The following text contain two main sections. Both are copyright articles authored by Bob Parrish CPA. The first will assist in some background to relate the real world and the Roth IRA. The second will offer very simplified common sense approach to the mathematics of the Roth IRA concept.
Washington has now allowed us a "new" IRA which is non-deductible version of the "Regular" IRA and offers a "Tax Killer". This new IRA ("Roth") features completely tax-free withdrawals at retirement. Sounds unbeatable. But should you accept Congress's invitation to convert conventional IRAs to Roth accounts and divert future contributions to the newfangled contraptions?
For those with adjusted gross income (AGI, which is
basically income before subtracting exemptions and deductions) is less than $100,000, one
may convert his or her present IRA to a Roth account. Doing so will make all future
earnings tax-free rather than simply tax-deferred--as long as you do not withdraw the
principal or earnings until s/he is over 59 1/2 and the account has been open for
at least four calendar years after the year the account was opened.
Before
you sign up, though, realize that "this is not a one-size-fits-all.
ALERT: To make the conversion, one must pay
all the tax due on the existing IRA amount being rolled over. To convert $100,000 means
paying tax on that $100,000, assuming none of the money came from nondeductible
contributions. That would cost $28,000 in the 28% bracket. (Money that's taxed in a
conversion doesn't count as income for figuring if your income is too high to make the
switch.) The cost in a 39.6% bracket would be $39,600! One can quickly grasp
the expensive proposition.
DO NOT DESPAIR AND DO
NOT BE QUICK TO ELIMINATE THIS CONVERSION !!!
Does it make sense to pay hard cash now to buy tax savings later? It certainly can.
In order to know if this makes common sense, consider several facts --
If you expect to be in the same or a higher income-tax bracket, switching to a Roth
will pay off. But if you wind up in a lower bracket, paying the tax at today's rate would
be a blunder.
You will also want to take
into consideration whether the income tax on the conversion will reduce the amount
available for the Roth IRA, or you can pay the tax from other funds and retain the balance
of the Original IRA.
If you can pay the tax bill without invading your IRA, converting to a Roth IRA can put
you in a better position -- assuming you do not drop into a lower tax bracket when you
retire. Why the advantage? Because it lets you keep more cash in your IRA -- where
it will grow faster in the tax shelter than it would on the outside.
But how can one know factually and using reasoning what a tax bracket will be ten, 30 or
50 years down the road? In the past retirees routinely moved into a lower tax
bracket. In this new financial and economic environment a growing number of
retirees expect to maintain their income. Not a single reasonable individual
will know what Congress might do in the future: A budget crisis might produce
tax increases for everyone. Furthermore Congress might decide replacing
the income tax base with a consumption/spending tax base is more lucrative for
the Central Government when the "Baby Boomers" start retirement. In
the latter case, paying an income tax now and a consumption tax in the future would be one
of the worst mistakes possible.
Let us make the circumstance where you are in a 28% tax rate or below. If your IRA balances are large, adding the money to their current income might push you into a 36% bracket for the next four years.
You will need to make some computations taking the above into consideration for you to
make a reasonable decision.
RolloversCan I Move Amounts From Other IRAs Into a Roth IRA?
You may be able to move (roll over) amounts from either a traditional IRA or another Roth IRA into a Roth IRA.
Rollover from traditional IRA. You cannot roll over amounts from a traditional IRA into a Roth IRA during a year if:
1) Your modified AGI (explained earlier) for the year is more than $100,000, or
2) You are married and filing a separate return for the year.
Allowable rollovers. You can withdraw all or part of the assets from a traditional IRA and reinvest them (within 60 days) in a Roth IRA. If properly (and timely) rolled over, the 10% additional tax on early withdrawals will not apply. You must roll over into the Roth IRA the same property you received from the traditional IRA. You can roll over part of the withdrawal into a Roth IRA and keep the rest of it. The amount you keep will generally be taxable (except for the part that is a return of nondeductible contributions) and may be subject to the 10% tax on early withdrawals. See Publication 590 for more information on withdrawals from traditional IRAs and the tax on early withdrawals.
Amounts that must be distributed from a traditional IRA during a particular year under the required distribution rules (discussed in Publication 590) are not eligible for rollover treatment.
If you inherited a traditional IRA from someone other than your spouse, you cannot roll it over.
Income. You must include in your gross income amounts you withdraw from a traditional IRA that you would have to include in income if you had not rolled them over into a Roth IRA.
Withdrawals before 1999. If you roll over into a Roth IRA an amount you withdraw from a traditional IRA before 1999, any withdrawal that you must include in income is included ratably over the 4-year period beginning in the year of withdrawal.
Conversions. The conversion of a traditional IRA to a Roth IRA is treated as a rollover from a traditional IRA into a Roth IRA.
Transfer of contributions. You can transfer contributions made to a traditional IRA into a Roth IRA without having to include them in your gross income if all the following apply.
1) You transfer the contributions by the due date (not including extensions) for filing your tax return for the year you made the contributions to the traditional IRA.
2) You also transfer any earnings on the contributions.
3) You do not claim a deduction for the contributions.
Rollover from a Roth IRA. You can withdraw all or part of the assets from a Roth IRA and reinvest them (within 60 days) in another Roth IRA. If properly (and timely) rolled over, the 10% additional tax on early withdrawals will not apply. You must roll over into the second Roth IRA the same property you received from the first one. You can roll over part of the withdrawal and keep the rest of it. The amount you keep is a distribution. See Are Distributions From My Roth IRA Taxable? later.
Waiting period. You can take a distribution from a Roth IRA and roll part or all of it over into another Roth IRA only once in any 1-year period. The 1-year period begins on the date you receive the distribution, not on the date you roll it over into the second Roth IRA.
When Can I Contribute?You can make contributions to a Roth IRA for a year at any time during the year or by the due date of your return for that year (not including extensions).
Is There an Age Limit
for Contributions?Contributions can be made to your Roth IRA regardless of your age.
What If I Contribute
Too Much?If you make an excess contribution to a Roth IRA, a 6% penalty tax applies to the excess.
Excess contributions. These are the contributions to your Roth IRAs for a year that equal the total of:
1) Amounts contributed for the tax year to your Roth IRAs (other than qualified rollover contributions described later) that are more than your contribution limit for the year, plus
2) Any excess contributions for the preceding year, reduced by the total of:
a) Any distributions out of your Roth IRAs for the year, plus
b) Your contribution limit for the year minus contributions to your Roth IRAs for the year.
For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed if you also withdraw any earnings on the contributions.
Are Distributions From
My Roth IRA Taxable?You do not include qualified distributions from your Roth IRA in your gross income. You may have to include part of other distributions in your income.
What are qualified distributions? A qualified distribution generally is any payment or distribution:
1) Made on or after the date you reach age 59 1/2,
2) Made because you are disabled,
3) Made to a beneficiary or to your estate after your death, or
4) That is a qualified special purpose distribution, defined later.
ALERT ! Exception (5-year rule). A
distribution is not a qualified distribution if either of the following applies.
1) It is made within the 5-tax-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for your benefit.
2) In the case of a distribution allocable to an allowable rollover from an IRA other than a Roth IRA (or income earned on the amount rolled over)), it is made within the 5-tax-year period beginning with the tax year in which you made the rollover contribution.
Qualified special purpose distribution. This is a qualified first-time homebuyer distribution used to buy, build, or rebuild the main home of a first-time homebuyer who is either the person for whom the Roth IRA was set up, the spouse of that person, or the child, grandchild, or ancestor of that person or that person's spouse.
Am I required to take
distributions when I reach age 70? You are not required to take distributions from your Roth IRA at any age.
Which distributions
are taxable?Part of any distribution that is not a qualified distribution may be taxable. To figure the taxable part, add the distribution to all previous distributions from the Roth IRA. Subtract from that total all contributions made to the Roth IRA. The result, if greater than zero, is the taxable part of the distribution. For this purpose, all your Roth IRAs are treated as one account.
RecharacterizationRecharacterizations of IRA Contributions. Prop. Regs. §1.408A-5 provides special rules for the recharacterization of IRA contributions (including Roth IRA regular and conversion contributions). Section 408A(d)(6) provides that, except as otherwise provided by the Secretary of the Treasury, an IRA contribution that is transferred to another IRA in a trustee-to-trustee transfer on or before the Federal income tax return due date (with extensions) for the taxable year of the contribution is treated as made to the transferee IRA and not the transferor IRA. Section 408A(d)(6) requires that the transfer include allocable net income on the contribution and that no deduction be allowed for the contribution to the transferor IRA. The proposed regulations provide that this statutory provision was intended to permit a taxpayer who had converted an amount held in a non-Roth IRA to a Roth IRA and later discovered that his or her modified adjusted gross income for the year of the conversion exceeded $100,000 to correct the conversion by re-transferring the converted amount to a non-Roth IRA. The proposed regulations interpret §408A(d)(6) liberally to provide broad relief to taxpayers who wish to change the nature of an IRA contribution (and not only to allow taxpayers to correct Roth IRA conversions for which they were ineligible). Moreover, the proposed regulations make application of §408A(d)(6) elective by the taxpayer and permit the taxpayer to recharacterize all or any portion of an IRA contribution.
Five Year RuleException (5-year rule). A distribution is not a qualified distribution if either of the following applies.
1) It is made within the 5-tax-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for your benefit.
2) In the case of a distribution allocable to an allowable rollover from an IRA other than a Roth IRA (or income earned on the amount rolled over)), it is made within the 5-tax-year period beginning with the tax year in which you made the rollover contribution.
Money withdrawn to pay the tax on the conversionEmail Bob Parrish CPA for the answer to this query. mailto:BMSarasota@Home.net or mailto:BMOdessa@Home.net
What About Years After the Conversion?But what about future $2,000-a-year contributions? Should
you put your money in a regular IRA or a Roth?
First the action of making non-deductible contributions to a "Regular" IRA:
The Roth IRA is far ahead of the Regular "nondeductible" account.
Withdrawals are tax-free rather than taxable. Congress thought about simply abolishing the
old nondeductible version, but decided to keep it around for taxpayers whose income is too
high for a Roth. (The right to use a Roth is phased out as AGI rises from $95,000 to
$110,000 on an individual return and from $150,000 to $160,000 on a joint one.)
What if you can deduct IRA contributions? The Roth remains the better choice
(assuming you can afford to deposit $2,000 a year without the help of the tax break you
get if you go the deductible route).
Contributions to Roth and regular IRAs grow in the same tax-sheltered environment, so when
you retire, both accounts would hold the same amount. The big difference, of course, is
that your pay-outs from the Roth account would be tax-free.
But what if you invest the annual tax savings from a deductible IRA in a separate
account--for a true apples-to-apples comparison? The Roth still wins, and the longer you
have to go until retirement, the further ahead you'll be with a Roth. And that does not
take into account the flexibility of taking or not taking withdrawals. One
should also make computations to determine whether the 401K or the Roth is the better
choice.
For 1997, if you're covered by a retirement plan at work,
the right to deduct deposits is phased out as AGI rises between $25,000 and $35,000 for
those who file individual returns and between $40,000 and $50,000 for joint filers. For
1998, the phaseout zones rise to between $30,000 and $40,000 for individuals and $50,000
and $60,000 for couples, and they'll continue to increase in future years.
1998 also brings a break
for couples when one spouse is covered by a retirement plan and the other is not. Starting
in 1998, a non-covered spouse--employed or not--can fully deduct a $2,000 IRA contribution
as long as the couple's AGI is less than $150,000.
 | The following is the article authored by Bob Parrish CPA |
| Who should read this section |
If you have already determined that a conversion from your existing IRA to a new Roth IRA is the best choice for you financially, then you should read this section. If you have not made that determination, then first read the section on "To Roth or Not To Roth"
Check to find if you
qualify - Your Adjusted Gross Income must not exceed $100,000.
The following methods/mechanics are used to change your regular IRA to the new Roth IRA:
You can transfer from an IRA, a SEP IRA or a SIMPLE IRA.
FIRST - The first message to you is to cover the concept of the Roth IRA. Common
Sense will always start a person on a good path.
| Principal Investment |
Regular IRA: You defer any income tax on the principal investment. You forego paying income tax today and elect to PAY TAX when you withdraw/use the principal.
Roth IRA: You pay the tax now and therefore there is NO TAX when you withdraw/use the principal.
| Investment Earnings |
Whether you elect the regular IRA or the Roth IRA, annual earnings are not taxed.
Regular IRA: When you withdraw/use the earnings you PAY TAX.
Roth IRA: When you withdraw/use the earnings there is NO TAX.
| Event | Roth Principal | Roth Earnings | Regular Principal | Regular Earnings |
| Principal Taxed Today | Y | N | ||
| Principal Taxed When Retired | N | Y | ||
| Earnings Taxed Today | N | N | ||
| Earnings Taxed at Retirement | N | Y | ||
Since the principal is the same dollar amount today, annually and at retirement we shall consider only the tax brackets. Please, do not confuse the item value of money in this focus on principal, as the yield on the investment (accumulated earnings) will be the focus for the time value of money.
Not one of us, and certainly not a professional making projections would pretend to know what will happen with tax brackets considering future legislation and your personal earnings effect on the marginal or effective tax rates.
If one believes that the tax rate today is less than the tax rate at retirement, pay the tax today so that there is no tax on the principal at retirement. If one believes that the tax rate today is more than the tax rate at retirement, pay the tax in the future. Therefore, good judgement is the primary source for projecting the future circumstances and the surrounding effect on the total cost of income tax.
This focus deserves a great amount of attention and perhaps computations. The is not the only factor to consider, but for many it will be the main factor to consider.
As a very brief example two simple examples are chosen that will be "painted in black and white" for clarity and simplicity.
Example 1:
Jeremy is a middle age executive and has great skill and insight for choosing investments. He has chosen to place $2,000 into an investment account. His goal is to keep the tax cost as low as possible by using either the Roth or the Regular IRA. He is 40 and does not plan to draw on his investment for 30 years. He is planning to earn an average of 15% per annum on his investments.
His investment of 2,000 will be worth more than $132,000 when he plans the withdrawal.
His choices are:
Since the $2,000 deduction today is very small compared to the tax on $132,000 in the future - Jeremy will be in a better position by paying the tax on the principal today and escaping the tax on the much larger amount at retirement.
Example 2:
Dolly is a middle age performing artist and has great skill at producing income currently. She has chosen to place $2,000 into an investment account. She is very cautious about her investments and wants to be certain her principal is safe. Since she has the ability to place in savings more principal than she will consume in her lifetime, she has chosen to use investments with very low yields. She expects the yield to be about 2% per year. However just like Jeremy she wants to keep the income tax cost low.
Her investment of $2,000 will be worth about $3,600 when she plans the withdrawal.
Since Dolly, has only $1,600 of income to pay tax on in the future, she will be in a better position by delaying the tax until retirement and taking a deduction on the principal today. The combination of the $2,000 deduction and the deferral of the tax on the comparatively small amount will place Dolly in a better position.
Real World Conditions:
Now we shall point out that real life is always gray. Nothing is ever simple.
Here are factors that can change your decision to Roth or not to Roth:
| Do you plan on letting the IRA accumulate earnings for a long time? |
| Is the life expectancy in your family long? |
| Will your receive a tax deduction for a Regular IRA? |
| Are you within the income limits for any IRA? |
| Will the principal investment be small or will it be large when compared to the accumulated earnings? |
| At what age will you start drawing the IRA? |
| Will you name a beneficiary for the income - usually a spouse? |
The above may not be an exhaustive listing, but will cover some of the major facts which can effect your decision.
Furthermore one can always make what some might consider to be very strange analogies for alternatives to the Roth IRA. IF the main consideration is that of providing for tax free income at retirement, then municipal securities can always be used to produce tax-free income. The drawing of the coupon rate is much like drawing from the Roth - neither is taxable. IF you sell a "muni" bond, then you may have a capital gain or loss (although this is not always the case). This would be similar to drawing the principal from the Roth. Neither will produce taxable income on an annual basis (If the bond is redeemed, or if there is no significant net capital gain or loss) - even though the Muni is available and the Roth is not.
BE CREATIVE
There are alternatives. The Roth can be a self-directed investment account, just as the Regular can be setup as a self-directed investment account.
Even if we consider the alternatives - I like the Roth for the person accumulating the income for a long time period. The more the accumulated income in relationship to the principal invested, the more the incentive to choose the Roth IRA. The more the principal in relationship to the accumulated earnings, the more the incentive to stay with the Regular IRA.