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Annual tax plan: Consider individual retirement accounts

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Now that most people have completed their 2012 tax filings, it’s time to think about tax planning for 2013.

One tried-and-true planning tip is to contribute to your individual retirement account (IRA) early in the year. That way, you start earning tax-favored investment returns as soon as possible.

For 2013, the maximum amount that you may contribute to your IRAs is $5,500, or $6,500 if you will be over age 50 by the end of the year. The limit applies to your total contributions to all IRAs, traditional and Roth.

Many people prefer to contribute to traditional IRAs if they can claim an income tax deduction for the contribution. Those who are not eligible for the deduction because, for example, they are covered by an employer-sponsored plan prefer to contribute to a Roth IRA. Some choose to forgo the immediate deduction and contribute to a Roth IRA because the retirement distributions from the Roth IRA will be entirely tax-free.

Some people who would like to contribute to a Roth IRA are barred by income limitations. For 2013, the following income limits apply to Roth IRA contributions:

  • For married couples filing jointly, the allowable contribution begins to phase out at $178,000 of adjusted gross income (AGI), and no deduction is available if AGI equals $188,000 or more.
  • For singles, the phaseout range is $112,000 to $127,000 of AGI.
  • For a married individual filing a separate return who is covered by a retirement plan at work, the phaseout range is $0 to $10,000 of AGI.

One recommendation to those who wish to contribute to a Roth IRA, but their income is too high, is to contribute to a traditional IRA followed by a conversion of the traditional IRA to a Roth IRA. Some years ago, Congress removed the income limits on Roth conversions.

While this strategy can work fine in many circumstances, it should be undertaken only with the counsel of a tax adviser. One reason to proceed with caution is that the IRS does not allow converters to specify which dollars are being converted. Therefore, it is impossible for those who have funds in any non-Roth IRA accounts to contribute to a traditional IRA and then “convert that account” to a Roth IRA. Conversions must be performed on a pro rata basis, not on specific dollars or accounts.

For example, assume you have $44,500 of untaxed money in traditional IRAs. During 2013, you contribute $5,500 to a traditional IRA and then convert that account to a Roth IRA. The conversion will result in $4,895 of taxable income.

The calculation looks at the $50,000 in total non-Roth IRA money as if it were one account. Since 89 percent of that balance (i.e., $44,500 out of $50,000) is untaxed, you will owe taxes on 89 percent of the conversion amount (i.e., $4,895).