The Roth IRA -- A New Way To Save
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 2016 and 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 -- $117,000 for single taxpayers, $184,000 for couples
filing a joint return for 2016. Contributions are pro-rated if income falls
in a phase-out range between $117,000-$132,000 for individuals and
between $184,000-$194,000 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.
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
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
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.
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
- Equal periodic payment withdrawals over owner's
- Medical expenses greater than 7.5% of Adjusted Gross Income
- Health insurance premiums for an unemployed
- Qualified higher-education expenses
- First-time home purchase
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
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
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
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
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