Roth IRAs
While no deduction is available for contributions made to a Roth IRA, it's fairly easy to qualify for tax-free distributions from one. Accordingly, it offers an
opportunity to earn tax-free income for retirement. Here's how the Roth IRA works:
Contributions
You can contribute up to $2,000 a year to a Roth IRA (as long as you have compensation for the year that is equal to the contributed amount).
However, the $2,000 maximum contribution allowance is reduced by any contributions (deductible or nondeductible) you make to "regular" IRAs.
Additionally, for single taxpayers, if adjusted gross income (AGI) is $110,000 or more, no contribution can be made to a Roth IRA. If AGI is between $95,000
and $110,000, the $2,000 maximum contribution is phased out (reduced) according to a formula. For married taxpayers filing jointly, no contribution can be made
if AGI is $160,000 or more, and the $2,000 maximum (per spouse) is phased out for AGIs between $150,000 and $160,000. For married taxpayers filing
separately, the allowable contribution is phased out for AGIs between $0 and $10,000.
Contributions can be made to Roth IRAs even if you are a participant in a qualified plan and even if you reach age 70 ½ .
Distributions
"Qualified" distributions from a Roth IRA are tax free. Thus, you can avoid tax on Roth IRA earnings forever (i.e., even at distribution). A
distribution is qualified if made once you reach age 59 ½ , upon death or disability, or (up to $10,000 lifetime) for first-time homebuyer expenses. However, a
distribution is not qualified if made within the five-year period beginning with the first tax year you made a contribution to a Roth IRA.
A nonqualified distribution is treated first as a nontaxable return of contributions. To the extent it exceeds contributions it is taxable and is also subject to a 10%
penalty under the regular early withdrawal rules (i.e., the penalty will not apply if the distribution is made once you reach age 59 ½ , or upon death or disability, or in
other limited circumstances).
Qualified rollover contributions
You may be able to roll funds over from a regular IRA into a Roth IRA so the post-rollover income can grow tax free in the
Roth IRA. (Converting a regular IRA into a Roth IRA is treated as such a rollover.) You can roll funds over from a regular IRA to a Roth IRA only if your AGI,
calculated with specified modifications, does not exceed $100,000 in the rollover year. Any funds rolled over will be taxed under the regular IRA distribution rules
as if there were no rollover. The 10% early withdrawal penalty will not apply to the rollover. However, if rolled over funds are withdrawn within the five year period
that renders them taxable, the 10% penalty will apply to the withdrawal.
Ordering rules apply if a Roth IRA contains conversion amounts (possibly from different years) as well as other contributions. The regular Roth IRA contributions
are treated as withdrawn first and then converted amounts, starting with amounts first converted. Withdrawals of converted amounts will be treated as first coming
from amounts already included in income. Earnings are treated as withdrawn after contributions. For these purposes, all Roth IRAs will be treated as a single Roth
IRA.
Special rules for 1998 conversions
For rollovers made in 1998, special 4-year averaging is available. That is, the taxable income from the rollover ("converted
amounts") can be spread over a four-year period starting with 1998. However, if converted amounts from the rollover are withdrawn before the fourth year of the
spread period (2001), income inclusion is accelerated. In addition to the regular (spread) amount that is to be taxed in the year of withdrawal, you would also be
taxed on the lesser of (1) the taxable amount of the withdrawal, or (2) the taxable amount of the conversion that has not yet been taxed. In later years, only the
remaining taxable amount of the conversion is included in income.
For example, say you have a regular IRA with a balance of $10,000, comprised of $7,500 in nondeductible contributions and $2,500 of earnings. If the IRA is
converted into a Roth IRA in 1998 (with 4-year averaging elected), the taxable portion of the converted funds would be $2,500 and you would include 25%
($625) in income in 1998, 1999, 2000, and 2001.
Now assume the balance in the account grows to $11,000 in 1999 and you withdraw $1,000. This withdrawal is treated as attributable entirely to amounts that
were able to be included in income due to the conversion (under the ordering rules discussed above). Thus, in 1999, $1,625 is taxable: $625 under the 4-year rule,
plus $1,000. This $1,000 is the lesser of (1) the taxable amount of the distribution ($1,000), and (2) the remaining taxable amount from the conversion, $1,250
($2,500 - $1,250). Since $2,250 has been taxed in 1998 and 1999, only the remaining $250 of the total $2,500 conversion would be taxed in 2000 and no
amount would be taxed in 2001.
As you can see from the above, certain elements of the Roth IRA can be complicated. Nonetheless, many taxpayers can benefit significantly from Roth IRAs.
Please contact our office if you would like to discuss these matters further, or if you have any questions or concerns.
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