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The Roth IRA -- A New Way To Save


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 was 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.


The Roth IRA for 2017 allows annual nondeductible contributions of up to $5,500 of earned income for singles, $11,000 for married couples who file jointly ($5,500 per spouse); in addition, individuals over age fifty can contribute up to $6,500. Earned income is work-related compensation (employee, self-employment) and alimony. Note: The annual contribution limit for a Roth IRA is reduced by contributions to any traditional IRA for a given year.

Roth IRA contributions are limited for higher incomes. The eligibility limit for full contributions is subject to annual Modified Adjusted Gross Income ceilings -- $133,000 for single taxpayers, $196,000 for couples filing a joint return for 2017. Contributions are pro-rated if income falls in a phase-out range between $118,000-$133,000 for individuals and between $186,000-$196,000 for married couple filing jointly. Contributions to a Roth IRA are not available if income exceeds the phase-out range.

Note: Modified Adjusted Gross Income (MAGI) is Adjusted Gross Income plus the following add backs: deductions for contributions to a traditional IRA, student loan interest or qualified tuition and related expenses, and passive activity losses; exclusions claimed for interest income from Series EE due to paid qualified higher education expenses, employer-paid adoption expenses, foreign earned income and foreign housing costs.

Furthermore, any conversions from a traditional IRA to a Roth IRA (discussed below) are not considered contributions and therefore should not be included in Modified Adjusted Gross Income calculations or annual contributions to determine Roth eligibility.


In 2011 and subsequent years, one can convert funds from a traditional IRA into a Roth IRA regardless of individual income. 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.

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. However, you are allowed only one conversion reversal for any tax year, so choose wisely.

Special Note: High income earners should consider the ramifications of future tax rates in deciding on Roth conversions. For example, Health Care legislation became law in early 2010 which imposes a 3.8% Medicare surtax on income exceeding $200,000 for individuals, or $250,000 for joint filers -- beginning in 2013. This surtax will be assessed on the lower of (1) Net Investment Income, or (2) Modified Adjusted Gross Income (MAGI) in excess of the income thresholds for single or joint filers.

Net investment income for the purposes of calculating the unearned income Medicare contribution tax includes interest, dividends, capital gains, annuities, royalties, rents, and pass-through income from passive businesses. The following types of income will not be subject to this additional Medicare tax: tax-exempt municipal bond interest, nontaxable veteran's benefits, capital gains excluded from the sale of a principal residence, and distributions from traditional and Roth IRAs, 403(b) plans, 401(k) plans, 457 plans, pensions and profit-sharing plans.
  • Case A: a single flier or a couple filing jointly exceeds MAGI thresholds with zero net investment income. No Medicare surtax is due (zero net investment income x 3.8% = zero).
  • Case B: a single flier or a couple filing jointly is under MAGI thresholds with $100,000 net investment income. No Medicare surtax is due since excess MAGI thresholds did not occur.
  • Case C: a single flier or a couple filing jointly exceeds MAGI thresholds by $40,000, of which $50,000 is net investment income. The 3.8% Medicare surtax of $1,520 would apply to the $40,000 excess MAGI since it is lower than the $50,000 net investment income.
  • Case D: a single flier or a couple filing jointly exceeds MAGI thresholds by $40,000, of which $30,000 is net investment income. The 3.8% Medicare surtax of $1,140 would apply to the $30,000 net investment income since is is lower than the $40,000 excess MAGI.


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 or (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 were clarified by technical corrections. In the original statute, 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 imposed a five-tax-year waiting period for individuals under age 59 1/2, 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.

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 or have reached age 59 1/2; 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

Inherited Roth IRAs

As in traditional IRAs, distributions in Roth IRAs differ depending upon whether the transfer is to spousal and non-spousal beneficiaries. In general, a spouse beneficiary has more flexibility compared to a non-spouse beneficiary.

Spouse beneficiary: can elect to treat the inherited Roth IRA as his or her own (spousal rollover) and would have (1) the same distribution applicable rules as the original owner, (2) the ability to make additional eligible contributions or conversions and (3) no mandatory distribution requirements. if spouse does not elect a rollover, then the minimum distributions rules for traditional IRAs apply.

Non-Spouse beneficiary: cannot combine with an existing Roth IRA or make contributions or conversions to the inherited Roth IRA. Non-Spouse distributions are required to follow one of the two following rules: (1) receive entire distribution by December 31st of the fifth year following the year of death of the original owner or (2) elect to receive distributions over remaining life expectancy.

Withdrawals of accumulated earnings within five years of the original Roth IRA would be subject to ordinary income tax rates; however, the 10% tax penalty for early withdrawals is waived.


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 nondeductibility 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.

Tip: click on the following link Roth IRA investment advice and strategies.