Dear Tax Talk,
When I did my federal taxes, I found that because of pay raises, my wife and I grossed too much -- around $169,000. We both invested $11,000 in a Roth IRA, but now have to declare overinvestment and withdraw the total amount.
Knowing that we will have to pay taxes on any interest income, what would you suggest we do with money returned? Should we place it in the Roth for 2009, invest in an IRA (I do not truly trust market returns at this point), a money market account, a CD or a high-yield tax-exempt fund? We are in process of remodeling and may need cash in the next few years.
Just how long does remodeling take? If you anticipate needing access to IRA funds in the next few years, then any IRA is not a good idea. Assuming you were just talking out loud, I suggest you still do an IRA, but make it a nondeductible IRA.
If you and your spouse were age 50 or older in 2008, your Roth or other IRA contribution could be up to $6,000 each. If one of you was under the age limit, then $11,000 was the proper contribution. As you point out, the returned IRA funds in excess of $11,000 are taxable income in 2008, but you are also fortunate you didn't invest the IRA in something that lost money.
Unlike a Roth or a traditional deductible IRA, a nondeductible IRA can be made regardless of income or participation in an employer-sponsored pension plan. While I was never a fan of nondeductible IRAs, there was a change a few years ago that made them advantageous come 2010.
I wasn't a fan because distributions from nondeductible IRAs were ordinary income, whereas if you invested outright in securities, which would also be nondeductible, the gain could be capital gain, assuming you can make a gain in the new economy.
Under the new rules, beginning in 2010, you can convert an IRA to a Roth IRA regardless of your income level. Prior to 2010, your income has to be around $100,000 or less to be eligible to convert an IRA to a Roth IRA.
This change, however, applies for one year only -- 2010 -- and the income taxes due on conversions can be spread over two years. So the 2010 conversion amount may be included as taxable income in 2011 and 2012, helping to spread out the tax bite.
Conversions in subsequent years are included in income during the tax year in which the conversion is completed. As far as an investment choice for an IRA or any other type of account, no one can provide certain guidance in these difficult times.
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