Andrew Palumbo, 50, got the equivalent of a kick in the gut when he looked at his 1998 tax forms recently.
Many tax breaks he qualified for in past years were ruled out or significantly reduced for 1998, Palumbo says. He calculates that about $2,500 in education credits and at least $800 in various itemized deductions are “all out the window.”
What happened? He converted his traditional individual retirement account to a Roth IRA last year.
Like many people who have converted to a Roth IRA, Palumbo is finding that the tax implications are more complicated, and costly, than he first realized. Fortunately, however, it isn’t too late to undo the conversion. Investors have until their tax-filing deadline to revert a Roth IRA back to a traditional IRA.
“Then for tax purposes, it’s as if it never happened,” says Ed Slott, editor and publisher of the Ed Slott’s IRA Advisor, a newsletter in Rockville Centre, N.Y.
A business consultant, Palumbo was keenly aware that he would owe income taxes on the amount he rolled into a Roth IRA. This point has been clearly emphasized in many educational materials supplied by financial-services firms administering conversions.
But he had no inkling about another big tax drawback. Namely, money converted to a Roth is counted as adjusted gross income and therefore affects eligibility to take certain tax deductions and credits.
“That’s the hidden cost of converting,” says Keith Cramer, a certified public accountant and financial planner in Concord, Calif. “Everything that keys off your adjusted gross income is going to be brutalized by that extra income.”
While the rule is clearly cited in Roth IRA regulations, the various tax implications aren’t mentioned in Roth IRA educational materials and Web sites provided by some major mutual-fund companies and other financial-services firms eager for investors to convert to a Roth IRA.
“Financial-services firms want you to convert because it lowers their administration costs,” says Ray Martin, principal at State Street Global Advisers in Boston, a subsidiary of State Street Corp. “With a Roth there’s no more costly tax reporting, because distributions from a Roth are tax-free.”
But figuring in some of the “ancillary” tax implications of a Roth conversion is “not a simple analysis. You almost have to do a tax projection on an individual-by-individual basis,” something a Web site or the general literature is not equipped to do, says Jack Brod at Vanguard Group, the mutual-fund giant. He says financial-services firms aren’t omitting any information about conversions for selfish reasons. “At the end of the day, we want our shareholders to do what’s right and in their best interest,” he says.
It’s easy for people to be confused about whether converted money is counted as income for all tax purposes, because converted assets aren’t counted as income when figuring eligibility to convert to a Roth, says Martin Nissenbaum, national director of personal income-tax planning for Ernst & Young, New York.
Investors can convert as long as their income–individual or joint–doesn’t exceed $100,000. If someone with a $90,000 income rolls $40,000 from an IRA to a Roth IRA, for instance, income is considered $90,000 for determining eligibility, not $130,000. Some taxpayers may not be aware that the converted amount is added to taxable income for other purposes, says Nissenbaum.
“I thought adjusted gross income is supposed to be a reflection of the money you brought in for the year. The money I converted is not in my pocket, it went from one account to the next,” says Palumbo.
For people who converted last year, the tax impact of converting is milder than it will be for those who convert this year or later. That’s because Roth regulations permit people who switched last year to spread the income from the conversion over four years, so that taxes on converted assets may be paid over four years. Someone who converted $100,000 last year, for example, can tack $25,000 to taxable income in 1998 and in each of the next three years.
The downside of spreading the burden over four years is that whatever tax breaks are lost or minimized for 1998 may also be diminished in the next three years.
A Roth IRA is a retirement-savings account that lets after-tax contributions grow tax free. Traditional IRAs defer taxes on gains until assets are withdrawn, but distributions are taxable.
The Roth IRA also has some attractive estate-planning benefits. Investors aren’t required to withdraw any money from a Roth during their lifetime, as they are with a traditional IRA, making it possible to leave more to heirs. Moreover, heirs don’t have to pay income taxes on inherited Roth assets, as they would on a regular IRA.
These advantages of a Roth IRA in many cases outweigh the tax drawbacks of converting to a Roth, Nissenbaum says. But the reduction or elimination of certain tax breaks may be too big a blow for some investors.
Here are some ways a Roth conversion may affect what you owe the IRS:
– Income-tax rate. You may find yourself in a higher income-tax bracket for 1998. Say your income without a Roth conversion was $80,000. Assuming you’re married filing jointly, that would put you in the 28 percent tax bracket. But if you converted $40,000, some of your income would be taxed at 31 percent, which begins with adjusted gross income of $102,300 for couples.
– Social Security payments. If you receive Social Security, the IRS may take a bigger bite out of your payments. “As adjusted gross income floats up, that directly affects the percentage of your Social Security payment that is subject to taxes,” says Cramer.
– Miscellaneous itemized deductions. Deductions for miscellaneous expenses such as tax preparation, investment advice, non-reimbursed business expenses and union dues may get minimized or lost. These expenses are deductible only when they equal more than 2 percent of adjusted gross income. So the greater your income, the greater your deductible expenses will have to be to get above that threshold.
For example, someone earning $90,000 would only be able to deduct miscellaneous expenses above $1,800. So a taxpayer who had, say, $2,500 in miscellaneous expenses, would be able to deduct $700. But now assume that a Roth conversion bumped that taxpayer’s income up to $130,000. In that case, the 2 percent threshold would be $2,600 and deductions wouldn’t be allowed.
– Personal exemptions and itemized deductions. Personal exemptions and itemized deductions are phased out gradually once income reaches certain thresholds. For singles, eligibility to claim a personal exemption begins to phase out when income reaches $124,500, and couples start losing the benefit when income hits $186,800. Taxpayers–both singles and couples–begin to lose itemized deductions at $124,500 in adjusted gross income.
– Education tax breaks. Various education tax breaks may go by the wayside. For example, eligibility for higher-education credits, including the new Hope credit (maximum: $1,500) and the lifetime learning credit (maximum: $1,000), phases out gradually for single taxpayers with income from $40,000 to $50,000, and for joint returns between $80,000 and $100,000.
Also, to make full contributions to an Education IRA, a tax-deferred investment vehicle, income for singles can’t exceed $95,000 and for couples, $150,000.
– Child credits. A $400 credit per child under age 17 starts to phase out for single taxpayers with income of $75,000, and for couples filing jointly, $110,000.
– Medical deductions. Medical expenses can be deducted after they total 7.5 percent of income. As with miscellaneous expenses, an increase in income can disqualify deductions you may otherwise have taken.
– Underpayment penalty. One final blow: possible IRS penalties if you converted a lot of cash but didn’t adjust your tax withholding or pay estimated taxes. Under certain circumstances you avoid penalties, such as if you underwithheld less than $1,000, or withheld at least 90 percent of 1998’s tax liability.
