By now you’ve heard that 2010 is a phenomenal opportunity if you have a high income and want to convert money to a Roth IRA.
In addition to Traditional IRAs, Federal Employees may also be able to convert money from their Thrift Savings Plan or CSRS Voluntary Contributions Plan to a Roth IRA. You can learn more about these conversions in my previous article, Unique Roth IRA Conversions for Federal Employees.
But what if you can’t convert in 2010? Is 2010 really your last chance?
Technically, the income limits on Roth conversions were repealed as of 1/1/2010. As it stands, there is no set date for the income limits to return.
But the tricky thing about tax laws is that they are in effect…until they’re not.
Congress has the ability to bring back those limits whenever they want. Most experts expect Congress to bring back limits on Roth Conversions, possibly as early as 2011. Right now, we simply don’t know what Congress will do.
Keep in mind, that this will not affect your ability to contribute or withdraw your money from the CSRS Voluntary Contributions program, or do an in-service age-based withdrawal from your TSP. But if you want to do a Roth Conversion and Congress brings back income limits on conversions, it might affect *when* you convert. You might choose to delay a withdrawal, or to move the money to another account and plan to convert it to a Roth later.
This is where good tax planning comes into play.
First, you need to know that the income limits on Roth IRAs typically revolve around a special calculated number called your Modified Adjusted Gross Income (MAGI).
MAGI can be tricky to explain. While you won’t see a line on your 1040 that shows your Modified Adjusted Gross Income, everything you need to calculate your MAGI will be on your taxes.
MAGI is a unique IRS specified amount. And most people don’t know they’re MAGI off the top of their head. You’ll be adding back certain items to your Adjusted Gross Income from your tax forms. To see exactly how MAGI is calculated, check out IRS Pub 590, Individual Retirement Arrangements (IRAs), and look for Worksheet 2.1 Modified Adjusted Gross Income for Roth IRA Purposes.
In the past, if your MAGI was above $100,000 (for Married Filing Joint), you could not convert money from a Traditional IRA, CSRS VCP, TSP, etc. to a Roth IRA.
If Congress does bring back MAGI limits on Roth Conversions (which they will likely do, it’s just a matter of when), and your MAGI is above the limit they set…you would not be able to do a Roth Conversion for that year.
However, with good planning, you may be able to lower your MAGI enough in the future in order to qualify.
Here are just a few ideas you could use to possibly lower your MAGI…
- (The most basic) Contribute more to tax-deferred accounts (like your Thrift Savings Plan) in order to lower your MAGI enough. Even if you’re trying to get more money into after-tax accounts like a Roth you may decide to contribute more to your tax-deferred accounts in one year in order to make the MAGI limit.
- Take Advantage of Tax Losses – if you have investments that have lost money in an after-tax account, then you might be able to sell those investments and ‘harvest’ the loss. If you still wanted to have that investment, you wait a certain amount of time (typically 31 days), then buy the investment back. There are limits to how much you can deduct for this situation – but it may be able to help you lower your MAGI.
- If you own rental property, there might be some changes you can make to take legal tax losses on expenses to lower your income. Passive Activity Losses, also called “PALs”, also have MAGI limits, so these may need to be used in conjunction with other ideas.
- LWOP – if you have adequate savings, you might be able to take Leave Without Pay for enough time to lower your MAGI. And if you take LWOP for less than 6 months in a calendar year, it won’t reduce your creditable service for retirement.
- Buying a Tax Deduction – This one is very tricky, but you should know that some high income earners can buy an above the line tax deduction (that would reduce your MAGI). But you should consult your tax or financial professional to make sure this is right for you.
Not all of these are right for everyone. It depends on your goals and your financial situation.
Tax planning is complex, and I recommend that you find a trusted tax or financial professional to assist you. Just because a tax planning strategy exists, doesn’t mean that it is right for you. And if you mess up at tax planning, the consequences are serious and expensive. It’s worth having assistance from someone who does this for a living.
However, many professionals are really more focused on tax-preparation: what happened, what form does it go on, and ‘poof’—here’s how much you owe…now cough it up.
The key to good tax planning is a future-orientation. You want to be asking the question, what can I do to lower my taxes in the future?
While I think tax planning is a phenomenal tool, it is not for everyone. If someone is in debt or living paycheck to paycheck – they should focus on getting financially fit first.
However, if you’re in a good situation financially, tax planning is the next level of financial planning.
Good tax planning helps you use the tax laws to your best advantage. It can also help keep more of your money in your pocket. You are legally required to pay taxes, but you are legally entitled to organize your finances in a way to pay the least amount of taxes required.
So even if MAGI limits on Roth conversions don’t come back, you can still use tax planning to help lower your taxes.
But if Congress does bring back income limits on Roth Conversions in the future, you should know that with good tax planning, you have a number of options that could still allow you to qualify.
