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Module 2: Roth IRAs
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Named for U.S. Senator William Roth, former chairman of the Senate Finance Committee, Roth IRAs differ fundamentally from “traditional” IRAs.  Any contribution to a “Roth IRA” is not tax- deductible.  The earnings in the account grow tax-deferred.  With a few restrictions, all distributions from the account are tax-free.  In a traditional IRA, the tax benefits occur when deductible contributions are made and as the earnings grow tax deferred.  The tax benefits in Roth IRA occur as the account grows and when funds are evenutally withdrawn.  Due to the delayed nature of the tax advantages, Roth IRAs have been called “backloaded” IRAs.

Opening and Contributing to a Roth IRA

Like traditional IRAs, persons who earned income during the year may open a Roth IRA.  However, unlike traditional IRAs, there is no maximum age limit on Roth IRAs.  Individuals over age 70½ who have earned income for the year may open and contribute to Roth IRAs.  For retirees who continue to work part-time, Roth IRAs may be their only available IRA option.

The same general contribution limit applies to Roth IRAs, that is, the lesser of:

$4,000 (in 2006 and 2007, $5,000 in 2008) or
100% of earned compensation.

Those age 50 or older may contribute an additional $1,000 as a “catch-up” provision.

 The maximum total yearly contribution that can be made by an individual to all IRAs  — that is, all deductible and nondeductible, traditional IRAs as well as Roth IRAs — is $4,000, or $5,000 in the case of older contributors  (excluding rollover contributions).  

The following discussion assumes Roth contributors are under age 50 unless noted otherwise.

Income Limits

Unlike traditional IRAs, the tax code prohibits certain high income workers from contributing to a Roth IRA.  Single taxpayers who earn under $95,000 may contribute the full $4,000 to a Roth IRA.  The Roth IRA contribution is phased out (i.e., partial contributions) for single taxpayers earning between $95,000 and $110,000.  Single taxpayers earning $110,000 or more may not contribute to a Roth IRA.  For married couples filing jointly, a full $4,000 Roth IRA contribution is available for those earning under $150,000.  The Roth IRA contribution is eliminated over those having incomes of more than $160,000 with partial contributions allowed between $150,000 and $160,000. Taxpayers who do not qualify to make a full Roth IRA contribution may still contribute to non-deductible traditional IRAs instead (if under age 70½ ).

Example: Mary McDonough, a 56-year old single taxpayer has an adjusted gross income of $135,000.  She is ineligible to contribute to a Roth IRA because her income exceeds $110,000. However, she may contribute to a nondeductible IRA.

Example: Jim and Bobbi Holmes are a married couple both working in 2007, earning $156,000 jointly.  They may make a "partial" contribution to a Roth IRA.  The phaseout for married couples disallows 40 cents for every $1 of earnings in excess of $150,000.  For, Jim and Bobbi the disallowance is $6,000 x .40 or $2,400.  They may each contribute up to $1,600 ($4,000 maximum — $2,400 disallowance) to a Roth IRA for 2007.  The remaining $2,400 may be contributed into traditional IRAs.

To be treated as a Roth IRA, the account must be designated as such when it is established.  Funds in a Roth IRA must be held separately from funds contributed to traditional IRAs.  So unlike traditional IRA accounts that can hold both deductible (before-tax)  and non-deductible (after-tax) contributions, taxpayers must establish a separate IRA account for their after-tax Roth IRA contributions.

Excess contributions

As with all IRAs, funds contributed in excess of the annual total dollar limits are subject to a 6% penalty tax.  However, with Roth IRAs there is a new twist. Taxpayers are also subject to the 6% penalty tax for contributions to Roth IRA in excess of the Roth income limitations above.

Example, Tag Adams, a single taxpayer, contributes $4,000 to a Roth IRA for 2007.  He earns $137,000 in 2007.  Although he does not exceed the $4,000 maximum permissible contributions, he is not eligible to contribute to a Roth IRA due to his income.  The $4,000 excess Roth contribution is subject to a 6% penalty, unless he withdraws it before his tax filing date.  He could redeposit those funds in a traditional IRA.
As with all IRAs, the taxpayer may “cure” an excess contribution by withdrawing the excess at any time before the tax filing deadline.  In these cases, taxpayers avoid the 6% penalty.  Taxpayers may also correct the situation by underfunding future contributions — this does not eliminate the 6% penalty this year, but does avoid the cumulative nature of the penalty in the future.

Distributions from Roth IRAs

The key advantage of a Roth IRA is that withdrawals from the account are tax-free.  To qualify for the tax-free status, the distribution must satisfy a five-year holding period and also meet one of four additional requirements.  To be tax-free, the distribution must be made:

after age 59½,
to a beneficiary upon the IRA holder’s death,
due to disability, or
to pay for "qualified first-time homebuyer expenses".

While similar to the list exemptions for the 10% penalty on premature withdrawals from traditional IRAs — this list serves a different purpose:  determining whether the withdrawal will be tax-free.

Five year holding period

Tax-free distributions are permitted only if the contributions have remained in the Roth IRA for five “tax years”.  Since contributions may actually be made up to April 15th of the following calendar year, the five year holding period may not actually be five full, calendar years.

Example: Margo Healey, age 56, makes a contribution to her Roth IRA on April 14, 2007, designating the contribution for 2006. Her holding period begins running in 2006 (the tax year of the contribution), not in 2007 when the contribution was actually made.  The five year holding period will end on December 31, 2010 (assuming Margo is a calendar year taxpayer).  Distributions prior to December 31, 2010  will not qualify for tax-free status.

Assume Margo contributes $4,000 to her Roth IRA each of the next nine years.  In 2015, at age 65, Margo withdraws the entire amount from the Roth IRA. The account value is $75,000 ($40,000 of contributions plus $35,000 of accumulated earnings). She may take the distribution tax-free: she satisfies the 5-year holding period (since the first contribution) and she is over age 59½.

Nonqualified distributions

If an individual withdraws funds from a Roth IRA without satisfying the holding period or other conditions, the distribution is "nonqualified", meaning the earnings portion of the withdrawal is taxable.  Contributions were made in after-tax dollars, so return of contributions is always tax-free.  The tax code treats nonqualified Roth distributions as being made from contributions first, then earnings.  [This is analogous to FIFO, “first-in, first-out”, accounting.]  Thus, no portion of a distribution is treated as taxable earnings until the total distributions from the Roth IRA exceeds the total amount of contributions.

Example:  Using the facts from the case above, Margo contributes to her Roth IRA each year beginning in tax year 2006.  By 2009, the account value has grown to $24,000 ($16,000 of contributions and $8,000 accumulated earnings).  In 2009, Margo takes a distribution of $18,000 from the account to pay emergency medical bills for her mother.  Since the five-year holding period has not elapsed, the distribution is "non-qualified".  The first $16,000 withdrawn is a return of contributions and is not taxable.  The remaining $2,000 is taxed as ordinary income in 2009.

Please note: Nonqualified distributions from Roth IRAs, and non-deductible traditional IRAs are treated differently (even though both are funded with after-tax dollar contributions).  Roth IRAs assume nonqualified distributions to be taken on a FIFO basis: tax-free contributions first, then taxable earnings.  In traditional, non-deductible IRAs, each distribution is considered to be partly taxable earnings and partly tax-free return of principal.   For a person choosing between withdrawals from a Roth IRA vs. a traditional IRA,  this difference can be important — especially for partial withdrawals.

Example: If Margo had contributed to a traditional non-deductible IRA instead of a Roth IRA, her withdrawal in 2009 would be taxed differently.  The tax-free portion of the withdrawal would have been only $12,000 leaving her to pay taxes on $6,000 (instead of only $2,000 in the Roth IRA)

           after tax
        contribution   $16,000 x $18,000 withdrawal = $12,000  tax free dist'n
         total value    $24,000

No penalty on "premature" distributions

While distributions from a Roth IRA will be taxed if taken prior to age 59½, these distributions are not subject to the 10% penalty tax, as are premature withdrawals from traditional IRAs.  In fact, the first withdrawals — up to the total contributions to a Roth IRA — are tax free, according to the rules above.  As a result, younger persons may “tap into” a Roth IRA much more easily than a traditional IRA.  Withdrawals, even before age 59½ are tax free up to the amount of contributions into the account.  Thereafter, taxes are paid only on the earnings.  After age 59½, even withdrawals of earnings are tax free (after the five-year holding period).

Generally, the 10% penalty has no impact on a Roth account — but there is one exception.  If a traditional IRA is converted into a Roth IRA, the 10% penalty on premature distributions continues to apply to the converted funds.   (see Rollovers & Conversions below)  

Example: Fred Thompson, age 58, faces upcoming tuition payments for his youngest son.  Fred has accumulated $50,000 in his Roth IRA ($20,000 in contributions and $30,000 in earnings).  Fred could tap into his Roth IRA, up to $20,000 (the amount of his contributions) tax free this year, even though he has not reached age 59½.  Next year (with careful timing) he could tap into the remainder without tax.  Since this is a Roth IRA, none of these withdrawals would be subject a penalty tax.

No minimum required distributions

Another major difference between traditional IRAs and Roth IRAs is that Roth IRAs do not require distributions at age 70½.  In fact, in Roth IRAs that age has no importance.  Individuals may open a Roth IRA and contribute past age 70½, and need not take monies out at age 70½.  Indeed, monies never need be withdrawn from a Roth IRA.  This is a significant advantage for those who wish to accumulate assets to pass on to beneficiaries.

Rollovers and Conversions

Distributions from one Roth IRA can be rolled over tax-free to another Roth IRA.  This is done by simply following the general rules for IRA rollovers: re-deposit of funds within 60 days and no more than one rollover each year.  Similarly, assets held in a Roth IRA can be transferred directly from trustee to trustee, just as in traditional IRAs.  There is no limit on how frequently direct transfers of Roth IRAs may occur.  

Special rules apply, however, where assets are moved from a traditional IRA into a Roth IRA — a so-called “conversion”.  These types of “conversions” must be accomplished within the 60-day limit, but the law waives the “once a year” rule for conversions from traditional to Roth IRAs.  

Conversions are allowed only if the taxpayer files individually or jointly (but not “married filing separately”) and has adjusted gross income for the tax year of less than $100,000 — not including any amounts resulting from the rollover.  The $100,000 income limit will exist through tax year 2009.  Beginning in 2010, all taxpayers regardless of income levels will be permitted to convert their traditional IRA into a Roth IRA.

Individuals may make a conversion without physically taking a distribution. An individual may make a conversion by simply notifying the IRA trustee. Or, a conversion may be made via a trustee-to-trustee transfer. Note, however, that if only a part of an IRA balance is converted into a Roth IRA, the Roth IRA amounts must be held separately from traditional IRA balances.

The taxpayer who converts from a traditional account to a Roth IRA must pay ordinary income taxes on the amount converted.  Technically, the conversion is  a distribution from the traditional IRA (and a subsequent redeposit into the Roth) — and it is taxed as a distribution from a traditional IRA. In the case of “conversion”, however, the 10% early withdrawal tax does not apply.    (The 10% penalty on premature withdrawals does apply if funds are subsequently withdrawn from the converted Roth account within five tax-years of the conversion or prior to age 59½, death or disability.  This is the only time the 10% penalty tax applies to a Roth account.  Without this provision, funds could be converted from a traditional IRA into a Roth IRA simply to avoid the penalty tax.)  The 5-year holding period for the “new Roth IRA” begins with the tax year in which the rollover conversion was made — and each converted Roth account maintains a separate holding period.  

Please note: Roth 403b (tax sheltered annuities) and Roth 401k plans  have been available since 2006.  Assets in these plans, funded with after-tax dollars, can be rolled over or transferred to a Roth IRA.  These are not subject to income taxation when converted (as the contributions to those accounts were already taxed). The five-year holding period begins when the Roth IRA was first established.  Assets in a Roth IRA many not be rolled over or transferred into a Roth 401k or Roth 403b plan.

The tax code permits those wishing to transfer “non-Roth” assets held in employer retirement accounts into a Roth IRA to do so, but the process is two-step:  direct transfer or 60-day rollover of the qualified plan assets into a traditional IRA and then a taxable conversion of that traditional IRA into a Roth IRA.  This process will be streamlined beginning in tax year 2008 and thereafter — qualified plan assets can be rolled over and converted into a Roth IRA in a single step.  Obviously, taxes are owed upon such a conversion, either under the current two-step process or the new single-step rollover / conversion.  

The Decision to Convert

The decision whether to convert assets into a Roth IRA is complex.  Each individual must determine how the conversion will affect his or her unique situation.  The most obvious factors to consider are current and anticipated future tax rates — does the taxpayer foresee being in a higher tax bracket when he or she retires? … and does that possibility offset the certainty of current taxes owed upon conversion?  Given anticipated deficits in the federal budget, Social Security and Medicare trust funds, one could conclude that future tax rates will probably increase.    

In addition to incurring an immediate tax liability in the year of conversion, other factors may also be affected.  For example, will a higher reported income in the year of conversion push the taxpayer into a higher tax bracket?  Or cause Social Security benefits to be taxable?  Will a higher income make the taxpayer ineligible for other tax breaks or benefits?  Many tax deductions and credits are based on adjusted gross income, as is financial aid for higher education.  At higher levels of income those deductions, credits and other benefits may not be available.