Financial Guide: ROTH IRAs--How They Work And How To Use Them

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		ROTH IRAs— How They Work And How To Use Them
		Roth IRAs differ from other tax-favored retirement plans, including other IRAs (called "traditional IRAs"), in that they promise complete tax exemption on distribution. But there are other important differences as well, and many qualifications about their use. This Financial Guide shows how they work, how they compare with other retirement devices--and why YOU might want one, or more.

TABLE OF CONTENTS

How Contributions Are Treated
How Withdrawals Are Treated
Converting From a Traditional IRA
Undoing a Conversion to a Roth IRA
Withdrawal Requirements
Use in Estate Planning
INFOSOURCES

Roth IRAs are the most publicized retirement investment device of the decade, but so far have found "surprisingly few" takers.

With most tax-favored retirement plans, the contribution to (i.e., investment in) the plan is deductible, the investment compounds tax-free until distributed, and distributions are taxable as received. There are variations from this pattern, as with 401(k)s where the exemption for salary diverted to a 401(k) takes the place of a deduction and for after-tax investments which are tax-free when distributed

With a Roth IRA, there’s never an up-front deduction for contributions. Funds contributed compound tax-free until distributed (standard for all tax-favored plans). And distributions are completely exempt from income tax.

HOW CONTRIBUTIONS ARE TREATED

Except for conversion of traditional IRAs to Roth IRAs—and that’s a huge exception, as we’ll see—no more than $2,000 can go into a Roth IRA in any year. To put in even that much, you must earn $2,000 from personal services and have income (technically, modified adjusted gross income or MAGI; roughly, line 33 on your Form 1040) below $95,000 if single or $150,000 on a joint return. The $2,000 limit phases out on incomes between $95,000--$110,000 (single) and $150,000--$160,000 (joint). Also, the $2,000 limit is reduced for contributions to traditional IRAs though not SEP or SIMPLE IRAs.

You can contribute to a Roth IRA for your spouse, subject to the income limits above. So assuming earnings of at least $4,000, up to $4,000 ($2,000 each) can go into the couple’s Roth IRAs. As with traditional IRAs, there’s a 6% penalty on excess contributions.

HOW WITHDRAWALS ARE TREATED

Since all your investments in a Roth IRA are after-tax, your withdrawals, whenever you make them, are often tax-free. But the best kind of withdrawal, which allows earnings as well as contributions and conversion amounts to come out completely tax-free, are qualified distributions. These are withdrawals meeting these conditions:

At least 5 years have elapsed since the first year a Roth IRA contribution was made or, in the case of a conversion, since the conversion occurred and
At least one of these additional conditions is met:

The owner is age 59 ½ .

The owner is disabled.

The owner has died (distribution is to estate or heir).

Withdrawal is for a first-time home purchase (tax-free limit of $10,000).

A qualified distribution isn’t subject to the 10% early withdrawal penalty.

Where a withdrawal isn’t a qualified distribution, it’s still generally treated as tax-free until after all after-tax contributions and conversion amounts have been recovered. However, nonqualified distributions can be hit by the early withdrawal penalty even if not subject to income tax.

Qualified distributions after the owner’s death are tax-free to heirs. Nonqualified distributions after death—which are distributions where the 5-year holding period wasn’t met—are taxable income to heirs as they would be to the owner (the earnings are taxed), except there’s no penalty tax on early withdrawal. However, an owner’s surviving spouse can convert an inherited Roth IRA into his or her own Roth IRA. This way, distribution can be postponed, so that nonqualified amounts can become qualified, and the tax shelter prolonged.

Roth IRA assets left at death are subject to federal estate tax, just as traditional IRA assets are.

CONVERTING FROM A TRADITIONAL IRA

Opportunity. Cost. Risk. These features of your option to convert your traditional IRA to a Roth IRA are what’s caused most of the excitement about Roth IRAs. Conversion means that what would be taxable traditional IRA distributions can be made tax-exempt Roth IRA distributions. That’s the Opportunity. The Cost—tax cost—is that the amount converted in 1999 or after is fully taxable in the year converted, except for the portion of after-tax investment in the traditional IRA.

So you must pay tax now (though there’s no early withdrawal penalty) for the opportunity to withdraw tax-free later, an opportunity that can extend to your heirs. (In 1998—only—there was the option to spread the income from the conversion equally over 1998—2001.)

Conversion is allowed only to taxpayers with income (again, MAGI) of $100,000 or less in the conversion year. That’s $100,000 for a single person and $100,000 for a couple filing jointly; a married person filing separately can’t convert. (The taxable amount converted isn’t counted in figuring whether income exceeded $100,000.) The risk is that if income exceeds $100,000, the conversion is taxable—as you expected—but the IRA your funds went to doesn’t qualify as a Roth IRA. And you will owe a 6% excess contribution penalty and maybe a 10% early withdrawal penalty (on the traditional IRA withdrawal).

The IRS has done what it can to make conversion easy. You can have a fund transfer of your traditional IRA assets to a Roth IRA, which is done between the trustees of the two IRAs, whether they are in the same or different financial institutions. Or you can do it yourself, moving the assets for the traditional to the new Roth IRA (which is subject to tax withholding and which must be completed within 60 days of withdrawal).

Conversions from traditional to Roth IRAs are sometimes called rollovers. But you may rollover—tax-free—from one Roth IRA to another Roth IRA. This might be done to set up separate Roth IRAs for different beneficiaries.

You can’t convert retirement assets from a company or Keogh plan to a Roth IRA. But it’s legal to rollover from such plans to a traditional IRA, and then convert. And you can convert SEP and SIMPLE IRAs to Roth IRAs.

UNDOING A CONVERSION TO A ROTH IRA

Since everyone recognizes that conversion is a high-risk exercise, the law and liberal IRS rules provide an escape hatch: You can undo a Roth IRA conversion by what IRS calls a "re-characterization". This move, by which you move your conversion assets from a Roth IRA back to a traditional IRA, makes what would have been a taxable conversion into a tax-free rollover between traditional IRAs.

TIP: One reason to do this would be where you find you’ve exceeded the $100,000 income ceiling for Roth IRA conversions.

TIP: Another reason to do this, dramatized by a volatile stock market, is where the value of your portfolio drops sharply after the conversion.

Example: If your assets are worth $180,000 at conversion and fall to $140,000 later, you’re taxed on up to $180,000, which is $40,000 more than you now have. Undoing—re-characterization—avoids the tax, and gets you out of the Roth IRA.

Re-characterization can be done any time until the due date for the return for the year of conversion, including filing extensions through December 31, 1999, for 1998 conversions. Unfortunately, there’s no current protection against the case where a taxpayer is later—say, on audit—found to exceed the $100,000 income ceiling because of overlooked income or mistaken deductions—one more example of conversion’s high risk.

Can you undo one Roth IRA conversion and then make another one? Yes—once. That is, if after re-characterizing the $140,000 in our example you then decided to convert that $140,000 to a Roth IRA in 1999, IRS would accept that and make $140,000 your taxable amount. Later re-characterizations and re-conversions would be recognized in determining how much was in your Roth IRA but wouldn’t affect the $140,000 taxable amount. Re-conversion rules will be stricter after 1999. For example, re-conversion can't occur in the same taxable year as the original conversion.

WITHDRAWAL REQUIREMENTS

Since tax-favored retirement plans are for retirement, there’s a general requirement that plan withdrawals must begin when the owner reaches age 70 ½, and continue at a rate calculated to pay out completely at the end of the owner’s life expectancy (or a joint and survivor life expectancy with a beneficiary). The beginning date can generally be postponed for employees who continue working, but the rule is absolute for business owners and for IRAs.

But not for Roth IRAs. Roth IRA owners need not withdraw at any age, and an IRA beneficiary can spread withdrawal over his or her life expectancy.

Also, unlike traditional IRAs (but like other tax-favored retirement plans), a Roth IRA owner who continues working may continue to contribute to the Roth IRA.

USE IN ESTATE PLANNING

Though Roth IRAs enjoy no estate tax relief, they are already figuring in estate plans. The aim is to build a large Roth IRA fund—largely through conversion of traditional IRAs—to pass to beneficiaries in later generations. The beneficiaries will be tax exempt on withdrawals (of qualified distributions) and the Roth IRA tax shelter continues by spreading withdrawal over their lifetimes.

* * *

Such moves call for highly sophisticated planning now, to achieve results for later generations. Taxpayers will need to be made confident that Roth IRA benefits promised now, which come at a current tax cost, will in fact survive for decades (Roth IRA rules have been twice amended already), and won’t be rendered meaningless by approaches such as a Flat Tax. Consultation with a qualified advisor is a must.

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