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October, 2008

Message from Nelson & Company, P.S., CPAs

Traditional and Roth IRAs---What's the difference?

Traditional IRAs provide tax-deferred growth, whereas Roth IRAs provide for tax-free growth. Roths are also more flexible because they have no age requirement for when you have to stop contributing to them---or when you must start taking distributions from them. Because all contributions are withdrawn tax and penalty-free before earnings, you have more flexibility in withdrawing money from a Roth. Phase-out limits are higher for a Roth IRA, and earnings can be transferred to beneficiaries free of income tax.

Should you convert your traditional IRA to a Roth?
Visit the IRS Question Corner below.

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IRS Times & Inquirer

Inside This Issue...

Tax Tips
Adult Film Star Faces Jail For Tax Charge
IRS Question Corner

Tax Tips

You may want to hold off on that new hot water heater.

The new tax law provides for a 10% credit for 2009 on energy efficient skylights, windows, outside doors, high efficiency furnaces, water heaters, or central air systems. If you have one of those projects on your mind, you may want to think about waiting to take advantage of the new credit.

Stock Market Losses? ---Make them count.

With stocks at a 5-year low, consider selling and taking your losses now. Capital loss deductions are limited to $3,000 a year, but the balance carries over.

Consider taking a position in a similar investment to lock in the "low" and avoid the 30-day wash rule.

Adult Film Star Faces Jail For Tax Charge

Adult film actress Janine M. James, 39, of Huntington Beach, CA, pleaded guilty today to one count of willfully failing to pay her outstanding federal income taxes. James admitted making a down payment on a $647,000 residence and purchasing a new Jeep and recreational vehicle, while knowing she owed more than $200,000 in federal income taxes which she did not pay. James faces up to one year in prison and a $100,000 fine.

IRS Question Corner

Question: Should I convert my traditional IRA to a Roth IRA?

Answer:  There is no easy answer. You must look at the big picture, and considering the state of the stock market, this may be a perfect time.

Contributions to a Roth are not deductible, so they are not subject to tax upon withdrawal as long as they are held for at least five years, beginning on the first day of the first year for which the contribution was made and a.) distribution starts when you are at least 59½ years of age, or b.) distribution is due to death or disability, or c.) distribution is made to you as a qualified first-time home buyer. Roth distributions of your contribution amounts are also not subject to the 10 percent penalty for early withdrawal. Within limits, contributions to a traditional IRA are deductible, so distributions are subject to income tax at current rates.

Understanding the main difference between the two, you now need to consider a few things before making the decision to convert. First, your distribution from your existing traditional IRA is a taxable distribution, so you must report any amount you take from it as ordinary income, even if it is immediately rolled into a Roth. In addition, you might be subject to the 10 percent penalty if you don't meet any of the IRA penalty exemption rules. Despite the income tax on the distribution, you still may want to consider conversion because you are not taxed on the income earned by the IRA over time.

There are two more major factors to consider. First, you can only convert if your modified adjusted gross income is less than $100,000 that year. The amount of income attributable to the IRA distribution is not included. Second, Conversions strongly favor younger taxpayers. The younger person has more time to recover taxes through market gains over time. If you're 40 years old and have $25,000 in a traditional IRA and your tax rate is 30 percent, by taking the distribution, you incur federal and state income taxes (but no early withdrawal fee) of $7,500. If you earn only 7 percent annually, it will take you less than six years to recover the taxes. At age 46, your investment regains pre-distribution value and further distributions would be free of both tax and penalty. By the time you retire, at say age 65, you enjoy 19 years of tax and penalty-free growth. If you are a conservative investor, consider that you may not get the growth that an aggressive investor will. Regardless of your age, you might not make up the taxes.

You must consider the size of your distribution before you convert. With our graduated income tax system, the larger the withdrawal, the more costly the conversion. In 2006, the 25 percent bracket for married filing jointly ran from $61,300 to $123,700. Let's say you and your spouse had taxable income of $90,000. You could have taken up to $33,700 of IRA distributions without being pushed into the 28 percent bracket.

People generally think in terms of the Roth IRA as a means of getting immediate access to retirement funds without risk of the 10 percent early withdrawal penalty. While it's true the initial Roth investments may be taken tax and penalty-free at any time, it is not so with gains or with conversion assets. With gains, distributions that don't meet conditions mentioned earlier are subject to current income taxes. Conversion assets are subject to the 10 percent penalty unless you meet rules discussed below.

There are potentially three Roth assets. First, there are the original contributions. They are not subject to either taxes or early withdrawal penalties, so if you contribute $5,000, and two years later, when the account is worth $5,400, you withdrawal $5,000, you are not subject to income tax or penalty because your withdrawal did not exceed the amount of the original contribution.

Second, there are conversion assets. These come into the Roth by conversion. To avoid the penalty on distributions, you must hold those assets in the Roth for at least five years, beginning with the year the conversion was made. After that, you can withdraw conversion assets (but not the investment gains) without risk of the 10 percent penalty. Keep in mind that each conversion has it's own five-year holding period.

The third is investment gains. The same rules that determine if they are taxable also determine if they are subject to the 10 percent penalty. For example, let's say you contribute $5,000 to a Roth at age 40, and two years later, the account is worth $5,400. You withdraw the entire $5,400. Withdrawal of the initial investment is free of tax and penalty, however, you are taxed on the $400 and are subject to an early withdrawal penalty of $40. The five-year holding period for gains is subject to a separate calculation than the conversion holding period. In other words, suppose you convert $5,000 to a Roth one year. By year six, you can take $5,000 free of tax and penalty. But suppose that in year three, investment gains of $400 are credited to the account. These gains are not subject to tax and penalty-free distribution until year eight.

As you can see, careful planning is a must when considering conversion. Get help. For a free, no-risk consultation, please call my office at 253-752-9522 or send me an E-mail at Do it today!


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Nelson & Company, P.S., CPAs Since 1979