by
Jack Piazza
Sensible Investment Strategies
Initiated in January 1998, a new type of Individual Retirement Account (IRA) offers a terrific feature that was previously unavailable in retirement plans: tax-free accumulation and tax-free withdrawal. This new IRA is known as the Roth IRA and is part of the Taxpayer Relief Act of 1997 and the IRS Restructuring and Reform Act of 1998.
Investors can establish, and add to, a Roth IRA by two different methods: (1) contributions, which represent "new" money and (2) conversions, which are transfers from existing traditional IRAs. A Roth IRA is funded with after-tax dollars, whether by contributions or by conversions -- there is no front-end deduction from gross income.
Contributions
The Roth IRA currently allows annual nondeductible contributions of up to $5,000 of earned income for singles, $10,000 for married couples who file jointly ($5,000 per spouse); individuals over age fifty can contribute up to $6,000. Earned income is compensation (employee, self-employment) and alimony.
Roth IRA contributions are limited for higher incomes. The maximum contribution for tax year 2008 is subject to annual Adjusted Gross Income ceilings -- $101,000 for single taxpayers, $159,000 for couples filing a joint return. Contributions are pro-rated if income falls in a phase-out range between $101,000-$116,000 for individuals and $159,00-$169,000 married couple filing jointly. Contributions to a Roth IRA are not available if income exceeds the phase-out range.
However, the annual contribution limit for a Roth IRA is reduced by contributions to any traditional (non-Roth) IRA for a given year. Furthermore, any conversions from a traditional IRA to a Roth IRA (discussed below) are not considered contributions and therefore should not be included in Adjusted Gross Income calculations or annual contributions to determine Roth eligibility.
In 2002, the dollar limit for annual contributions for a Roth IRA (as well as a traditional IRA) increased from $2,000 to $3,000. This dollar limit increased to $4,000 in 2005 and increases to $5,000 for 2008. After 2009, the annual maximum is adjusted for inflation. Special note: In 2002, an individual over age 50 was allowed an additional $500 per year (over the regular maximum) and an additional $1,000 per year beginning in 2006. The following table summarizes maximum contribution limits per individual.
Year Regular 50+ 2008 $5,000 $6,000 2009 $5,000 $6,000
Conversions
You can convert funds from a traditional IRA into a Roth IRA if your Adjusted Gross Income is $100,000 or less; the amount of this ceiling applies to single or joint tax payers. All Roth conversions are treated as distributions and are therefore subject to ordinary income tax rates, so proceed with caution: consider the time horizon for the Roth IRA as well as the tax consequences. All taxes that are due from conversions must be accountable in the year of the conversion.
Special note: Beginning in 2010, the existing $100,000 Adjusted Gross Income test for conversions will no longer apply. In addition, conversions that occur in 2010 will be able to pay 50% of the conversion taxes for year 2010 with the remaining 50% paid in the following year.
A substantial portion, if not all, of the conversion is likely to be subject to taxation at ordinary income rates, depending on the proportion of nondeductible contributions, deductible contributions and accumulated earnings in the conversion amount; only nondeductible contributions are not subject to taxation. Furthermore, the aggregate balance of all IRAs owned must be factored to determine taxable income resulting from the conversion. For example, if you have one deductible IRA and one nondeductible IRA, you must consider the proportionate percentages of both IRAs (in terms of accumulated earnings, deductible and nondeductible contributions) for tax purposes -- even if you transfer funds from only the nondeductible IRA.
It is permissible to reverse a Roth conversion; in other words, it is possible to cancel the conversion and revert to a traditional IRA. The circumstances for reversal could include an unexpected rise in Adjusted Gross Income above $100,000 (which would preclude a conversion) or a severe decline in net asset value after the conversion (to avoid declaring higher taxable amounts). However, you are allowed only one conversion reversal for any tax year, so choose wisely.
Withdrawals
The special treatment of withdrawals is what distinguishes the Roth IRA from other IRAs. Because the contributions to a Roth IRA are nondeductible, withdrawals of contributions are tax-free and penalty-free: they are permitted anytime without restriction. Withdrawals of accumulated earnings are entirely tax-free only if you (1) hold the Roth IRA for a minimum of five years and (2) meet one of the following qualified exemptions:
- Reach the minimum age of 59 1/2
- Take up to $10,000 for first-time home purchase
- Disability
- Death
Withdrawals of amounts attributable to conversions have been clarified by technical corrections. In the original statue, a big loophole allowed investors to convert traditional IRAs to a Roth IRA, declare the taxable income from a 1998 conversion over four years and then immediately withdraw those conversion amounts without any additional tax ramifications. That loophole no longer exists because the technical corrections impose a five-tax-year waiting period, beginning with the year of first conversion (discussed below in Taxes and Penalties).
Technical corrections also imposed ordering (distribution) rules: withdrawals are deemed to first come from contributions, followed by a first in-first out basis for any conversion amounts which were subject to taxation, then any conversion amounts which were not subject to taxation upon conversion and, finally, accumulated earnings. These ordering rules also eliminated the need for separate Roth IRA accounts for contributions and conversions.
Finally, unlike other types of IRAs, the Roth IRA has no minimum distribution requirements; if you wish, you can hold your Roth IRA indefinitely without ever taking any withdrawals. Upon your death, your heirs would receive the Roth IRA proceeds which would be entirely free from federal income taxes -- unlike other IRAs.
Taxes and Penalties
As previously stated, any withdrawals of contributions are tax-free and penalty-free anytime. Withdrawals from conversion amounts are also withdrawn tax-free and penalty-free, provided you have held conversion amounts for a minimum of five years; however, if you withdraw from conversion amounts within five tax years of your first conversion and are under age 59 1/2, then a 10% early withdrawal tax penalty would apply to all withdrawn conversion amounts for that year. Once total contributions and all conversion amounts have been withdrawn, subsequent withdrawals would be from accumulated earnings. If you have not met one of the qualified exemptions discussed in "Withdrawals", then all early withdrawals of accumulated earnings are taxed at ordinary income rates plus a 10% early withdrawal tax penalty.
The 10% tax penalty on early withdrawals for conversions and accumulated earnings is waived for the following exceptions:
- Death
- Disability
- Equal periodic payment withdrawals over owner's life expectancy
- Medical expenses greater than 7.5% of Adjusted Gross Income
- Health insurance premiums for an unemployed person
- Qualified higher-education expenses
- First-time home purchase
Strategies
The Roth IRA is not intended to replace a 401(k) plan, especially if your employer matches a portion of your 401(k) contributions. Ideally, after maximizing your 401(k) plans, the Roth IRA should be your next investment priority since earnings grow tax-free and withdrawals are tax-free -- a terrific combination, provided you qualify and can meet the minimum holding requirement of five years and meet one of the qualified withdrawal requirements.
Many investors may also face a decision between the Roth IRA and either (1) a nondeductible IRA or (2) a deductible IRA. The Roth IRA is the clear choice over the nondeductible IRA; both are very similar except the withdrawal of earnings are tax-free in the Roth IRA, but are taxable at ordinary income rates in the non-deductible IRA. The choice between the Roth IRA and a deductible IRA is more complicated due to the comparisons of the front-end tax savings and taxable withdrawals from the deductible IRA versus the nondeductability and the tax-free accumulations from the Roth IRA; present and future tax brackets should be considered. As a general rule, if your tax rate will be higher at withdrawal, choose the Roth; if it will be lower, choose the deductible IRA. If you believe that your tax rate will be unchanged, some analysts give the edge to the Roth, others say it is a dead heat. However, investors with a long-term time horizon are likely to prefer the Roth over the deductible IRA to accumulate tax-free, as opposed to tax-deferred, earnings.
Another decision facing investors is whether to convert a traditional IRA to a Roth IRA. Tax consequences and time horizon are the most important factors in considering a Roth conversion. The key is to compare current taxes resulting from the conversion versus future tax-free accumulated earnings from the Roth IRA. Generally, if you are nearing retirement, you probably should not convert to a Roth IRA. However, if you have a long-term time horizon and if the taxes due from your regular IRA will not constrain your finances, then a conversion to a Roth IRA would be beneficial.
In summary, whether your goal is supplementing retirement, estate additions or a first-time home purchase, the Roth IRA offers benefits of both totally tax-free accumulation and withdrawal features that were previously unavailable in qualified plans. As long as you meet the minimum holding requirements for accumulated earnings withdrawals, the Roth IRA is a vehicle that you can use to accomplish your goals.
Here is a great site for more detailed information about a Roth IRA: www.fairmark.com/rothira/index.htm
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