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	Understanding Roth IRAs Personal Finance Advisor by OnLine June 1, 1998

It's another complicated choice for your retirement savings.

The 1997 Taxpayer Relief Act provided taxpayers with another choice in the already complex area of retirement savings accounts -- the Roth IRA. Contributions to the Roth IRA are nondeductible, qualified distributions are not taxable, and income accumulates tax-free in the account. There are several issues, however, that should be considered before contributing (or converting a traditional IRA) to a Roth IRA.

Annual Contributions: Beginning in 1998, married taxpayers with modified adjusted gross income (AGI) of $150,000 or less ($95,000 for single taxpayers) can each make nondeductible contributions up to $2,000 annually to a Roth IRA (provided combined earned income is equal or greater than the contribution amount). Contributions are phased-out for married taxpayers with AGI between $150,000 and $160,000 ($95,000 to $110,000 for single taxpayers). Married individuals filing separately may contribute a portion of $2,000 to a Roth IRA if AGI does not exceed $15,000.

A taxpayer can make contributions to a Roth IRA even if he/she is

a participant in a qualified retirement plan (such as a 401(k) plan), or
over age 70½.

Contributions to Roth IRAs are coordinated with contributions to traditional IRAs (that is, the total annual maximum IRA contribution considers amounts contributed to both types of accounts).

Rollover Contribution: As of Jan. 1, 1998, a taxpayer (married or single) can convert an existing traditional IRA into a Roth IRA during any tax year in which his/her AGI does not exceed $100,000. Married individuals filing separately are not eligible to convert, regardless of their income level. In most cases, the rollover amount is included in gross income, but there is no early withdrawal penalty (a 10% penalty typically applies to a premature distribution from a traditional IRA). If the conversion occurs before Jan. 1, 1999, the rollover amount is included in gross income ratably over a four-year period.

The best option for paying income taxes due on the conversion of a traditional IRA to a Roth IRA would be to pay with non-IRA (after-tax) funds -- using non-IRA dollars is equivalent to making an additional contribution to the Roth IRA in the amount of tax paid (thereby increasing the total amount of the taxpayer’s tax-advantaged investments).

The AGI thresholds will prohibit higher-income taxpayers from taking advantage of the Roth IRA. If a taxpayer (under age 59½) converts a traditional IRA to a Roth IRA in a year when his/her AGI exceeds the $100,000, the conversion will be treated as a taxable distribution, and the 10% early withdrawal penalty will apply. Congress is considering a technical corrections bill that will lessen the severity of the current penalty for conversion when AGI exceeds $100,000.

Distributions: Tax usually is not assessed on qualified distributions from Roth IRAs that occur after five years from the date of the initial contribution (or date of rollover contribution). Qualified distributions are defined as those occurring

after age 59½
upon death or disability, or
for first-time home purchases (provided the distribution is less than $10,000).

There is no tax on a rollover from one Roth IRA to another. For withdrawals occurring within five years of the initial contribution or conversion, the income (earnings) portion is subject to both income tax and a 10% early withdrawal penalty.

Distributions After Age 70½: Unlike traditional IRAs, distributions from Roth IRAs are not required to begin at age 70½. This can be a valuable estate planning tool for individuals who do not need Roth IRA funds for living expenses during retirement years. If the taxpayer is married at the time of his/her death, a Roth IRA may be rolled over by the surviving spouse into his/her own Roth IRA. Required distributions begin only upon the death of this spouse -- distributions are made over the life expectancy of his/her designated beneficiaries. If there is one Roth IRA account with multiple beneficiaries, the life expectancy of the eldest beneficiary is generally used to compute minimum distributions for all beneficiaries. To extend the payout period (and consequently, the tax-deferred benefit of the account), separate accounts should be set up for each beneficiary (so that minimum distributions will occur based on the life expectancy of each beneficiary).

Withdrawal of Contributions: Rollover or annual contributions to a Roth IRA can be withdrawn at any time without incurring tax or penalty on the withdrawal (earnings withdrawals may be taxable). Consequently, a taxpayer who converted a traditional IRA to a Roth IRA (or made annual contributions to a Roth IRA) could take withdrawals of the rollover (or contribution) amounts before age 59½ from the Roth IRA, and avoid the 10% penalty normally assessed on early distributions from IRAs. The technical corrections bill that Congress is considering would modify this provision.

Consider Your Tax Bracket: If an individual’s effective tax rate in the years of withdrawal is lower than the rate in the years of contribution, the traditional IRA will generally provide a greater after-tax balance in the year of retirement than a Roth IRA. Conversely, if the tax rate in the years of withdrawal is the same as or greater than the rate in the years of contribution, the Roth IRA will usually provide a greater after-tax balance in the year of retirement. This general rule does not consider other positive attributes of the Roth IRA (e.g., distributions not required at age 70½, tax- and penalty-free withdrawals to the extent of contributions, favorable estate tax treatment).

Other Considerations: If there is a conversion from a traditional IRA to a Roth IRA, the additional taxable income may affect the availability of the child or education credits, or deductions for interest expense on loans for higher-education expenses. The additional income could also affect the phase-out of itemized deductions (a calculation based on the taxpayer’s AGI).

These are some thoughts to consider about Roth IRAs. Your financial and tax advisors can provide additional information and should be consulted before any action is taken.