As night follows day, regulations follow tax laws. And the new Roth IRA is no exception. Congress smiles in the spotlight when it passes a new tax break. Then it tosses the nascent law to the IRS and says, “Make it work.”
The IRS, laboring in the fog, has to produce an enforceable rule. Presto more paperwork, new tax forms and regulations that nobody understands. For this, the Congress will ritually bash the IRS, although Congress was the prime mover of the mess.
This brings me to the question of converting a regular IRA into a Roth IRA. I’ve gotten more mail on this issue than any other investment matter I can remember.
Conversion sounds simple on the surface, but the questions surrounding it are incredibly complex. The IRS recently closed a loophole that some converters were using to enhance their tax break.
A Roth IRA lets you accumulate investment earnings entirely tax free, as long as you’re at least 59 & #733; when you take the earnings out and have held the Roth at least five years.
Roth conversions are terrific for people who’d like to leave part or all of their IRA money to heirs. With a regular IRA, you have to start making withdrawals no later than 70 & #733;. With a Roth, no withdrawals are required. You can leave the Roth to heirs entirely income-tax free.
You can move part or all of the money in your regular IRA into a Roth if your adjusted gross income doesn’t exceed $100,000, married or single. One hitch: The money you convert will be treated as current, taxable income.
If you do the conversion before Dec. 31, you can stretch the income hence the taxes over four years. By paying the tax with non-IRA money, you leave the maximum in the Roth to accumulate tax free.
Taxophobes resist the cost. “There’s a psychological impact to writing that tax check,” says certified public accountant Ed Slott, of “Ed Slott’s IRA Advisor” newsletter in Rockville Centre, N.Y. “It’s turning some people away from what would be a good deal for them.”
You’re taxed on the value of the IRA money on the day you convert. Not surprisingly, this summer’s stock market plunge created a Roth IRA game.
To understand the loophole that allows that game, let’s follow the ploys of Taxpayer Smart. He converted to a Roth in May, when his regular IRA was worth $50,000. That meant he’d be taxed on an IRA income of $12,500 on each of his following four tax returns.
But after the market drop in July, the money in his Roth was worth only $40,000. So Taxpayer Smart switched the money back to a regular IRA. Then he reconverted to a Roth again.
That quick switch reset the Roth’s taxable value at $40,000. He now owes a tax on only $10,000 of income in the following four years.
Some taxpayers made this switch more than once. The multiple switches produced a blizzard of paperwork for the banks, mutual funds and brokerage houses that handle Roths, and potentially made the transactions tough for the government to track. So the IRS said, “stop.”
Under a new rule, you can still go from a regular IRA to a Roth, then back to a regular IRA again. But you can make that trip only once, between Nov. 1 and Dec. 31.
If, during that period, you make a second switch back to a Roth, the second Roth won’t count for tax purposes. Only the first one counts. (But all switches prior to Nov. 1, 1998, are OK.)
If you’re currently holding a Roth that’s worth less than it was originally, by all means save taxes by switching back to a regular IRA, then reconverting to a Roth, before year-end.
But what if you end the year with a Roth and the market plunges next March? You might decide that you don’t want to pay the tax on the higher amount.
In that case, you’re allowed to go back to a regular IRA before the due date of your tax return. Your Roth transactions are erased.
You can make one switch from a regular IRA to a Roth in 1999 (and back again, if you want). There will be new switching rules for subsequent years.
You could hedge your bets by converting part of your IRA money this year and part next year, Slott says. But the tax on 1999 conversions can’t be spread over the following four years.
Bottom line: Roth converters should pick their date and not look back.
College hope
I’ve gotten a letter from a frustrated parent, Burton C. Bradshaw Jr., a machinist working for Union Camp Corp. in Franklin, Va.
He’s rounding up college money for his daughter, who wants to study clinical psychology. She’ll attend James Madison College in Harrisonburg, Va. For state residents, one semester’s tuition and fees come to $2,128.
Bradshaw writes that he has heard about the new Hope Scholarship, a $1,500 tax credit. But he can’t find out how to apply for it and the brochure the college sent him sheds no light. “It sounds like a real nice benefit, but nobody is telling us how to go about it,” he says.
I’m not surprised that he’s confused. The very name “scholarship” makes you want to hunt for an application form.
But it’s not actually a scholarship. It’s an income-tax credit aimed at middle-income people. You pay the college the full amount you owe. When you file your tax return, you subtract the amount of your credit from the tax you owe. Effectively, the government gives you up to $1,500 back.
The Hope credit goes to students in their first or second academic year, as long as they’re enrolled at least half time. You can claim as many credits as you have qualified students. If your twins are freshmen, you get up to $3,000.
The credit equals 100 percent of the first $1,000 paid in tuition and fees and 50 percent of the second $1,000, for a total of $1,500, for qualified expenses since January 1. (It can’t be applied to other expenses, such as books, room, board and student activities.)
Warning: You have to pay the tuition in the calendar year when the credit is claimed, says Kalman Chany, president of Campus Consultants in New York. To claim a credit for the spring semester 1999, for example, pay after January. If you prepay in December 1998, you can only use any credit remaining for ’98.
Syndicated columnist Jane Bryant Quinn can be reached in care of the Washington Post Writers Group, 1150 15th St., Washington D.C. 20071-9200.
