Mickey Nobile's Tax Tip of the week!

Roth IRA - This is the year!

Other helpful resources include this Roth IRA calculator and this table summarizing the pros and cons to help you make the right decision.

What is a Roth IRA?

Beginning in January 1998, a brand-new Individual Retirement Account (IRA) offers a terrific feature that was previously unavailable in qualified retirement plans: totally tax-free accumulation. This new plan is known as the Roth IRA and is part of the Taxpayer Relief Act of 1997.

Contributions.

The Roth IRA is funded with after-tax dollars; there is no up-front tax deduction. This plan allows annual non-deductible contributions of up to $2,000 of earned income for singles, $4,000 for married couples. The maximum contribution is subject to annual Adjusted Gross Income (AGI) ceilings -- $95,000 for single taxpayers, $150,000 for couples filing a joint return. Allowable contributions begin to phase out for the next $10,000 over the annual AGI ceilings.

However, the annual $2,000 contribution limit for a Roth IRA is reduced by contributions to any traditional (non-Roth) IRA for a given year. Conversions from a traditional IRA to a Roth IRA are not considered contributions.

Withdrawals.

The special treatment of withdrawals is what distinguishes the Roth IRA from other IRAs. Since the contributions to a Roth IRA are non-deductible, withdrawal of contributions is tax-free and is permitted anytime without restriction. Furthermore, withdrawal of accumulated earnings entirely tax-free if you hold the Roth IRA for a minimum of five years and meet one of the following exemptions:

Reach the minimum age of 59 1/2
Take up to $10,000 for first-time home purchase
Disability
Death

Unlike other types of IRAs, the Roth IRA has no minimum distribution (withdrawal) requirements; if you wish, you can hold your Roth IRA indefinitely without taking any withdrawals. Upon your death, your heirs would receive the Roth IRA proceeds which would be entirely free from federal income taxes (unlike other IRAs). Note that accumulated earnings from the Roth may be subject to income taxes in some states.

Taxes and Penalties.

Once total contributions have been withdrawn, subsequent withdrawals would be accumulated earnings. If you have held the Roth IRA for a minimum of five years, but have not met one of the above withdrawal exemptions, then all accumulated earnings withdrawals are taxable. However, if the Roth IRA is held for less than five years and accumulated earnings are withdrawn, then the accumulated earnings are subject to both ordinary income tax rates and a 10% early-withdrawal penalty. However, the10% penalty, but not the income taxes, is waived if you meet one of the following exceptions (applicable only to accumulated earnings held for less than five years):

Death
Disability
Equal periodic payment withdrawals
Medical expenses greater than 7.5% of AGI
Health insurance premiums for an unemployed person
Higher-education expenses
First-time home purchase

Special Conversion Provisions.

You can convert funds from a traditional IRA into a Roth IRA if your AGI is $100,000 or less; the amount of this ceiling applies to single or joint tax payers. The rollover would be subject to ordinary income tax rates, so proceed with caution: consider the time horizon for the Roth IRA as well as the tax consequences. If you convert in 1998, you spread the taxable amount of the conversion in equal increments over four years -- 1998, 1999, 2000 and 2001; however, if you rollover after1998, all taxes that are due must be paid for the year in the year of the conversion.

All conversions to a Roth IRA are treated as distributions. A portion, or all, of the conversion is likely to be subject to taxation at ordinary income rates, depending upon the proportion of nondeductible contributions, deductible contributions and accumulated earnings in the conversion amount; only nondeductible contributions are not subject to taxation. Furthermore, the aggregate balance of all IRAs owned must be factored to determine taxable income resulting from the conversion. For example, if you have one deductible IRA and one nondeductible IRA, you must consider the proportionate balance of both IRAs (in terms of accumulated earnings, deductible and nondeductible contributions) for tax purposes -- even if you transfer funds from only the nondeductible IRA.

Do not plan to withdraw Roth IRA conversion funds within five years from the date of your last conversion. A pending technical corrections bill would impose (1) a 10% early withdrawal tax on Roth IRA conversion amounts which were subject to taxation in the conversion and (2) an additional 10% tax on converted taxable amounts which are subject to the special four-year installment rule. To avoid confusion with regard to these potential tax penalties, it would be wise to establish two Roth IRAs -- one for conversions, one for contributions.

Strategies.

The Roth IRA is not intended to replace a Keogh or 401(k) plan, especially if your employer matches a portion of your 401(k) contributions. Ideally, after maximizing these Keogh or 401(k) plans, the Roth IRA should be your next investment priority since earnings grow tax-free and withdrawals are tax-free -- a terrific combination, provided you can meet the minimum holding requirement of five years and one of the withdrawal requirements.

Many investors may also face a decision between the Roth IRA and either (1) a nondeductible IRA or (2) a deductible IRA. The Roth IRA is the clear choice over the non-deductible IRA; both are very similar except the withdrawal of earnings are tax-free in the Roth IRA, but are taxable at ordinary rates in the non-deductible IRA.

The choice between the Roth IRA and a deductible IRA is more complicated because of the comparison of the up-front tax savings and taxable withdrawals from the deductible IRA verses the nondeductability and the tax-free accumulations from the Roth; present and future tax brackets should be considered. As a general rule, if your tax rate will be higher at withdrawal, go with the Roth; if it will be lower, go with the deductible IRA. If you believe that your tax rate will be unchanged, some analysts give the edge to the Roth, others say it is a dead heat. However, investors with a long-term time horizon are likely to prefer the Roth over the deductible IRA to accumulate tax-free, as opposed to tax-deferred, earnings.

Another decision facing investors is whether to convert a traditional IRA into a Roth IRA. Tax consequences and time horizon are the most important factors in considering this type of switch. The key is to compare current taxes resulting from the conversion verses future tax-free accumulated earnings from the Roth. Generally, if you are nearing retirement, you should probably not convert to a Roth IRA. However, if you have a long-term time horizon and if the taxes due from your regular IRA will not constrain your finances, then a conversion to a Roth IRA would be beneficial. Should you decide to switch, do so in 1998 to take advantage of the special four-year tax installment provisions.

In summary, whether your goal is in supplementing retirement, estate additions or a first-time home purchase, the Roth IRA offers after-tax return benefits that were previously unavailable. As long as you meet the minimum holding and withdrawal requirements, this new type of IRA is a vehicle that you can use to help accomplish your goal.