Retirement Planner's Tax Guide
Take advantage of the tax benefits -- and avoid the tax pitfalls -- of retirement accounts.
January 2007
Advertisement
If you're saving in a 401(k), IRA or other retirement account, you probably already are aware of the tax benefits you're getting. But your family may not be taking full advantage of tax breaks that retirement accounts can provide. For example, a recent grad may be eligible for a saver's credit, or your industrious child may be eligible for an IRA. Likewise, if you are unaware of the income or contribution limits for 2006, you could get stung.
- Still time to start an IRA
- IRA rules for kids
- Contribution limits
- Contributing too much to an IRA
- Contributing too much to a 401(k)
- Retirement savings credit
- Deducting IRA losses
- Undo a Roth Conversion
- Minimum IRA distribution rules
- Taxing social security
Still time to open an IRA
Taxpayers have until April 16, 2007, to open and make a contribution for the 200g tax year.
You must have earned income to open either a Roth or a traditional tax-deductible IRA. You cannot be too young to open an IRA, but, if you want to open a tax-deductible IRA, you can be too old. You cannot open a traditional IRA if you will turn 70½ by the end of the year.
If you contribute to your new IRA before April 17, you may get to write-off your contribution on your 2005 tax return. Your deduction is limited if you or your spouse is covered by an employer retirement plan any time during the year. The write-off is phased out if your employer merely offers a retirement savings plan, such as 401(k), and your adjusted gross income exceeds certain levels (see the table).
Roth IRA contributions are not deductible, but qualified withdrawals are tax-free. See the table below to determine whether you are eligible to open a Roth.
You can put up to $4,000 a year into your IRA, and the cap will rise to $5,000 in 2008. Taxpayers age 50 and older can set aside an extra $1,000.,
| ||||||||||||||
| ||||||||||||||||
Roth IRA rules for kids
To be eligible for a Roth IRA, a child has to have earned income from a job. Investment income doesn't count, nor does an allowance or sporadic payments for chores kids do around the house.
The dollar limit is the same for kids as it is for adults: a maximum of $4,000 per year or 100% of earned income, whichever is less. Children don't actually have to contribute their own money. Parents can make a gift, but no more than the amount of the child's earned income (up to the $4,000 limit).
You don't report Roth contributions to the IRS. But if the child earns $400 or more from self-employment, a return must be filed to pay the 15.3% social security tax.
2005 Retirement account contribution limits
| |||||||||||||||||||||||||||
Contributing too much to an IRA
If you've contributed more than your limit to either a Roth or traditional IRA you must withdraw the excess by the date your tax return for the year is due (including extensions). Otherwise, you'll be subject to a 6% tax. The extra tax will follow you year after year until you pull the excess out.
To avoid paying the tax each year, apply any excess contributions to the following year then contribute less that year (so you don't exceed the maximum).
Contributing too much to a 401(k)
If you are a highly compensated employee -- generally one who makes more than $100,000 a year -- your company retirement plan might kick out some of the contributions made during the previous year.
Such "corrective distributions" are required if the plan discovers that highly paid employees contributed too much of their salaries compared with the amount contributed by lower-paid workers. This discrimination testing is required by Congress to prevent the tax benefits of 401(k)s from going disproportionately to higher-paids. Because the test can't be completed until after the plan year closes, the checks for any excess contributions are mailed out after January 1.
How you report that money on your tax return depends on the timing.
If a plan makes such a corrective distribution by March 15, then you report it as part of your 2006 salary -- even though it means reporting more salary than is shown on your W-2. After all, the W-2 amount was set assuming all the 401(k) money you contributed would avoid tax. The corrective distribution retroactively reduces the amount in the tax shelter and hikes your taxable pay.
If the company makes the payout after March 15, it counts as 2007 salary.
If you file your 2006 return before you get a corrective distribution -- and you receive the money by March 15 -- you're supposed to file an amended return using Form 1040X to report and pay tax on the extra money.
Retirement savings credit
Among the many ways Congress encourages Americans to save for retirement is a special credit for workers in low-paying jobs. The "retirement savings credit" rebates up to 50% of the first $2,000 put in a 401(k) plan or an IRA. So, a $2,000 IRA contribution can cut your tax bill by $1,000.
There's a big catch, of course. The credit phases out quickly as income rises. On single returns, you get the 50% credit only if your adjusted gross income is less than $15,000. It drops to 20%, then 10% as income moves up to $25,000. For married couples, the thresholds double: The 50% credit is good until AGI passes $30,000, and it evaporates at $50,000.
Figure the credit on Form 8880, Credit for Qualified Retirement Savings Contributions. Report the credit on line 51 of your Form 1040 or line 32 of your Form 1040A and attach Form 8880 to your return. (You cannot use Form 1040EZ to claim this credit.)
The credit is not available to those younger than age 18, full-time students or dependents.
Deducting IRA losses
You can deduct a loss in an IRA when you close the account -- if you itemize and you're not subject to the Alternative Minimum Tax. To deduct a loss in a Roth IRA, you must close all Roth accounts. To deduct a loss in a traditional IRA, you must close all traditional IRA accounts.
Here's how it works: When you close an IRA, you compare the amount you receive to your "basis" in the account. With a Roth, your basis is the total of contributions plus any conversions minus any earlier withdrawals.
But your IRA loss is not a capital loss to be reported on a Schedule D. Instead, it is an ordinary loss, which is considered a miscellaneous itemized deduction on a Schedule A. The trick there is that miscellaneous expenses are deductible only to the extent that they exceed 2% of your adjusted gross income.
If your adjusted gross income for the year were $50,000, then the first $1,000 of miscellaneous deductions, including your IRA losses wouldn't be deductible.
If you're among the increasing number of taxpayers hit by the AMT, however, you don't get this deduction. Miscellaneous deductions are not allowed under the AMT.
Undo a Roth Conversion
If you converted a regular IRA to a Roth IRA last year, then watched the value of the account dwindle, you still have to report the full amount you converted on your tax return -- and pay tax on it in your top bracket, even on the money that has disappeared.
Fortunately, there's a way around this double whammy. You can undo the conversion -- using something the IRS calls a "recharacterization." Basically, you tell the IRA sponsor to put your money back in a regular IRA. If you do so, you don't have to report the original switch to the IRS. You actually have six months from the due date of your 2006 return to undo a 2006 Roth conversion. But doing so before you file your 2006 return saves you the cost and hassle of having to pay tax now, then filing an amended return to retrieve it if you recharacterize later.
If you really want a Roth, you can re-convert the account next year.
Minimum IRA distribution rules
You need to start taking required minimum distributions from a traditional IRA no later than April 1 of the year following the year in which you turn 70½. After that you'll have to take your withdrawals by December 31 of each year.
The withdrawal requirement is based on your life expectancy and your IRA balance at the end of the previous year. Someone age 70, for example, needs to divide their IRA balance by 27.4. So if your IRA were worth $100,000, you'd need to withdraw $3,649.64 that first year.
To calculate how much money you'll need to withdraw, see our IRA distribution calculator.
Taxing social security
Taxes on social security benefits are based on your combined income -- your adjusted gross income plus any tax-exempt interest plus half of your social security benefits.
Your benefits will be tax-free if you're single and your combined income is less than $25,000 ($32,000 if married filing jointly). No more than half of your benefits can be taxed if your combined income is between $25,000 and $34,000 if single (or $32,000 and $44,000 if married filing jointly). And up to 85% of your benefits can be taxed if you're single and your combined income is more than $34,000 (or $44,000 if married filing jointly). The worksheet in IRS Publication 915 can help you figure out how much of your benefits are taxable.
| |||||||||||||||||||||||||||