Eligible taxpayers can contribute up to $2,000 to a Roth IRA. The contribution is not deductible. Eligible taxpayers also may convert their traditional IRAs to Roth IRAs. If the taxpayer is ineligible for the contribution or merely wishes to change his/her mind, the contribution generally can be recharacterized.
A Roth IRA is an individual retirement account (trust, custodial account, or annuity contract) that is set up in the United States solely for the benefit of one individual and is designated at the time of establishment as a Roth IRA.
A Roth IRA is similar to a traditional IRA in many ways. However, it differs from a traditional IRA in that contributions never are deductible but can be made past the age of 70-1/2. If the funds are left in for five years and distributions are taken out in a qualified manner, they are nontaxable. In addition, there are no minimum distributions required from a Roth IRA while the owner (or owner's spouse) is alive and the account is treated as belonging to the surviving spouse.
Annual contributions
To make an annual contribution, the taxpayer (or the taxpayer's spouse if a joint return is filed) must have compensation that is includible in the taxpayer's gross income for the taxable year. In order for each spouse to make the maximum contribution of $2,000, the taxpayers must have compensation equal to at least $2,000. There is no minimum age restriction. However, some financial institutions will not allow a minor to establish a Roth IRA. Under the rules of the National Association of Securities Dealers (NASD), a minor may not establish a brokerage account. The IRS allows a parent or guardian of a minor child to establish a Roth IRA on behalf of the minor child. A parent or other person may contribute the $2,000 contribution as a gift to the child's Roth IRA. However, in the case of any contribution to a Roth IRA established for a minor child, the compensation of the child for the taxable year for which the contribution is made must satisfy the compensation requirements.
A husband and wife do not have to contribute to the same type of IRA. For example, the husband could contribute to a Roth IRA and the wife could contribute to a traditional IRA, or vice versa.
Limits and limitations on contributions
Contributions are limited annually to 100% of compensation or up to $2,000 per year (whichever is less) per individual reduced by the qualified retirement contribution made to all other IRAs (traditional or Roth) maintained for the benefit of the individual. The term qualified retirement contribution does not include amounts contributed to an Education IRA, SEP, SIMPLE, or SARSEP. Because contributions to a Roth IRA are not deductible, contributions are permitted without regard to the active participation rules that generally apply to traditional IRAs.
The term compensation means wages, salary, professional fees, or other amounts derived from or received for personal services actually rendered. Compensation also includes alimony paid under a divorce or separation agreement that is includible in the income of the recipient under Section 71 of the Internal Revenue Code (Code). The term compensation does not include any amount received as a pension or annuity and does not include any amount received as deferred compensation.
Restrictions on Roth IRA contributions for high-income taxpayers
The maximum contribution limit of $2,000 per individual is phased out depending upon the filing status and modified adjusted gross income of the individual (MAGI). If MAGI is more than the minimum phaseout amount but less than the maximum phaseout amount, the contribution is phased out. In general, the phaseout is determined in a ratable manner. If MAGI is below the minimum phaseout amount, the $2,000 limit applies. If MAGI is above the maximum phaseout amount, no contribution is permitted. The chart on the following page shows how the contribution limits are restricted.
Note: The maximum Roth IRA contribution limit phases out over the first $10,000 of MAGI if the individual is a married taxpayer filing separately. In such case, if MAGI is $10,000 or more, no annual contribution is permitted to be made into a Roth IRA for the year.
Example 1. Susan, a married taxpayer who files jointly, has MAGI of $155,000. The amount of contribution permitted to Susan's Roth IRA would be $1,000.
Example 2. John, a single taxpayer, would like to establish a Roth IRA. John's MAGI is $90,000. Since John's MAGI is less than $95,000, the total $2,000 may be contributed to a Roth IRA.
Example 3. Mary, a single taxpayer, has MAGI for the year of $97,000. The total contribution permitted to be made into a Roth IRA for Mary is $1,740.
Roth contribution deadlines
Annual contributions to a Roth IRA may be made for a tax year up to the individual's tax filing deadline for such year, not including extensions.
A conversion contribution for a taxable year must be started in that year; that is, the amount was removed from the traditional IRA commencing on or before December 31 of that year by means of a rollover or a transfer. There are three ways to convert a traditional IRA to a Roth IRA.
1. Rollover conversion. Generally, the rollover conversion of a traditional IRA to a Roth IRA is treated for federal income tax reporting purposes as a distribution from the traditional IRA and as a subsequent rollover contribution to the Roth IRA.
2. Trustee-to-trustee transfer. An amount in a traditional IRA may be transferred in a trustee-to-trustee transfer from the trustee of the traditional IRA to the trustee of the Roth IRA. In this case, the trustees are different institutions.
3. Internal conversions. The direct transfer within the same financial institution of a traditional IRA to a Roth IRA is permitted and is generally treated as a rollover.
Conversions and rollovers of less than the full amount in the account are permitted. To convert a traditional IRA to a Roth IRA, the taxpayer must establish a Roth IRA. If the taxpayer already has a Roth IRA containing annual Roth IRA contributions, that Roth IRA may be used for the conversion.
Eligibility to convert a traditional IRA to a Roth IRA depends on the taxpayer's adjusted gross income (MAGI) and filing status. The MAGI limit for conversion is $100,000. A taxpayer is not permitted to make a qualified rollover contribution (that is, a conversion) to a Roth IRA from any IRA plan (other than another Roth IRA) if the taxpayer's MAGI for the year during which the rollover is made exceeds $100,000. Taxable IRA distributions that are not rolled over to a Roth IRA are included in the MAGI amount.
A taxpayer is not permitted to convert a traditional IRA to a Roth IRA if the taxpayer is a married individual filing a separate return. A husband and wife who file separate returns for any taxable year and live apart at all times during such taxable year shall not be treated as married individuals.
If an IRA participant is converting a traditional IRA to a Roth IRA and such participant is age 70-1/2 or older during the year, the required minimum distribution (RMD) amount (which is always treated as being withdrawn first) is not eligible to be converted. Conversion contributions are not subject to the 12-month limitation that limits rollovers (but not direct transfers) between each traditional IRA (or each Roth IRA) to one rollover per 12-month period.
Example 4. Julie's AGI for 2000, before she contemplates rolling her traditional IRA to a Roth IRA, is $85,000. She has a traditional IRA valued at $100,000. Julie withdraws the entire $100,000 from her traditional IRA but rolls over only $80,000 to her Roth IRA. The $20,000 not rolled over increases her AGI for 2000 (for purposes of the $100,000 MAGI rule) to $105,000. Therefore, Julie is not eligible to convert her traditional IRA to a Roth IRA (a failed conversion) for 2000. The $80,000 amount needs to be withdrawn from the Roth IRA or corrected through a recharacterization.
Recharacterizations. If an individual makes a contribution to an IRA (the first IRA) for a taxable year and then transfers the contribution (or a portion thereof) in a trustee-to-trustee transfer to another IRA (the second IRA), the individual can "elect" to treat the contribution as having been made to the second IRA, instead of the first IRA, for federal tax purposes. This process is called a recharacterization and may be effectuated only by a direct trustee-to-trustee transfer, rather than a distribution and subsequent rollover.
The recharacterization "election" can be made only if the transfer from the first IRA to the second IRA is made on or before the due date (including extensions) for filing the individual's federal income tax return for the taxable year for which the contribution was made to the first IRA. However, a conversion that is accomplished through a rollover of a distribution from (or a transfer from) a traditional IRA in a taxable year that, within 60 days, is contributed to a Roth IRA in the next taxable year is treated as a contribution for the earlier tax year.
However, if the contributor's federal income tax return was timely filed and the individual takes timely and appropriate corrective action, an amount that has been converted from a traditional IRA to a Roth IRA can be recharacterized (as a traditional IRA contribution). Treasury regulations provide for an automatic extension of six months from the due date of a return, excluding extensions, to make certain elections that otherwise must be made by the due date of the return or the due date of the return plus extensions. To change any such election the regulations require that:
1. The taxpayer's return was timely filed for the year the election should have been made, and
2. The taxpayer takes appropriate corrective action within this six-month period. For 1998 conversions only, the date to recharacterize was extended until December 31, 1999.
In general, the taxpayer must notify the Roth IRA trustee of the taxpayer's intent to recharacterize the amount; the taxpayer must provide the trustee (and the transferee trustee, if different from the transferor trustee) with specified information that is sufficient to effect the recharacterization transfer; and the trustee must make the transfer. If not already in existence, the transferee IRA (Roth or traditional) may have to be established.
Reconversions of amounts previously converted and recharacterized
Effective for conversions made on or after January 1, 2000, an IRA owner who converts an amount from a traditional IRA to a Roth IRA during any taxable year and then transfers that amount back to a traditional IRA by means of a recharacterization may not reconvert that amount from the traditional IRA to a Roth IRA before the later of:
(a) The beginning of the taxable year following the taxable year in which the amount was converted to a Roth IRA, or
(b) The end of the 30-day period beginning on the day on which the IRA owner transfers the amount from the Roth IRA back to a traditional IRA by means of a recharacterization.
If a reconversion occurs before the end of the period specified in "a" or "b," the subsequent reconversion transaction is treated as a "failed conversion," a distribution from the traditional IRA and a regular contribution to the Roth IRA, but may be corrected by recharacterization.
Distributions
In general, qualified distributions from a Roth IRA are not subject to federal income tax.
A qualified distribution is generally any payment or distribution--made on or after age 59-1/2, made because of disability, made after death, or that is a qualified special purpose distribution. A distribution is not a qualified distribution if either of the following applies:
--It is made within the five tax year period beginning with the first tax year for which a contribution (including a conversion contribution) was made to any Roth IRA set up for the benefit of the same individual.
--In the case of a distribution allocable to a conversion contribution from an IRA other than a Roth IRA, if made within the five tax year period beginning with the tax year in which the conversion was made it will be subject to an additional 10% tax regardless of whether it is included in gross income (unless accelerated, see below), unless an exception applies.
A qualified special purpose distribution is a qualified first-time home buyer distribution used to buy, build or rebuild the main home of a first-time home buyer 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 (item 3 in chart).
Part of any distribution that is not qualified may be taxable.
Contributions made to a Roth IRA are treated as distributed in the following order: regular contributions, and conversion contributions, on a first-in, first-out basis, and finally gain. For this purpose all of an owner's Roth IRAs are treated as one account. Any amount withdrawn from a traditional IRA that is converted to a Roth IRA must be included in gross income (in the same manner that it would have been taxed had it not been converted). Assuming all of the conversion taxes have been paid (the conversion income was not spread out over a four tax year period as was allowed for conversions made in 1998), then the distribution of that contribution from the Roth IRA will not be subject to federal income tax. To the extent of any unpaid conversion taxes (which can't happen after 2000), the amount will be included in income and, unless an exception applies, subject to a 10% premature distribution penalty.
After all contributions have been recovered, the gain is deemed distributed. If the gain is distributed in a qualified distribution (made after five years AND made on or after age 59-1/2, because of disability, after death, or that is a qualified purpose distribution) it too will not be subject to federal income tax.
Subject to the rules just discussed, the chart on page 38 summarizes the rules that apply to distributions of gain only.
Tax and financial planning professionals, administrators, and financial consultants have been gearing up for what is expected to become an important new market and, over time, significantly affecting the way people do retirement planning, estate planning and family financial planning. Millions of taxpayers will be asking their advisors for Roth IRA contribution and conversion information. Some clients (and their advisors) will be guided by common sense and intelligence, others by using software especially suited to the task. There is even an award-winning Roth IRA Web site at http://www.rothira.com where readers can find additional tax and non-tax information on Roth IRAs.
Several recent legislative proposals, if they had been enacted, would have created Roth 401(k) and Roth 403(b) plans that would allow participating employees in those plans to contribute funds on an after-tax (payroll reduction) instead of pre-tax (salary reduction) basis.
While some will rush in and take advantage of the Grapes of Roth, others will wonder who will watch over this statutory scheme after Senator Roth's influence is gone. Alvin D. Lurie, former IRS assistant commissioner for employee plans and exempt organizations, recently stated: "Even bright stars have dark sides." May The Roth Be With You.
Advantages: "The Grapes Of Roth"
1. Qualified distributions are not subject to federal income tax.
2. Spread income on conversion aside, contributions may be returned income-tax free at any time.
3. Helps pass more assets to heirs. No minimum distribution requirements for original owner.
4. Spousal beneficiary may rollover to his/her own Roth IRA and continue without distribution obligation at any age.
5. Life expectancy factors not locked in after age 70-1/2. May use a new beneficiary's life expectancy upon death of last spouse beneficiary.
6. Social Security benefits not taxable if distribution is qualified. Qualified distributions of contributions and/or earnings do not affect modified adjusted gross income in determining whether any portion of Social Security benefits are taxable. On the other hand, conversion (or acceleration) income could have an effect on determining the taxability of any Social Security or Tier 1 Railroad Retirement Benefits.
7. Income taxes are paid at the current rate before assets grow significantly.
8. More useful in a "credit shelter trust" than a traditional IRA where income tax may reduce the amount going into the trust, thus wasting part of the credit shelter.
9. Can do partial conversions. Keep in mind, however, that all traditional IRAs (deductible and nondeductible) have to be aggregated for purposes of determining the taxable amount.
10. May make annual contribution and rollover after age 70-1/2 (except that required distributions cannot be rolled over, transferred, or converted).
11. A conversion following a market decline is more effective.
13. Can be an active participant in an employer's qualified retirement plan and have a Roth IRA too.
14. Slight advantage of paying income tax in a Roth IRA conversion compared with the income tax deduction obtained when a traditional IRA is subject to estate tax. Payment of taxes lowers amount subject to estate tax.
Disadvantages: "The Gripes Of Roth"
1. No deduction for new contributions.
2. Roth IRA conversions not available if MAGI exceeds $100,000. The amount converted does not count toward the $100,000 income limit.
3. Regular Roth IRA contribution not available to high-income taxpayers--MAGI exceeds $110,000 (single) or $160,000 (joint).
4. Spread income (possibly resulting from a 1998 conversion) may have a negative impact on all tax issues based on AGI (except for current or future Roth contribution and/or rollover issues).
5. Creditor Protection. Creditor protection status unknown in most states.
6. State Income Tax Treatment. State income tax treatment of Roth IRA distributions not always known.
7. Difficult to pay conversion taxes with outside assets.
8. Congress could change rules regarding taxation of distributions or add consumption taxes.
9. Not wanting to pay taxes up front may serve as an excuse or detriment to good planning.
10. Possible distribution penalties for amounts that have not aged for five years or for amounts distributed other than for a permitted event. *
If You Are Single If You Are Married Then You
Taxpayer Filing Jointly May Make
Modified
Adjusted Up to $95,000 Up to $150,000 Full
Gross Contribution
Income (MAGI)
| Level | More than $95,000 | More than $150,000 | Reduced |
| but less than | but less than | Contribution | |
| $110,000 | $160,000 | ||
| $110,000 and up | $160,000 and up | No Contribution |
Roth IRA Earnings Roth IRA Earnings
Paid Out BEFORE 5 Years Paid Out AFTER 5 Years
Reason For Distribution Earnings Subject to Earnings Subject to
Taxable 10% Penalty Taxable 10% Penalty
| On or after age 59-1/2 | Yes | No | No | No | |
| Before age 59-1/2, | Yes | Yes | Yes | Yes | |
| see penalty exception 1-7 | |||||
| 1. Death | Yes | No | No | No | |
| 2. Disability | Yes | No | No | No | |
| 3. First-time home buyer | Yes | No | No | No | |
| $10K limit | |||||
| 4. Substantially equal | Yes | No | Yes | No | |
| periodic payments | |||||
| 5. Medical expenses | Yes | No | Yes | No | |
| above 7-1/2% of AGI | |||||
| 6. Insurance premiums | Yes | No | Yes | No | |
| by unemployed | |||||
| 7. Higher education expenses | Yes | No | Yes | No | |
©COPYRIGHT: The Rough Notes Magazine, 1999