Q&A: Roth IRA and Joint Tax Returns

Question: I am planning on converting my regular IRA to a Roth this year and so is my husband. I want to report all of the conversion in 2010 and pay the taxes while my husband wants to spread out the tax payments over two years. What can we do as we file a joint tax return?

Allison B., Cambridge, MA

Answer: For married couples who file a joint tax return, you do have some options. First, the tax laws allow you and your husband to each convert the IRAs in 2010 and elect different tax treatment. Thus, it is possible for both to convert in 2010 and the husband (in this case) can elect to defer the taxes while the wife can elect to have all taxes paid for 2010. There are some different reasons why you may want to make either of these elections- it may be better to pay the taxes for 2010 because you believe (as do I) that tax rates will be increasing in 2011 (and thus by deferring you will end up paying more in taxes than paying the tax bill in 2010). However, some taxpayers may want to defer the taxes to take advantage of a rule that allows the taxes to be paid in 2011 and 2012 (with or without tax rate increases).

In addition, there is another rule present in these cases: each individual must be consistent in his or her tax treatments with respect to the conversions. For instance, if the husband has 3 different Traditional IRAs that he wants to convert to Roth IRAs, he must use the same tax treatment on all three IRAs. This means that if he elects to defer the taxes, he can do so but must do so for all three of his IRAs that he is converting. He is NOT permitted to pay taxes on one in 2010 and defer the other two until 2011 and 2012.

Thus, it is fine for each spouse to choose a different method of paying the taxes due on a Roth conversion as long as each spouse is consistent with his or her own tax treatment of these conversions.

January Tax Tip

You are now permitted to make a direct rollover from your 401(k) plan at work to a Roth IRA (assuming your income is less than $100,000 per year and you do not file married separate).

This conversion is a taxable event (like a conversion from a regular IRA to a Roth IRA) and thus tax planning must be done before making the conversion, as you want to do this in a year in which the tax bills will be minimized to the extent possible.

All taxpayers will be able to do this beginning January 1, 2010, as the income limits are eliminated.

Tax Court Rules on Roth IRA Tax Planning

The Tax Court, in Taproot Administrative Services, Inc. v. Commissioner, 133 TC 9 (2009), has ruled that a Roth IRA is NOT an eligible shareholder for an S corporation.

An S corporation, as opposed to a C corporation, taxes its earnings on the shareholder(s) tax returns and is not typically assessed tax at the corporate level. In this case, the sole shareholder of the corporation was a Roth IRA. The IRS issued a notice revoking the S status of the corporation (and thus changing it to a C corporation) due to the “fact” that a Roth IRA cannot be an eligible shareholder (and thus none of the earnings of the S corporation would ever be taxed with this entity set-up). To be an eligible shareholder requires the shareholder to be an individual (US resident), estates, certain trusts and certain exempt organizations. This was a case of first impression with the Court.

The Court noted at the outset that there were no rules which specifically prohibited a Roth IRA from being a shareholder in an S corporation. While there are current regulations to prohibit this (Regulation § 1.1361-1(h)(1)(vii)), there were none back in 2003 (the year at issue in this case). The court relied upon a older IRS Revenue Ruling (passed in 1992) which prohibited a traditional IRA shareholder to be a shareholder in an S corporation as primary authority for ruling against the taxpayer in this case. The rationale of this older Revenue Ruling was basically that an S corporation cannot have any shareholders that are not taxed currently on any profits of the business. In fact, all shareholders, including the eligible trusts previously mentioned, had this attribute.

A Roth IRA, by definition, is not currently taxed on any of its income and, in fact, is never taxed on its income. The court reviewed the facts and Congressional intention to rule that it would not permit a Roth IRA account to be the owner of shares in an S corporation.

IRA Conversions

If you converted your regular IRA to a Roth IRA in 2008, you have until October 15, 2009, to undo the change for tax purposes. There are two common reasons for why you would want to do this:

(1) If your Adjusted Gross Income was over $100,000, you were not eligible to make this conversion

(2) If you were eligible to make the conversion but the value of the Roth has fallen since making the conversion (a somewhat likely event), you can undo the conversion and eliminate the need to pay taxes on the conversion amount.

You can then wait 30 days (the minimum time) and then make another conversion to the Roth, this time with a lower value and hence a lower tax bill.

If you have already filed your 2008 tax return and did not make the switch back to a regular IRA and now want to make this switch, all is not lost. You can file an amended tax return (Form 1040X) and undo the tax treatment on the Roth IRA Conversion. You may want to handle the re-characterization first and then wait 30 days, make the conversion and then file the amended tax return, as there still could be a tax bill due on the conversion (just a smaller tax bill).

Please also remember that all taxpayers, regardless of income, can convert their regular IRAs to a Roth IRA beginning in 2010. This is one of the better tax plans for those who have been previously ineligible.

Q&A - Summer Job and IRA Contributions

Question

My 16 year old son is working this summer and I wondered if he can contribute to an IRA?

Michael L., Des Moines, Iowa

Answer

Michael, your son is in luck, as he can contribute up to $5,000, or the amount of his earnings, whichever is less, to an IRA in 2009. You can even gift this amount to him, although this will count against the $13,000 annual gift amounts.

If a 16 year old contributes $5,000 to his Roth IRA (the most attractive IRA for younger workers) this year, it would be worth about $137,000 when he turns 65 and $193,000 at age 70, assuming an annual rate of return of 7% per year. You can imagine if he does this for the first ten years of his working career. He will retire a millionaire (whatever that may be worth when he retires)!

A Roth IRA is tax free when withdrawn and the funds can also be used for other purchases, such as a first home. In addition, these funds can be placed into a self-directed IRA to provide more flexibility in terms of available investment vehicles.