By now, everyone is at least somewhat familiar with the Roth IRA. Lately, it seems that everyone is espousing its virtues, with futuristic ads depicting how smart those people were to establish Roth IRAs way back in 1998. Even with all the advertising, how much do you really know about Roth IRAs, and how do you decide if it's right for you?
The basic concept behind the Roth IRA is that contributions are not deductible; however "qualified distributions" are tax free. In other words, by forgoing an income tax deduction now, all future earnings will be received income tax free, provided that a few requirements are met. Thus, the Roth IRA is not just a deferral tool, but a tax diminution tool as well. Furthermore, there is also no required minimum distribution, no magic age 70 1/2 for required distributions, and contributions can be made after age 70 1/2, provided that other requirements are met.
Before you can even contemplate the benefits of a Roth IRA, you need to meet the two basic requirements necessary to establish a Roth:
1. You must have earned income, as opposed to investment income, and
2. Your adjusted gross income (AGI) must be less than $95,000 for a single person and $150,000 for a married couple filing jointly.
As with the "traditional" IRA, you can only contribute up to $2,000 in any calendar year unless you are doing a conversion from an existing IRA, which I will discuss in a moment.
Distributions from a Roth IRA will not be taxable if the following criteria are met. A so-called "qualified distribution" is defined as:
One which is made after a five-year period, beginning with the first taxable year from which a contribution is made (later contributions do not start a new period), and one of the following:
1. Distributions made after the participant attains age 59 1/2;
2. Distributions made to a beneficiary after the participant's death;
3. Distributions made to a participant as a result of being totally disabled; or
4. Distributions made for a "qualified special purpose."
A "qualified special purpose" is similar to the requirements that waive the 10% penalty under traditional IRAs, but they are not identical. For example, you can make a withdrawal of up to $10,000 for the purchase of a "first home"; however, you cannot use withdrawals from a Roth to pay for higher education expenses as you can with a traditional IRA, although no one seems to know why this is.
Equally as perplexing is the requirement that the Roth IRA funds remain in the account for the entire five years to receive the tax benefit, even after the participant's death. Presumably, the purpose of the five-year rule is to encourage the participant to use the savings for retirement. However, this rule should have no bearing upon a beneficiary who receives the fund as a result of the participant's death. Hopefully, this anomaly will be addressed in the technical corrections act.
One of the great benefits of the Roth, which may have been unintentional, is that nonqualified distributions are taxed on a FIFO basis, meaning that the participant is deemed to receive his contribution first, then income (similar to the taxation of the cash value of a life insurance policy). So, even if one is to make a nonqualified distribution from the Roth, he will not pay an income tax or a penalty on the amount withdrawn until the withdrawal exceeds the amount contributed. For all intents and purposes, the money set aside in a Roth can still be accessed.
Converting to a Roth
Now that you understand the concept of the Roth IRA, the question now becomes, what do I do with my existing IRA? To convert or not to convert, that is the question.
Why pay today what you can put off until tomorrow, or why would I want to convert my IRA and get hit with all of the income tax in one year? If the conversion is done in 1998 (and only this year), you have four years over which to spread the tax liability, so any contemplated conversion should be done this year.
The ability to convert is also subject to income limitations, which are different from the requirements of merely contributing to a Roth. While a married couple with an AGI of up to $150,000 can contribute to a Roth, the AGI limit for a conversion Roth is $100,000, whether the participant is married or single. (Another matter for the technical corrections act.)
There are many reasons for converting to a Roth, such as:
1. The participant is nearing age 70 1/2 and does not want to have to take minimum distributions from an existing IRA.
2. The participant is past the required beginning distribution date and wants to change the beneficiary. (In a traditional IRA, the beneficiary designation is irrevocable after the distribution date.)
3. It enables the participant to leave the IRA to the "B" (or "credit shelter") trust, or generation skipping trust (for clients with a large net worth who have such trusts), without incurring income tax liability.
4. The participant is relatively young and is facing a long accumulation period.
5. It enables an individual to name a child or even a grandchild as a beneficiary, allowing that beneficiary to receive the benefits, income tax free, over the beneficiary's lifetime. This technique allows the funds to accumulate, again income tax free, for years after the participant's death.
One important note--In order to avoid the additional 10 percent (10%) penalty tax on early withdrawals from the IRA, the income tax generated by the conversion should be paid from funds other than the IRA. In other words, for maximum tax benefit, you must convert the entire amount of the existing IRA and pay the income tax from another source.
Even if you do not qualify for your own Roth IRA, you can use a portion of your annual gift tax exclusion to establish Roth "gift" IRAs for children or grandchildren who have earned income. The only drawback is that the child has immediate access to the contribution. However, if the child is disciplined enough to leave the money in the fund, the Roth IRA provides an excellent vehicle for annual gifting.
It should be pointed out that the Roth IRA may not be for the client who expects that he or she will be in a lower tax bracket in retirement (assuming, of course, that the tax brackets remain constant). Thus, if you are in the maximum bracket today, it may not make sense to pay the tax now in order to forgo income tax tomorrow. It depends upon your age and whether you are planning to utilize the IRA funds for living expenses.
The Roth has many tax benefits and many idiosyncrasies which will need to be worked out in the technical corrections act. In addition, the Commonwealth has legislation pending (which I'm told is expected to pass) which would tax Roth conversions in the same way that the federal government does.
In any event, for those persons who are making the maximum 401(k) contribution, or otherwise do not qualify for a deductible IRA and meet the annual income limitations, a Roth IRA makes sense. Perhaps we really will be looking back in 30 years and saying how smart we were to have established a Roth IRA way back in 1998.