Thursday, April 7, 2011

More IRA Tips

After publishing my last blog post about it not being too late to make a 2010 IRA contribution (you have until April 18, 2011), I realized that there is more information that could be useful in making the decision about whether or not to do so. Even if not relevant now, this information may be useful to you in the future.

What If You Already Have Filed Your Tax Returns?

If you already have filed your 2010 tax returns, and you want to make a traditional IRA contribution for 2010 before April 18, you will have to file amended returns to get the tax deduction. File IRS form 1040X to amend your federal return. California residents file form 540X to amend their state returns. You have up to 3 years to file an amended return, so you can make your IRA contribution before April 18, and have plenty of time to file your amended returns.

If you already have filed your 2010 tax returns, and you want to make a Roth IRA contribution for 2010 before April 18, you don’t need to file an amended return, since there are no tax reporting requirements for eligible Roth IRA contributions. However, if your adjusted gross income is not more than $27,750 ($41,625 if head of household; $55,500 if married filing jointly), you should check out the possibility of getting the Retirement Savings Contribution Credit (Saver’s Credit), which would require filing an amended federal return. See the IRS form 1040 Instructions for Line 50 (page 38) or the 1040A Instructions for line 32 (page 33) for more details on the saver’s credit.

You Must Have Earned Income

You cannot contribute to an IRA unless you (or your spouse) have earned income. For example, if you (and your spouse) have no income, or have income only from investments, Social Security, pensions, and retirement plan distributions, you are not eligible to contribute to an IRA (traditional or Roth). In addition to the $5,000 annual limit ($6,000 if age 50 or older) per person, your spouse’s and your combined IRA contributions are limited to your spouse’s and your combined earned income. As another example, you cannot contribute to an IRA for your child who has no earned income.

Spousal IRA Contributions

Your spouse with no earned income (or less earned income than you) may be able to contribute to an IRA based on your earnings. See Spousal IRA Limit and Can You Contribute to a Roth IRA? in IRS Publication 590 for details. If you are in the 25% federal and 8% state tax brackets, contributing to a spousal traditional IRA could save you up to an additional $1,650 ($2,000 if age 50 or older) in income taxes. Contributing to a spousal Roth IRA gives you and your spouse the potential for more tax-free income in retirement.

IRA Deduction Worksheet

Although IRS Publication 590 has all of the information you need to determine your eligibility for IRA contributions and deductions, you can also use the IRA Deduction Worksheet on pages 30 and 31 of the IRS form 1040 Instructions, or pages 27 and 28 of the 1040A Instructions, to determine the amount, if any, of your deduction for a traditional IRA contribution.

Traditional or Roth: You Can Change Your Mind After Making a Contribution

If after making your traditional or Roth IRA contribution for 2010, you decide that you would prefer to make a 2010 contribution to the other type of IRA instead, there is a process to make the switch, as long as you do so before October 17, 2011. This is called recharacterizing the contribution. See Recharacterizations in IRS Publication 590 for details.

There are many reasons you might want recharacterize your IRA contribution. Perhaps you made a traditional IRA contribution, but when doing your taxes you realize that your income is too low to get any benefit (or the full benefit) from the deduction. In this case, you can recharacterize all or part of the original traditional IRA contribution to a Roth IRA contribution, and get the future benefit of tax-free distributions.

Conversely, if you made a Roth IRA contribution, and then received unexpected income that puts you in a higher tax bracket for 2010, you may decide that you prefer taking the 2010 tax deduction for a traditional IRA contribution (assuming your income doesn’t exceed the limits for taking the deduction). Recharacterizing the contribution from Roth to traditional is the solution.

Your IRA custodian will have the appropriate form to fill out to complete an IRA recharacterization. It’s easier if you haven’t filed your 2010 tax returns yet, but even if you have, you still can recharacterize the contribution any time before October 17, 2011, and then amend your returns.

See the IRA Recharacterization article in the Bogleheads Wiki for more details on IRA recharacterizations.

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