Author Topic: Lost tax advantages of a Trad IRA, paid the IRS, what now?  (Read 2386 times)

Offline javabrewer

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Lost tax advantages of a Trad IRA, paid the IRS, what now?
« on: October 10, 2010, 09:50:03 PM »
While doing my taxes for 2008 I found I owed the IRS money and was determined to escape that by funding a traditional IRA in my wife's name and take the deduction.  My IRAs were maxed out already.  Well I found out later that because my wife is a teacher and has a special retirement fund (is also excluded from SS) that I need to pay those taxes because the deduction was not qualified.  So I paid the IRS the tax with a little interest to square things up.

My contribution was in Feb 2009, at about the lowest low in the S&P 500 index and the IRA has grown about 40% since then and I moved 50% of it to cash recently due to the new highs.  I dont want to keep it around any longer because while my wife is a teacher it will never be useful to me.  Can I roll it over to a Roth IRA and only pay tax on the earnings, or should I cash it out, pay tax and penalties on the earnings and apply the balance towards debt? 

The part I am confused with is that it is a traditional IRA funded with taxed money (not usually the case).  What are my options?

Offline cohutt

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Re: Lost tax advantages of a Trad IRA, paid the IRS, what now?
« Reply #1 on: October 11, 2010, 04:55:30 AM »
My understanding is you can convert. 

BUT:

Non deductible contributions are accounted for on a pro-rata basis, so you might not want to do it. 
Example: 
Say the total value of all your traditional IRAs is 25,000, of which $5,000 is the non-deductible contribution from 2008.  If you converted $5000, you would still owe taxes on $4000 of it. Why? The nondeductible portion all all your IRAs is 20% (5k/25k) therefore only 20% of the conversion gets a pass.
Nondeductible portion can't be cherry picked; it is the same for one day when you start drawing. The tax excluded part is only the pro-rata portion.  No fifo or lifo here, strictly % prorata exclusion from total withdrawals or conversions.
The big IRS IRA publication (590 I think) has this buried in it somewhere.

Offline javabrewer

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Re: Lost tax advantages of a Trad IRA, paid the IRS, what now?
« Reply #2 on: October 11, 2010, 10:21:48 AM »
Yes, I could convert to a Roth.  But I was curious as to how the funds in there would be treated given I've paid tax on them.  From what you wrote it sounds like they have a rule in place for that already.  This IRA was created with only these funds and I haven't added to it (I became an ant since then and am diligently paying down debts vs investing in the markets) so the only part which will be taxable will be the earnings.  According to your formula approximately $4500/$6500 = 69% gets a pass, so I should pay taxes on just over $2k -- the earnings.  That makes sense, +1 for the info.

If I decided to not roll it over but instead apply it to student loan and car debt and get a guaranteed rate of return equal to the interest on the debt.  If I did this I could knock out the student loan and shave a 10 months off the car loan meaning I'd have 22 months left on it, which when I snowball the S.L. payment on it would be about 15/16 months.  Decisions....

Offline cohutt

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Re: Lost tax advantages of a Trad IRA, paid the IRS, what now?
« Reply #3 on: October 11, 2010, 06:08:43 PM »
WRONG!


ALL deducted contributions and deferred earnings of ALL you IRAs total is the total you measure your % against.   

Unless this is your only IRA the 69% isn't accurate. 

For illustration purposes, say you have another $20,000 current market value in IRAs that were funded with deductible contributions.   The total value of all your IRAs would be $20,000 + $6500 = $26,500

If you convert the "$6500" (current value of the ira in question) your formula is as follows:

After tax contributions, all IRAs = $4500
divided by
Total value all IRAs = $26500
=
17% "After tax" ratio
so
$ amount of $6500 converted total that is NOT subject to tax =
.17%
x
$6500
=
$1105
Taxable amount = the rest = $5395

That's why the after tax contributions of a Roth are so much more useful and manageable that non deductible traditional IRA contributions.  Once in a traditional you are screwed in conversion unless you don't have much more value in all your IRAs. 

Offline javabrewer

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Re: Lost tax advantages of a Trad IRA, paid the IRS, what now?
« Reply #4 on: October 11, 2010, 08:54:19 PM »
Cohutt, what if this is the only IRA in my wife's name?  I have some so maybe they will be counted separately?