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The Question: Please explain what a Roth IRA is.

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The Answer

Prepared by the Staff

of the

Senate Finance Committee

William V. Roth, Jr., Chairman

The Roth IRA was created effective January 1, 1998 as part of the Taxpayer Relief Act of 1997. The following is a explanation of the provisions dealing with the Roth IRA which includes the technical corrections to the Roth IRA made as part of the recently enacted IRS Restructuring and Reform Act of 1998.

Contributions to Roth IRAs

Contributions to a Roth IRA are not tax-deductible by a taxpayer. Contributions for any year must be made by the due date (without extensions) of the tax return for the year in which the contribution relates. In most cases, this will mean that the contribution must be made by April 15 of the following year.

Contributions are limited to the lesser of $2,000 or the amount of earned income of the taxpayer. If a taxpayer is married, the taxpayer and his or her spouse can both contribute $2,000, as long as they jointly have at least $4,000 of earned income and file a joint return.

All taxable income is not considered earned income; distributions from pension plans, Social Security payments, interest income, capital gains and disability income are not considered earned income. Consequently, a taxpayer with only those forms of income cannot make a contribution to a Roth IRA.

Unlike regular IRAs, contributions to a Roth IRA are permitted after the taxpayer attains age 70 1/2.

A single taxpayer with adjusted gross income not exceeding $95,000 is eligible to make a full $2,000 Roth IRA contribution. If a single taxpayer's adjusted gross income is between $95,000 and $110,000, the maximum amount that the taxpayer can contribute to a Roth IRA is reduced proportionately. For example, a taxpayer with adjusted gross income of $102,500 can only contribute $1,000 to a Roth IRA. A single taxpayer with adjusted gross income in excess of $110,000 cannot make a contribution to a Roth IRA.

Married taxpayers who file jointly with combined adjusted gross income not exceeding $150,000 are eligible to make full $2,000 Roth IRA contributions. The maximum amount that a jointly filing married couple can contribute is reduced proportionately if the combined adjusted gross income is between $150,000 and $160,000. For example, a jointly filing married couple with adjusted gross income of $155,000 would each be limited to a $1,000 Roth IRA contribution. If the adjusted gross income for the married couple is $160,000 or greater, then neither member of the couple can make a Roth IRA contribution.

A taxpayer who is married, but files a separate return, cannot make a Roth IRA contribution if the taxpayer's adjusted gross income is greater than $10,000. If such a taxpayer has income less than $1,000, then the amount that can be contributed to a Roth IRA is prorated. However, if the separately filing married couple lives apart at all times during the year, they are not treated as married persons.

These complex income limits were not part of Senator Roth's initial proposal for the Roth IRA, as passed by the Senate. However, these limits were imposed by the Clinton Administration as a part of Administration's support for the Taxpayer Relief Act.

A taxpayer can still make contributions to a Roth IRA even if the taxpayer is an active participant in an employer-sponsored retirement plan. This is in contrast to a regular IRA, where tax-deductible contributions may be limited if a taxpayer is an active participant in a retirement plan.

The maximum contribution to a Roth IRA is reduced dollar for dollar for any contributions made to a regular IRA, regardless of whether the IRA contribution is tax-deductible.

Roth IRA Conversions

Any taxpayer who has an IRA can "convert" that IRA into a Roth IRA, as long as the taxpayer does not have adjusted gross income in excess of $100,000. If the taxpayer is married filing a joint return, the taxpayer and his or her spouse's income are taken into account in applying this $100,000 limit. A taxpayer who is married and is filing a separate tax return can not make a conversion to a Roth IRA. These complex income limits on the ability to convert were not part of Senator Roth's initial proposal for the Roth IRA, as passed by the Senate. However, these limits were imposed by the Clinton Administration as a part of Administration's support of the Taxpayer Relief Act.

The conversion must be made by the end of the calendar year, unlike Roth IRA contributions which can be made by the due date of that year's tax return. However, the taxpayer can revoke the conversion and roll the funds (and any attributable earnings) back to the taxpayer's regular IRA by the due date of that year's tax return. This will permit a taxpayer who finds that his or her income is in excess of the $100,000 limit for conversions to roll the amounts back into his or her regular IRA without any penalties.

Required minimum distributions from an IRA are not eligible to be rolled over to a Roth IRA. Required minimum distributions will also be included in the taxpayer's adjusted gross income for purposes of the determining whether the taxpayer has adjusted gross income not in excess of $100,000 and that a Roth IRA conversion can be made. However, in tax years beginning in 2005, these required minimum distributions will not be counted toward the $100,000 adjusted gross income limit. Nevertheless, the required minimum distribution amount cannot be rolled into a Roth IRA. Remember that required minimum distributions only are made to taxpayers who have attained age 70 1/2 and thereafter.

The amount of the conversion is included in the taxpayer's adjusted gross income for the year in which the conversion is made. If the conversion is made in 1998, then the amount of income which is included in the taxpayer's income is spread ratably over four years, so that one quarter of the income recognized due to the conversion is included in the taxpayers' income in each of the next four years. This means that the conversion is made at one time; only the recognition of the income is spread over four years.

Conversions made in 1999 and in the years thereafter are not eligible for this four-year spread. In addition, a taxpayer can elect (under a method to be determined by the Internal Revenue Service) to include all the income from a 1988 conversion in 1988 income.

If, during the four-year period that for income recognition for the 1998 conversion, a taxpayer takes a distribution from the Roth IRA, any amounts withdrawn which were not included in income will become included in income in the year the amounts were withdrawn. For example, if $100,000 was converted to a Roth IRA in 1998, each year for the next four years, the taxpayer must recognize $25,000 in income. If in 1999, the taxpayer takes a distribution of $60,000 from his Roth IRA, the taxpayer will have to include an additional $50,000 in income in 1999 in addition to the $25,000 that the taxpayer was scheduled to include in income.

There is no special tax rate for amounts included in income due to the conversion. This amount will be taxed as if it was part of the taxpayer's taxable income. This inclusion could result in higher tax rates being imposed and reducing deductible amounts and limiting tax credits where the amount of the deduction or credit is limited by the amount of the taxpayer's adjusted gross income. The conversion could also result in subjecting a portion of a taxpayer's Social Security to taxation. Consequently, taxpayers may want to review their current tax situation before making a conversion to a Roth IRA.

Distributions from Roth IRAs.

Qualified distributions from a Roth IRA is not subject to any federal income tax. A qualified distribution is a distribution made after a Roth IRA has been open for at least 5 years (measured from the first day of the year in which any Roth IRA was opened) and which is made after the taxpayer has attained age 59 1/2, on account of death or disability or for a first time home purchase (limited to $10,000 per Roth IRA holder). This 5-year holding period is not imposed separately for conversion amounts and contribution amounts; the 5 years starts with the first conversion or contribution amount being made to any Roth IRA.

If the distribution is not a qualified distribution, then a portion of the distribution may be subject to income tax. The distribution will be treated as coming first from after-tax contributions or already taxed Roth IRA conversions. Distributions in excess of those amounts (the earnings on the already-taxed conversion amounts) will be taxed currently.

In addition to the regular income tax, a ten percent additional tax may be imposed on certain distributions. If the distribution is of an amount which was converted from an IRA within the last five years, then the distribution will be subject to the ten percent additional tax. However, this additional tax will not apply if the distribution is made after the taxpayer attains age 59 1/2 or if the distribution is used for higher education expenses, medical expenses exceeding 7.5 percent of adjusted gross income, medical insurance premiums while unemployed (not subject to the 7.5 percent limit), first time home purchases (not to exceed $10,000) or one of annual payments over the lifetime of the IRA holder or the joint lifetime of the IRA holder and his or her designated beneficiary. Distributions of earnings on amounts contributed to a Roth IRA will also be subject to the ten percent additional tax, with the same exceptions noted above.

Unlike regular IRAs, distributions from a Roth IRA do not have to start after the taxpayer who established the Roth IRA attains age 70 1/2. Consequently, a taxpayer does not have any fixed schedule in which to take distributions from his or her Roth IRA and has the ability to defer distributions during his or her lifetime. Distributions must commence after the death of the taxpayer who established the Roth IRA, however. If a beneficiary was designated, then distributions must be made commencing one year after the date of the taxpayer's death over a period of time not exceeding the life expectancy of the designated beneficiary. If a beneficiary is not designated, distributions must be made within 5 years of the death of the taxpayer.

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