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In contrast to the traditional IRA, when using a Roth IRA, the taxpayer does not get a deduction on his or her income tax return for contributions; meaning the contributions are in “after-tax” dollars. The upside to the lack of current deductions in the Roth is that qualified distributions are tax-free. In addition, the Roth IRA does not mandate RMDs, so if the taxpayer does not need a distribution, contributions continue to grow tax-free in the account. Also, there is no age limit on making contributions to a Roth IRA, so the taxpayer could continue to make contributions as long as he is alive and within the contribution limitations. One of the few drawbacks of the Roth IRA is that the Roth IRA account must be open for five years before withdrawals can be made without penalty.
Benefits of Conversion
· You can hedge the current low income tax rates against increases that may come in the future. Currently, the highest marginal tax rate is 35%, but this is due to increase to up to 44% in 2013, and could possibly go higher, depending on legislation before Congress. If you are in the highest tax bracket currently, and foresee remaining in the highest tax bracket throughout your retirement, a conversion will lock in the lower current tax rates.
· Unlike traditional IRAs, Roth IRAs do not have mandates for required minimum distributions (RMDs). If you do not foresee a need for distributions during your retirement (because of sufficient other income-producing assets), there is really no need for distributions from the IRA. Each distribution loses tax-free growth otherwise afforded in the account.
· Beneficiaries who inherit any undistributed portions of the Roth IRA will not have to include distributions in their taxable income. In addition, if you do not take distributions, the amount given to beneficiaries could be much greater than if RMDs were required. Because of these two factors, the potential return for all beneficiaries is much greater for a Roth IRA than a traditional IRA.
· The younger the IRA account holder’s age, the more the benefit. This really comes down to two principles: 1) There will be less in the IRA because of the younger age, so there will be less taxes incurred at the time of conversion; and 2) The owner will have more time to plan his or her retirement, thus avoiding the need for distributions, giving the Roth IRA more time to grow, taking advantage of compounding interest.
· State taxes. If, at the time of conversion, you live in a state with no income taxes, but you anticipate your retirement home in a state with income taxes, then a conversion could lessen your potential tax burden by avoiding state income taxes by accelerating the tax due.
Disadvantages of Current Conversion
· Tax rates may not increase. The main benefit of a conversion is you are locking in the current 35% maximum tax rate on income, opposed to the projected 39.6% (or higher) maximum rate in future years. If you expect your income to fall in your retirement years when you are actually drawing from the IRA, then you may qualify for a lower tax bracket, making this tax hedge a needless expense.
· You accelerate the tax due to the current year. Even though this is “rollover” you are switching the account from a before-tax account to an after-tax account, so the total value will have to be included in your taxable income. The best way to benefit from this rollover is to pay the taxes from non-IRA assets. If you do not have sufficient assets to pay the necessary taxes, then this conversion is not recommended for you as the amount which could grow tax-free will be lessened.
· You could incur penalties. If the rollover occurs before the IRA owner is 59 ½ years old, then any amount not rolled-over (i.e., amounts used to pay the taxes incurred) will be subject to an additional 10% penalty tax for early withdrawal. Also, all amounts contributed must remain in the account for 5 years. If amounts are withdrawn before the 5 year mark, regardless of whether the owner is retirement age, they will incur a 10% tax penalty. If you foresee either of these applying to you, a conversion is probably not a good idea.
· State taxes. If, at the time of conversion, you live in a state with income taxes, the converted amount will be taxed at the state level. If you plan on retiring to a state without income taxes, like Florida, then you will have needlessly paid income taxes to your current state.
Is Conversion Right for Me?
Although this article cannot specifically address every situation for every person, it is written to address the two main benefits of a conversion from a traditional IRA to a Roth IRA; hedging income tax rates and no RMDs. The current tax rates are the lowest they have been in recent history and they are likely going to be lower than tax rates in the foreseeable future given the current political alignment in Washington. Even if tax rates are not raised through specific legislation, the current maximum rate of 35% will revert back to 39.6% in 2011when the Bush tax cuts expire. If a taxpayer currently is in the highest income tax bracket, and foresees staying in the highest bracket throughout retirement, then this hedge would probably be beneficial for him, strictly speaking to saving taxes. Secondly, if the taxpayer is in the highest marginal income tax bracket he probably will not need the RMDs as required by a traditional IRA, so by converting to a Roth IRA, the taxpayer can continue to grow the account tax-free until it passes to his or her beneficiaries at death. This tax-free growth could result in significantly more value over a taxable RMD and a subsequent investment of the distributed amount.
If these two characteristics apply to you, then a conversion of your traditional IRA should be reviewed more fully with your tax professional.
For farmers looking to lessen their employment tax burden on amounts paid to their employees, the Tax Code provides an exception which is little known and widely underused. According to the Tax Code, a farmer can make payments of wages in-kind (paying value in the commodity the farmer grows instead of cash) and these values will not be subject to FICA taxes or income tax withholdings, as long as the employee is not in the business of farming other than as an employee.
This tactic only reduces employment taxes and is not effective in reducing income tax burdens of either the farmer or the employee. The farmer will have to recognize ordinary income for the value of the commodity used as the payment, but this will be offset by a wage deduction, resulting in no tax gain or loss. The employee will still be required to report the value of the commodity received on his income tax return as ordinary income. Since there were no income tax withholdings, the income tax due for this amount will still be outstanding and the employee will have to take affirmative efforts to pay the tax.
This transaction will result in three main benefits to the employer and employee: 1. There is an instant savings in FICA taxes for both the employee and employer. 2. The employee is able to convert the wage to a capital asset, and if he holds it for more than one year, he is able to get favorable tax rates at the time of the sale. 3. The employee actually gets more “bang for his buck” on purchases of food. Consider an employee getting paid $1,000. FICA taxes and income taxes equal to about $350 will be owed. Employee will then only have the $650 remaining to purchase food and essentials. Now, if the Employee is paid with $800 in cash and $200 of beef from the Farmer, only $280 is paid in FICA taxes and Employee’s food costs have decreased because he has $200 in beef.
An Example: Farmer has a modest farming operation that nets $100,000 in taxable income before the deduction for wages. Farmer has one employee who he normally pays $35,000 per year in wages. These wages are normally paid in cash. Through bargaining, the Farmer and the Employee agree the wages should be set for the current year at $20,000 in cash and $15,000 in value of wheat and cattle that are produced on the farm. Because $15,000 is now being paid in commodities grown on the farm, neither the Farmer nor the Employee owe FICA taxes on this amount. This results in a savings of $1,148 ($15,000 x 7.65% the rate for FICA withholding) for each.
Seeing the numbers (PIK = Payment in-Kind)
Farmer (Normal) Employee (Normal) Farmer (PIK) Employee (PIK)
Net Farm Income
before Wages $100,000 $ - 0 - $100,000 $ - 0 -
Wages ( 35,000) 35,000 ( 35,000) 35,000
FICA tax ( 2,678) ( 2,678) ( 1,530) ( 1,530)
Income Tax - 0 - ( 3,000) - 0 - ( 3,000)
TOTAL $ 62,322 $29,322 $ 63,470 $ 30,470
As you can see from the above example, there are tax savings of $2,296 from just one employee. This savings are split evenly between the Farmer and the Employee because each is responsible for ½ of the FICA taxes. If the Farmer had a larger operation with more employees, these numbers could greatly increase.
Although this transaction could be helpful to both the farmer and the employee, there are some very important book-keeping and technical matters that must be reviewed. The IRS has enumerated certain requirements that must be followed. First, the arrangement must have a business purpose; it cannot be entered into strictly to lessen taxes. An example of a business purpose is if the farmer otherwise would lack liquidity to pay the wages and the payment in-kind is a way to avoid the liquidity problem.
Second, the employee must bear the cost of ownership. If the commodity is grain, the employee must pay storage and insurance costs for the grain; if the commodity is a calf, the employee must pay feed and medicine costs. The employee owns the commodity and costs associated with it must be reflected as such.
Third, the commodity must be separately identified at the time the wage is paid. If the commodity is grain, the employee should receive the grain and have it stored in a separate bin than that of the farmer to avoid commingling of assets. If separate storage is not available, then the employee should have a grain scale ticket or other storage receipt showing how much grain is his, and relating back to storage costs, he should pay the proportionate share of storage on it. If the commodity is a calf, then it needs to be identified at the time of paying the wage so that the employee can show ownership and costs associated with his ownership on the specific calf. It will not suffice for the farmer to say the employee gets the equivalent of so many bushels or so many calves on the date of sale by the farmer.
Fourth, the payment in the commodity should not just be a cash substitute. The farmer should not sell the commodity and just pay the employee the percentage that related to his “wage”. This does not give the employee any power over the commodity and it signifies the intent of the whole transaction was to really just pay cash value at the time of the transaction.
Lastly, the wages paid to the employee do not count towards amounts contributed to the employee for consideration of future Social Security benefits or eligibility. It is our recommendation that part of the wages be paid in cash (which is considered for Social Security purposes) and part in the commodity.
It is recommended that all employees paid in commodities be covered by an employment contract. This contract should:
- Specify the employee’s status;
- Define the quantity or percentage of commodity to be transferred as compensation;
- State that the employee has complete control and risk of loss with respect to marketing/sale of the commodity after transfer of the commodity from the employer;
- State that the employee provides labor only; all farm expenses should continue to be the responsibility of the employer; and
- Recite any fringe benefits, which are also being provided to the employee.