Roth IRAs: How they work and how to use them
by Kathey Hickey FulhamWith 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 where invested capital is 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 $4,000 can go into a Roth IRA. To put in even that much, you must earn $4,000 from personal services and have income (technically, modified adjusted gross income or MAGI for 2007) below $99,000 if single or $156,000 on a joint return. The $4,000 limit phases out on incomes between $99,000-$114,000 (single) and $156,000-166,000 (joint). If your filing status is married filing separately, you lived with your spouse at any time during the year, you cannot make a Roth IRA contribution if your modified AGI is more is $10,000 or more. The contribution phases out between $0 and $10,000. Also, the $4,000 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 (your own or combined with your spouse) of at least $8,000, up to $8,000 ($4,000 each) can go into the couple’s Roth IRAs. As with traditional IRAs, there’s a 6 percent penalty on excess contributions. Contribution dollar limits for your own Roth IRA rise to $5,000 for 2008, and after (double these amounts for Roth IRAs of a couple). Additional "catch-up" contributions of $1,000 are allowed persons age 50 or older (2006 and after). The rule continues that the dollar limits are reduced by contributions to traditional IRAs.
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:
1. 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
2. At least one of these additional conditions is met:
• The owner is age 59½.
• 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 percent 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
Conversion means that what would be taxable traditional IRA distributions can be made tax-exempt Roth IRA distributions. The amount converted this year 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.
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.) There is a risk 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 percent excess contribution penalty and maybe a 10 percent early withdrawal penalty (on the traditional IRA withdrawal).
Based on a recent law change, the use of a nondeductible IRA now looks more appealing for taxpayers who can’t qualify to make a Roth IRA (because their income is too high). The new provision allows taxpayers, beginning in 2010, to convert traditional IRAs (such as a nondeductible IRA) to a Roth IRA regardless of the taxpayer’s income level. Currently only taxpayers with gross income of no more than $100,000 can convert a traditional IRA to a Roth IRA. At the time of conversion, ordinary income tax due on the income portion of the IRA, but future earnings accrue tax-free. In addition, for conversions in 2010, the new law allows the resulting tax to be paid over two years – 2011 and 2012.
Why am I telling you this more than two years in advance of 2010? Because, if you’re not yet age 70½ and want to maximize the funds that can go in a Roth IRA, you should be funding nondeductible IRA now – up to the lesser of your earned income or $4,000 (or $5,000, if you are age 50 or older by the end of the year for which you’re making the contribution). It is not too early to fund for 2007, provided you know you’ll have at least $4,000 or ($5,000) of earned income for the year.
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 from 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.
Directly converting retirement assets from a company or Keogh plan to a Roth IRA won't be allowed until 2008. 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.
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 70½, 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. Now is a great time to maximize the tax efficiency of your retirement savings.
Kathey Hickey Fulham, CPA, MST, is an Osterville-based CPA. She can be reached at kathey@katheyfulhamcpa.com.
Published in Cape Business Health & Wealth July/August 2007
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