Traditional to Roth IRA Conversion at Vanguard

So, you’ve done your research, read the articles, crunched the numbers, and you want to convert your Traditional IRA held at Vanguard into a Roth IRA. But, how do you actually do it at Vanguard.com? There is no explicit “Convert” button or link to run this conversion. After some fumbling around, I managed to figure it out. But why not just share it here in mind-numbing detail and hopefully save folks some time.

You’ll need to have both a Traditional and Roth IRA set up at Vanguard first (mutual fund only). If you don’t have the Roth yet, click on the “Open an Account” link on the black bar on the top of every page and open an account first. Be sure to indicate that the funds you’ll use to open the new account are “At Vanguard”.

After you already have both a Vanguard Traditional IRA and a Vanguard Roth IRA:

  1. Log in to your account online. Click on “My Portfolio” so that you can view all your accounts.
  2. Under your Traditional IRA section, click on “Buy & Sell”.
  3. Next, click on “Exchange” on any of your funds.
  4. Now, you can choose to Exchange from all your Traditional IRA funds, to funds in your Roth IRA. You may need to add a new fund.
  5. For the exchange amount, if you are doing a complete conversion, chose All. You may be asked to verify and accept any redemption fees.
  6. You’ll also need to choose your tax withholding options. In order to maximize my balances in these tax-deferred accounts, I chose not to withhold and to pay the taxes separately myself later from a taxable account. Also, I can spread the taxes due for a 2010 conversion over two years.
  7. At the end of the next available business day, your mutual funds will be exchanged into your Roth at their net asset values. Your Traditional IRA will still show up with zero balances, which you can hide from displaying.
  8. Your conversion is complete! Keep your transaction confirmations for tax time.

Keep on reading below for some of the warnings and notifications that you’ll encounter during the conversion process.

A conversion is a taxable event. Generally, you’ll owe taxes on the amount you convert from your traditional, SEP-, or rollover IRA into a Roth IRA.

When you convert to a Roth IRA, you may elect to withhold Federal and certain state taxes. You can get the most benefit from the conversion if you don’t have taxes withheld and instead pay taxes from a separate nonretirement account. Keep in mind that the money withheld for taxes isn’t part of the conversion, and, if you’re under age 59½, you may have to pay a 10% federal penalty tax on it. You also can’t “recharacterize”, or restore to a traditional IRA, the amount you withhold. If you choose not to withhold, you may need to make estimated tax payments to avoid an underpayment penalty.

We encourage you to consult a tax advisor about your individual situation. For 2010 conversions only, you have the option of postponing the tax due and paying it off over two years. If you choose this option, taxable income from the conversion gets split evenly between 2011 and 2012. Alternatively, you can choose to pay all the conversion income in 2010.

Moving money out of a retirement account is a distribution, and all or a portion of your distribution may be subject to federal or state tax. You can elect to have either no federal income taxes withheld from your Vanguard IRA® distribution or a percentage between 10 and 100. If you don’t elect to have income taxes withheld from your IRA distribution, you’ll remain liable for income taxes. Tax penalties may also apply if your estimated income tax payments or income tax withholdings are insufficient under federal or state rules.

Inflation As a Hidden Tax Increase

With all of the current government spending, future promised spending, and the huge trillion-dollar budget deficit, there is a lot of talk about impending inflation. Many people are convinced that there is going to be a tax increase as a result, regardless of your political affiliation. However, this reminded me that we shouldn’t forget that the government can increase taxes without ever passing a bill, making you a new line on your IRS 1040 form, or even telling you about it. It simply has to keep pumping more money into the system.

The Wikipedia entry on “inflation tax” focuses on the idea of increasing prices and devalued currency as a increasing burden on people. But rising inflation itself is a hidden tax increase.

Let’s take a simple investment like a savings account or a bond earning an interest rate of 2% a year, but there is no inflation. Income tax is 25%. So you grumble about your low interest rates, pay your 2 x 0.25 = 0.5% in taxes, and keep the other 1.5% as your after-tax “real” return.

What if inflation is 3%, but you are slightly happier because you’re earning 2% above that for a total of 5%. Income tax stays the same, 25%. But now you’re paying 5% x 0.25% = 1.25% a year in taxes, and after 3% inflation you are left with 0.75% as your after-tax real return. Even worse.

Finally let’s say that inflation is now 6%, and you are still earning 2% above inflation. Income tax again is based on your nominal income, so you’re stuck paying 25% of that 8% interest. This leaves you earning 2% above inflation pre-tax, and then going and paying 8 x 0.25 = 2% in taxes. Your after-tax real return is now zero. You’re not making any money, it all went towards taxes.

All this could happen without ever raising the official income tax rate. This fact is sometimes brought up when talking about inflation-indexed bonds, but applies the same to all investment returns.

Infographic: Overall Tax Rates For Single, Married Filers

VisualizingEconomics has a nice series of infographics that explore how various income-based taxes change with your adjusted gross incomes. It uses 2009 IRS numbers, but should still remain relevant to today. Below is a snapshot of a married filing jointly couple with two kids and one income (click to enlarge):

Not you? Check out also:

Death and Taxes 2011: Visual Guide to the Federal Budget

The 2011 edition of the Death and Taxes poster is out, which outlines in spectacular detail how the United States federal budget spends its (your?) tax dollars. View the huge image online, or buy it as a 2 ft. x 3 ft poster. If you haven’t seen it before, you really should check it out.

Due to what the creator deems complexity and size constraints, the poster focuses on the $1 Trillion discretionary portion of the budget. Discretionary spending refers to the portion of the budget which goes through the annual Congressional debates every year, and amounts to about 1/3rd of the total budget. Currently, the biggest chunk goes to defense spending. Want to know how much the V-22 Osprey gets? It’s on the poster ($2.2B).

The other 2/3rds of the federal budget is mandatory spending, which includes programs which are funded by eligibility rules or payment rules. An example is welfare. If you’re eligible, you get it. The only way to change how much is spent is by changing the eligibility rules.

The poster does include a little chart on the bottom right about the total federal budget, but I think it tries to convey too much information in a very small space. Here’s a simpler breakdown from the 2007 budget, courtesy of PerotCharts. As you can see, entitlement programs like Social Security and Medicare are also huge expenses.

And here’s another breakdown of the 2009 total spending via Wikipedia.

As long as take all of this into perspective, this graphic does a great job of making a complex subject accessible. Not sure how long this will last, but right now with code BOGO you can get two posters for $24 + $1.50 shipping.

How Much Did Your Tax Return Cost? U.S. Average $229

As CPAs everywhere are burning the midnight oil, the National Society of Accountants (NSA) released the results of their 2009-2010 Fee Survey of nearly 8,000 tax preparers, which showed the average tax preparation fee for an itemized Form 1040 with Schedule A and a state tax return to be $229. The average cost to prepare a Form 1040 and state return without itemized deductions is only $129.

Here’s a link to the full press release. The costs varied by geographic region, with the highest being the Pacific (AK, CA, HI, OR, WA).

They also listed the average fees for preparing other tax forms:

• $212 for a Form 1040 Schedule C (profit or loss from business)
• $551 for Form 1065 (partnership)
• $692 for Form 1120 (corporation)
• $665 for Form 1120S (S corporation)
• $415 for Form 1041 (fiduciary)
• $2,044 for Form 706 (estates)
• $584 for Form 990 (tax exempt)
• $58 for Form 940 (Federal unemployment)

If you used an accountant, how do you compare?

2010 Non-Deductible Traditional IRA Contribution Made

I talked about taking some “action” in my last net worth update. We both contributed $5,000 each to a non-deductible Traditional IRA earlier this week. In doing so, I was reminded of how some folks can be intimidated by the amount of IRS fine print you must read every time you try to achieve some tax savings. Perhaps it is a small minority, especially of people reading this, but still significant.

Just to figure out if we were allowed to contribute took some searching. Per this IRS flowchart, because we are married filing jointly and will most likely have a modified adjusted gross income (MAGI) over $177,000, we are unable to contribute to a Roth IRA. How many people know what their MAGI is? In this world of spiraling credit card debt, how many people are willing to try to figure it out?

However, anyone can contribute to a Traditional IRA, even though it doesn’t explicitly state that anywhere. Then the question is whether it is tax-deductible. From this other IRS flowchart, because we are married filing jointly, covered by a retirement plan at work, and have an MAGI of over $109,000, I figure out that our contribution is not tax-deductible.

Finally, I happen to know in 2010, there is no income limit on the conversion from a Traditional IRA to Roth IRA. I must rely on the many mentions from financial media and investment brokers to know this. Even so, there are even more catches in terms of pre-tax and post-tax bits of the IRA to be converted.

I personally don’t mind all of this. But there must be a study somewhere that shows that every time a person has to walk themselves through an IRS flowchart, the overall IRA participation rate drops something like 5%.

Changing 401k Contribution Rates During Year, Catch-Up Contributions

401k company matches are great ways to boost your retirement savings, but sometimes you have to be careful in order to capture it all. My wife’s company offers a 3% match, but only up to 3% of whatever you contributed that pay period. What if you contribute less than 3% for some period, and then a much larger amount a later period, with the overall total being much more than 3%? With some plans, you are simply out of luck and have missed out on potential money. Other plans offer what is called a “catch-up” or “true-up” contribution. Do you know which one you have?

I wrote about 401k true-up contributions and maxing out 401ks earlier, but finally got my hands on the employer’s Summary Plan Description which addresses it explicitly. Luckily, my OCR software was working, and I scanned it in below:

Is a year-end Matching Contribution provided if I changed my saving percentage during the year?

If you are employed by the Employer on the last day of the Plan Year, a true-up calculation is made so that your Matching Contributions will be maximized even if you changed the percentage of your Compensation that you elected to contribute during the Plan Year. The amount, if any, of the true-up Matching Contribution is the excess of (i) 100% of your Employee Contributions for the entire Plan Year that do not exceed 3% of your Compensation for the entire Plan Year that was paid to you while you were eligible for Matching Contributions, over (ii) the total amount of Matching Contributions already contributed to your Account for the Plan Year.

For example, John was eligible for Matching Contributions for all of 2010. John, who earned $40,000 evenly throughout the year, did not elect to contribute to the Plan from January 1 to June 30, 2010. From July 1 through December 31, 2010, John made Employee Contributions of 12% of his Compensation (12% of $20,000 = $2,400), and received Matching Contributions of $600. His year-end Matching Contribution is calculated as (i) minus (ii), as follows:

(i) 100% of John’s Employee Contributions to the Plan for the entire year that do not exceed 3% of his Compensation for the entire year. 100% x 3% x $40,000 = $1,200

(ii) The total amount of Matching Contributions already contributed to his Account for the year = $600

Year-end Matching Contribution to John’s Account for 2010 = 1,200 – 600 = $600

The year-end Matching Contribution generally is contributed to the Plan within a few months after the end of the Plan Year. hi some cases, IRS rules limit or reduce the amount of Matching Contributions the Employer can make on your behalf if you are Highly Compensated, as defined in Question 1, above. You will be notified if you are affected by this limit or reduction.

An important note here is that, at least for this plan, you must be employed on the last day of the Plan Year in order to be eligible for this catch-up contribution.

E-File Your Federal Tax Return Extension For Free

April 15th is only a month away, and you haven’t started your taxes yet. Time to file an extension! The IRS automatically grants a 6-month extension to anyone who asks. Asking a search engine will often direct you towards websites like FileLater.com that charge upwards of $20 to file the form, but here are two ways that anybody can e-File for free. Apparently, the only thing keeping these sites in business is lack of education!

Method #1: TaxACT
This is how I did my extension last year. Just sign up with TaxACT and e-file your extension for free through them. It’s quick. It’s easy.

You don’t even need to actually use them to file your taxes later, although TaxACT is also free for federal taxes with e-File included regardless of income, and is only $14.95 for state returns including free e-File. That’s cheaper than TurboTax or TaxCut, although if you’re already familiar with those programs it may be worth the extra bucks to stick with them.

Method #2: Free File Fillable Forms
This one’s a little harder to find, but here are some step-by-step instructions. Go to the Free File Fillable Forms site (say that 5 times fast) and click on “Start Free File Fillable Forms”. Click “Sign-in” on the top left, and create a new account.

After you’re signed in, click on “Continue” and pick your form. Go with 1040. On the top right, you should see an icon with the label “File an Extension”.

This will bring up Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, a long title for a really short form. You’ll need to estimate your total tax liability for 2009. This form only extends the time to file, not the time allowed to pay. Overestimate your tax liability to avoid penalties. Here is how I estimated my tax liability.

You can even request your estimated tax payment to be withdrawn electronically by supplying your bank’s routing and account numbers. For identification purposes, you’ll need your adjusted gross income (AGI) from your 2008 tax return.

Got state income taxes as well? Here is a helpful page on manually requesting state-specific tax extensions.

Giveaway: QuickTax Platinum Tax Software For Canadians

I don’t know how many Canadian readers I have, but I do have one free copy of QuickTax Platinum ($69.99 value, download version) available to give away.

The Platinum version is the most fully-featured “personal” edition, and includes assistance with investment gains/losses and rental property, as well as RRSP guidance. Other than that, I don’t know much about QuickTax, other than it is made by Intuit and thus looks a lot like TurboTax in the US. However, there doesn’t seem to a similar product by H&R Block for the Canadian market. Who is their biggest competitor then?

To enter, simply leave a comment with a valid e-mail in the proper field below by Midnight Pacific on Sunday, 2/21. Real name not necessary, you can even leave the actual comment box blank. One entry per reader. I’ll randomly pick one winner. Thanks!

How To Generate and Issue Your Own 1099-MISC Forms

Did you as a small business pay another person or business more than $600 total in 2009 for services rendered? You may have to provide them a 1099-MISC form. There are lots of rules, see the 1099-MISC Instructions for complete details. Here’s a summary:

The Internal Revenue Service (IRS) requires businesses (including not-for-profit organizations) to issue a Form 1099 to any individual or unincorporated business paid in excess of $600 per calendar year for services rendered. This is required whether these payments are spread out over the course of the year or are paid in one lump sum payment. The most effective way to obtain the information needed to prepare the Form 1099 is by requiring that an IRS Form W-9 be completed prior to any payment being made. The penalty for failure to file Form 1099 can be as much as 50% of the amount paid for services.

If you’ve got your own accountant or payroll service, then you can pay them to generate the proper forms and send out these 1099s. (They are supposed to be sent out to independent contractors by January 31st following the end of the tax year in which you made the payments.) But if you’re a micro-business or a one-person show and still do all your own taxes, you can easily generate a few 1099-MISCs yourself.

You can get blank forms sent to you for free from this IRS order form. You’ll need at a minimum, Form 1099-MISC and Form 1096. You cannot use the PDFs that you find online; they are only examples. The page says it may take 4-6 weeks, but I got mine in less than two weeks. If you need them faster, you can buy them from any office supply store like Staples or OfficeMax. As noted above, get a W-9 form filled out by the person you paid, and follow the directions.

Finally, if you buy TurboTax for Business (not the personal edition), the software can also generate both 1099 and W-2 forms for you.

H&R Block At Home 2009 Deluxe Discounts (TaxCut)

I don’t know how long this will last, but right now former H&R Block TaxCut fans can get H&R Block At Home 2009 Deluxe Federal + State for only $25 from Amazon, including five federal e-files and free Super Saver shipping. Retail is $45.

From the description: This is the Deluxe version, which handles things like home interest tax deduction, donations, and investment income. Imports data from TaxCut, TurboTax, Quicken, and Microsoft Money software. Compatible with both Windows and Mac OS X. Includes H&R Block Audit Support.

* You can save another $1.26 and download it directly onto your computer if you have Windows.

TurboTax 2009 Discounts For Early Birds

Ready to do your taxes already? Wow, not me. My usual advice for cheap tax software is to check the Sunday newspaper ads. Every year, the office supply stores will eventually sell them for essentially free after rebate. But if you’re not into rebates or just can’t wait, here are some current discounts for TurboTax. It does seem like TurboTax has been shifting their profit margins onto their state software. For reference, TurboTax Deluxe Online for Federal is $29.95 retail with free eFile, but TurboTax Online State retails for $36.95 with eFile. Total: $66.90.

Free TurboTax Federal for 1040EZ (Simple Returns)
If you have a simple return with no itemized deductions, and don’t have any state income tax, then you can get the TurboTax Free edition with free eFile.

Free TurboTax Federal w/ Income Restrictions and Military
If you meet the income and/or military status requirements, the TurboTax Freedom Edition is free for Federal including eFile. Covers all the forms, not just 1040EZ. State filing may also be free for those in AL, AR, AZ, GA, IA, ID, KY, MI, MN, MO, MS, NY, NC, ND, OK, OR, RI, SC, VT, WV. Otherwise it is $14.95.

Free TurboTax Deluxe with State Farm Bank
If you have a bank or credit card with State Farm, you get free TurboTax Deluxe (log-in required). I can’t tell if this includes State? In any case, not a bad perk.

25% off through Vanguard, Fidelity, or everyone via State Farm
Site visitors all can save 25% off TurboTax online for both federal and state. Anyone can be a “site visitor”. This results in final prices of $22.45 Federal and $27.70 State. Total: $50.15

If you’ve got Flagship status at Vanguard (usually $1M in assets), then you get TurboTax Federal and State online for free. One day!

35% off Federal only via Bank of AmericaSite visitors can get 35% off TurboTax Federal, for a final price of $19.45. However, there is no discount on State, making it cheaper to go with the offer above unless you only want Federal.

25% off Desktop Edition via Amazon.com
You can buy the desktop edition for Mac or PC from Amazon.com for $44.99 total, which includes Federal w/ eFile + State. According to the description, it does not seem to include eFile for state.

Additional Notes – IRS FreeFile and TaxAct
Not devoted to TurboTax? You can also check with the IRS FreeFile site to see if you qualify for other free software, usually restricted by income or military status.

Then there’s always the best no-hassle deal around: TaxACT, which again offers a free Federal return + free Efile + $14.95 for State. Total for both: $14.95.