that I can contribute to my account in 2013? | For 2013, the maximum you can contribute to a traditional IRA is the lesser of:
|
For 2013, the maximum you can contribute to a traditional IRA is the lesser of:
|
| Are my contributions deductible? | Maybe—depending upon your income, filing status, whether you (or your spouse) are covered by a retirement plan at work, and whether you receive social security benefits. | No. You can never deduct contributions to a Roth IRA. |
| Do I have to pay taxes on distributions from my account? | Distributions from a traditional IRA are taxed as ordinary income. However, if any of the contributions were non-deductible, then a portion of the distribution will not be taxable. | Distributions from a Roth IRA (both what you contributions and earning on that money) generally are not taxed. |
In addition to being a helpful retirement planning vehicle, the IRA can help offset income tax liability while you are still working. Because you can claim an IRA contribution deduction on your tax return—even if an IRA was established and you made a contribution made after year-end—it can serve as a "last-minute" tax savings strategy.
Keep in mind, though, that the contribution must be made no later than the due date for filing the income tax return for that year, not including extensions. This generally means that you have until April 15of the following year to make the contribution and deduct it on your tax return.
You cannot open a traditional IRA during the year in which you turn 70.5 years old. If you are interested in establishing an IRA and you are age 70 or older, you must consider a Roth IRA.
The most you can contribute to an IRA in 2013 is the smaller of $5,500 or an amount equal to the compensation includible in income for the year. You don't have to contribute the full amount allowed every year, and you may skip making contributions for a year or even several years. Unfortunately, you cannot "catch up" for years no contribution was made.
The contribution limit is based on your compensation, not your income. While most people think of these terms as interchangeable, in this context it means your IRA contribution limit is based on your wages, salaries, commissions and other sources of earned income. It does not include deferred compensation, retirement payments or portfolio income such as interest or dividends.
Those 50 years old and above will also be allowed to make additional $1,000 catch-up contributions to an IRA each year to help them save more for retirement. The same dollar limit applies even if you have more than one IRA, or more than one type of IRA.
When both a husband and wife receive compensation, the limit applies separately to each, meaning a total of $11,000 can be contributed in 2013 (13,000 if both are 50 or over). Also, up to $5,500 may be contributed to an IRA on behalf of a nonworking spouse in 2013 ($6,500 if the nonworking spouse is age 50 or over), but separate accounts must be used for each spouse. The couple must file a joint tax return to claim the deduction, and the combined compensation of both spouses must be at least equal to the amount contributed to both spouses' IRAs.
Everyone is eligible to establish and maintain an IRA, but whether the contributions into the IRA are deductible depends on the individual's or married couple's income level and whether or not the individual (and/or the spouse) is covered by another pension plan at work.
If neither the individual nor spouse is covered under another retirement plan, they may take full advantage of the tax deduction for the amount contributed, regardless of their income level.
If the individual making the contribution is covered under another retirement plan, the amount of the contribution eligible for deduction is determined by the filing status and adjusted gross income of the couple, as shown on the Form 1040 Income Tax Return. The following table was in effect for 2013.
| Figuring Your Maximum Deductible IRA Contribution if You are Covered by Another Plan | ||
|---|---|---|
| If you file a single return and compensation is no higher than: | If you file a joint return and compensation is no higher than: | Maximum deduction is |
| $58,000 | $95,000 | $ 5,000 |
| $59,000 | $97,000 | $ 4,500 |
| $60,000 | $99,000 | $ 4,000 |
| $61,000 | $101,000 | $ 3,500 |
| $62,000 | $103,000 | $ 3,000 |
| $ 63,000 | $105,000 | $ 2,500 |
| $ 64,000 | $107,000 | $ 2,000 |
| $ 65,000 | $109,000 | $ 1,500 |
| $ 66,000 | $111,000 | $ 1,000 |
| $ 67,000 | $113,000 | $ 500 |
| $ 68,000 or more | $115,000 or more | $ 0 |
If the individual making the contribution is not covered by another retirement plan at work, but his or her spouse is covered by such a plan, the non-covered individual may make deductible contributions to an IRA. The deductibility of the contributions, however, is still phased-out if joint income is too high. In 2013, the deductibility of contributions phased-out at income levels ranging from $178,000 to $188,000.
These dollar amounts have been adjusted for inflation through the past several years, and will continue to be adjusted in the future.
You can make a nondeductible contribution to an IRA, even if your income is to high to claim a deduction for that amount. However, your total annual contributions to any type of retirement IRA, both traditional and Roth, may not exceed $5,500 in 2013 ($6,500 if you are at least age 50).
Just be sure that you don't mix deductible and nondeductible contributions,or Roth IRAs and converted Roth IRAs, in the same account. The earnings on nondeductible contributions will still accumulate on a tax-deferred basis. And when you make withdrawals from your account, you'll be able to receive your original contributions (but not the additional buildup in value over the years) tax-free. To report nondeductible contributions, you must file Form 8606 with your tax return.
If you contribute more than the allowable amount, a six percent excise tax penalty will be assessed. This penalty is due for the year of the excess contribution and for each year thereafter until you correct it. In addition, no contributions may be made to an inherited IRA in a form other than cash, or during or after the year in which the individual reaches age 70.5.
Like any retirement plan, rules limit the withdrawal and use of your IRA assets. Violation of the rules generally results in taxation of the withdrawn amount, plus a penalty equal to 10 percent of the withdrawal.
Generally, you violate the rules if you withdraw assets from your IRA before you reach the age of 59.5. However, there are special exceptions that allow you to take distributions from a traditional (non-Roth) IRA if the amounts are used to pay medical expenses in excess of 7.5 percent of adjusted gross income or if the distributions are used by certain unemployed, formerly unemployed, or self-employed individuals to pay health insurance premiums. You can take a penalty-free withdrawal from any type of IRA to purchase your first home.
For IRAs that are not Roth IRAs, you can also take penalty-free withdrawals before age 59.5 to pay certain education expenses for yourself or your dependents, or if you set up a schedule to take "substantially equal" periodic payments for the rest of your life.
Unfortunately, you cannot keep funds in a traditional IRA indefinitely. After all, it is designed to serve as a a retirement account, not an estate planning tool. The amount that must be distributed each year is referred to as the required minimum distribution (RMD).
If there are no distributions, or if the distributions are not large enough, you may have to pay a 50 percent excise tax on the amount not distributed as required.
Even if you starting making withdrawals from your account before you reached age 70.5, you must calculate the RMD and make sure that you receive at least that much annually.
You generally must start receiving distributions from your IRA by April 1 of the year following the year in which you reach age 70½. This is referred to as the required beginning date. Once you reach the age where you must take a RMD, you must continue to take that withdrawal by December 31 of each succeeding year.
Roth IRAs differ from traditional IRAs in several ways. But the most significant of these is that all distributions from a Roth IRA, including all the build-up in value over the years, are tax-free if certain conditions are met.
Bear in mind, though, that the contributions to a Roth IRA are never deductible from income as can be the case with a traditional IRA because all contributions are made with "after-tax" dollars.
Distributions from a Roth IRA will be tax-free if the following two conditions are met:
While tax-free income is great, there are other significant benefits to a Roth IRA as well, such as:
Roth IRAs are not created equal. Higher income taxpayers are limited in the amount they can contribute to a Roth IRA. Joint filers with income under $178,000 in 2013 can make full contributions to Roth IRAs. For those with income between $178,000 and $188,000 in 2013, the contribution amount is phased down, until it is phased out completely at $188,000 in 2013. For singles, the phase-out range is between $112,000 and $127,000 in 2013. These amounts are adjusted for inflation annually.
Unfortunately, penalty-free early withdrawals of funds from a Roth IRA differ from those of a traditional IRA:
You can convert a "regular" IRA to a Roth IRA. The catch is that you must pay income tax for the year of conversion on the entire amount that you convert. Plus, the converted amount must remain in the account for five years. If it is withdrawn prematurely, a 10 percent penalty will apply, not to mention any tax due on the conversion that has not already been paid will become due in the year of the withdrawal.
Prior to 2010, higher-income taxpayers were barred from converting a traditional IRA to a Roth IRA. However, starting in 2010, this $100,000 adjusted gross income ceiling was eliminated. Thus, anyone with a regular IRA can convert it to a Roth IRA. A conversion is treated as a taxable distribution, but is not subject to the 10-percent early withdrawal penalty.
The Roth conversion decision is not clear cut because there can be significant advantages, as well as significant risks. We have compiled a number of factors to consider as you evaluate whether a Roth conversion is a brilliant financial move or costly blunder. Bear in mind you will need to work with a financial professional in order to maximize your benefit and minimize the cost should your initial analysis point toward conversion.
You should, first and foremost, consider:
Another critical factor, and one that is often overlooked in Roth advice columns, is state tax law, which may or may not follow the federal rules. Less important factors, but certainly worth mentioning, are the nature of the contributions to the traditional IRA, any upcoming education expenses you will incur and the impact on social security and Medicare B.
If you are planning to retire in the near future and expect to see your tax rate decline as a result, avoiding tax on the conversion may be wiser than attempting to avoid tax on the distributions in the future.
Keep in mind, though, it's probable that income tax rates will be at their lowest for many years—therefore, you may want to pay your tax bill now. Remember, state taxes figure into your overall tax picture, and it's likely they will increase in the future. This is where a professional can help you decide by crunching the numbers for a variety of scenarios.
State taxes vary widely. If you thinking of relocating in another state, then make sure to have your accountant take that into consideration when comparing the tax liability for the various scenarios.
The larger the amount of non-deductible contributions, the more attractive a Roth conversion can be. The roll-over from the nondeductible contributions is tax-free. Once the principal is in a Roth IRA, the earnings in the Roth IRA will accumulate tax-free until they are taxed on distribution from a traditional IRA.
This math can get complicated rather quickly and needs to be handled by a professional.
If the amount converted was largely from earnings and/or deductible contributions, then you may have a significant tax bill. If you need to dip into your tax-deferred savings to pay the tax bill, you should be very hesitant to convert funds.
If you are younger than age 59.5 and, as a result, will incur the 10 percent excise penalty on early withdrawals, you should be very, very hesitant.
You don't have to convert the entire amount in your traditional IRA in one transaction. Therefore, it is possible to work out a conversion schedule that will prevent a large tax bill.
Keep State Taxes Top of Mind
Nearly all of the information out there about Roth IRA conversions focuses on the changes in federal tax rules. However, nearly everyone also has a state tax bill to worry about. And, not all states will follow the federal rules—whether by design or inertia. Overlooking state tax consequences can derail an otherwise sound investment decision. Make sure your financial planner knows the state laws that affect you.
When their legislature recessed for 2010, Wisconsin had not "conformed" to the federal rules for 2010—and their legislature is not back in session until after the first of the year. This means that a Wisconsin resident could not elect to postpone state income tax on the converted amount: The full amount was due with the 2010 tax return. Even worse, a Wisconsin resident with adjusted gross income over $100,000 (the old federal limit) faced an annual excess contribution penalty of two percent until the amount is withdrawn. If that person was under 59.5 at the time of the 2010 conversion, an additional penalty of 3.33 percent of the amount converted was tacked on the first year penalty.
If you are going to need to draw upon those funds sooner rather than later, conversion might not pay off. First, you may not have enough tax-free appreciate to offset the tax hit you took on conversion. Second, even you are over 59.5 when you withdraw funds, you may be liable for penalties earnings must stay in the Roth for five years. From this angle, the ideal candidate for a Roth conversion is a taxpayer who is in a relatively low income tax bracket now and who is able to let the money accumulate for many years.
While the items discussed above are the major factors that play into a decision to convert several others should be noted: