8 Years Later, Same Old Questions: Evaluating Roth IRAs

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1 8 Years Later, Same Old Questions: Evaluating Roth IRAs By Mark H. Gaudet, CPA, CFP The Taxpayer Relief Act of 1997 introduced a new type of IRA for taxpayers and investors the Roth IRA. Eight years have passed since the enactment of that law, but many taxpayers are still questioning whether or not they should contribute to a Roth IRA. They are also questioning whether they should convert or rollover a portion of their traditional IRA into a Roth IRA. There is no clear rule of thumb behind either question, because the answers depend substantially on assumptions about the future. In order to answer these questions, you need a framework from which to evaluate your unique circumstances and assumptions. This article will provide that framework. The first and easy question is: Am I eligible? The second and harder question is: Should I contribute or convert? Roth IRA Basics A Roth IRA is not an investment. Instead, it is a taxdeferred savings option that is a wrapper for an individual s retirement assets. Roth IRAs can hold any combination of stocks, bonds, mutual funds, and other permitted IRA investments. There is no guaranteed rate of return for a Roth IRA; the return is based on the performance of the portfolio that is inside of the IRA. A Roth IRA grows taxdeferred and, if certain conditions are met, distributions from the IRA will be completely tax-free for federal income tax purposes. [The state taxation of Roth IRAs varies by state and is beyond the scope of this article.] Contributions to Roth IRAs are not deductible on an individual s federal income tax return, and therefore contributions are made with aftertax dollars. The Benefits of a Roth A Roth IRA provides an individual with several benefits that are not available from a traditional IRA. The main benefit allows for all qualifying distributions to be free from federal income taxation. In the event that a distribution is not qualified, an individual may still be able to take distributions prior to age 59½ and not incur any income tax or premature distribution penalty. An individual may withdraw their previous Roth contributions without subjecting them to tax. Only the portion of a nonqualifying distribution that represents investment earnings will be taxed and possibly subjected to a penalty. Roth IRAs provide additional benefits to individuals 4

2 Table 1. Roth IRA Contribution Limits Allowable Roth IRA Contribution Based on Modified Adjustable Gross Income (MAGI) Tax Status Maximum Partial None Single taxpayer or MAGI under $95,000 MAGI $95,000 to under $110,000 MAGI: $110,000 or more head of household Married filing joint or MAGI under $150,000 MAGI $150,000 to under $160,000 MAGI: $160,000 or more qualifying widow(er) Married filing separately N/A MAGI: $0 to under $10,000 MAGI: $10,000 or more that are age 70½ or older that are not available from a traditional IRA. An individual may continue to make contributions to a Roth IRA even after the age of 70½ as long as they have taxable compensation income, whereas contributions to a traditional IRA would not be permitted once that age is reached. Unlike traditional IRAs, Roth IRAs are not subject to the required minimum distribution rules. The Internal Revenue Service requires individuals to take annual required minimum distributions from traditional IRAs when the IRA owner reaches age 70½. Since Roth IRAs are not subject to the minimum distribution rules, individuals are able to continue to grow the value of their Roth IRA tax-free. This can be a significant benefit for individuals looking to transfer wealth to future generations upon their death. Beneficiaries of a Roth IRA will continue to enjoy income tax-free distributions from Roth IRAs upon the owner s death. The tax-free distributions apply, as long as the original owner satisfied the five-year holding period (described below). However, Roth IRAs are included in the owner s taxable estate and may be subject to estate tax. Tax-Free Distributions The main attraction of a Roth is income tax-free distributions. However, in order for Roth IRA distributions to be completely income tax-free, the distributions must satisfy a five-year holding period, plus they must meet one of the following conditions: The distributions are made on or after the date on which the individual attains age 59½; or The distributions are made to a beneficiary on or after the individual s death; or The distributions are made due to the individual being disabled; or The distributions are made to pay qualified first-time homebuyer expenses (lifetime limit of $10,000). To meet the five-year holding period requirement, a distribution from a Roth IRA must not occur before the end of the five-year holding period, which begins with the first taxable year in which the taxpayer made a contribution to the Roth IRA. Generally, once an individual has met the five-year holding period on their initial contribution, all future contributions are not subject to a new holding period requirement. However, the treatment of distributions associated with Roth IRA conversions may be different. If a distribution from a Roth IRA doesn t meet the holding period requirement, the distribution amount may be included in the individual s taxable income and may be subject to the 10% premature distribution penalty. There are specific ordering rules that determine the taxation of distributions from Roth IRAs. Distributions are deemed to come first from regular contributions, then from amounts converted/rolled-over from traditional IRAs, and finally from earnings. Roth Contributions In order for an individual to make a contribution to a Roth IRA in a given year, they must receive compensation income. Generally, compensation income includes: wages, salaries, commissions, self-employment income and taxable alimony received. The maximum annual contribution that can be made to a Roth IRA for 2004 is $3,000. This amount will increase to $4,000 for tax years 2005 through 2007 and $5,000 for tax year Starting in 2009, the maximum contribution to a Roth IRA will be based on an annual inflation adjustment. In addition, taxpayers 50 years of age or older are permitted to make catchup contributions of an additional $500 to a Roth IRA through 2007, after which the catch-up contributions increase to $1,000. Contribution Eligibility In order for an individual to make the maximum contribution to a Roth IRA, the individual s modified adjusted gross income (MAGI) must not exceed certain levels. Single taxpayers and married taxpayers filing a joint return with modified adjusted gross income below $95,000 and $150,000, respectively, will be eligible to maximize their contributions to a Roth IRA. Single taxpayers will not be eligible to make Roth IRA contributions if their modified adjusted gross income exceeds $110,000, and their contributions will be gradually phased-out if their modified adjusted gross income is between $95,000 and $110,000. The modified adjusted gross income cap for married taxpayers filing a joint return is $160,000 and their phase-out limits are between $150,000 September

3 Table 2. Traditional IRA vs. Roth IRA: Distribution in 10 Years Traditional (Deductible) IRA Higher Tax Rate Tax Rates Lower Tax Rate Contribution Yr Unchanged Contribution Yr Roth IRA Marginal Tax Rate: Contribution Year 25% 25% 25% 25% Marginal Tax Rate: Distribution Year 15% 25% 28% N/A IRA Contribution Amount: Year 1 $3,000 $3,000 $3,000 $3,000 Tax Benefit: Year 1 $750 $750 $750 N/A Tax Benefit: Investment Fund (after 10 years) $1,259 $1,251 $1,249 N/A IRA Account Balance (after 10 years) $5,901 $5,901 $5,901 $5,901 Taxes Upon IRA Distribution: Year 10 $(885) $(1,475) $(1,652) N/A Net Assets After Taxes: Year 10 $6,276 $5,677 $5,498 $5,901 Assumptions: $3,000 contributions made in Year 1 Rate of return of IRAs: 7% Rate of return of Investment Fund: 7% less each year s marginal tax rate No distributions made until Year 10, complete distribution in year 10 Marginal tax rate for each year is 25%, with the exception of distribution year and $160,000. Table 1 summarizes the allowable contribution levels. Does It Make Sense? Evaluating a Contribution If an individual is eligible to make a Roth IRA or a traditional deductible IRA contribution, the individual must consider their income tax rates and their time horizon. The individual s income tax rates both during the periods of contribution and periods of withdrawal need to be analyzed. With a traditional IRA contribution, the individual would receive a tax deduction in the year in which the contribution is made. Conversely, Roth IRA contributions are made with aftertax dollars. If the individual anticipates being in a higher income tax bracket in retirement, it would most likely be beneficial to forego the current tax deduction and make a contribution to a Roth IRA; the same would hold true if the individual expected to be in the same tax bracket during the contribution and withdrawal years. The decision to make a traditional IRA contribution or a Roth IRA contribution is not as clear if the taxpayer is expecting to be in a lower tax bracket during the withdrawal years, and depends on various other factors, such as: What is the expected tax bracket during the IRA distribution years? How much lower is it compared to the current tax bracket? How long does the taxpayer expect that the money may grow before distributions must begin? Tables 2 and 3 provide examples showing how the results differ based on these variables. Table 2 compares the results when distribution occurs after 10 years for contributions made to a traditional deductible IRA and to a Roth IRA. For the traditional IRA contribution, the analysis considers three different tax scenarios: a tax rate that is higher during the contribution year compared to the rate during the distribution year, an unchanging tax rate, and a tax rate that is lower during the contribution year compared to the rate during the distribution year. To make the $3,000 deductible contribution to the traditional IRA comparable with the $3,000 aftertax Roth IRA contribution, an investment fund consisting of the tax benefit the IRA deduction is set up; this earns an annual aftertax rate of return. The net aftertax amount for the deductible IRA after 10 years consists of the IRA account, less taxes due on the IRA distribution, plus the tax benefit investment fund. Table 3 performs a similar analysis, but shows aftertax total values when the assets are allowed to grow for 35 years. Another tax savings vehicle available to most taxpayers is their employersponsored 401(k) plans. The decision as to whether to contribute to an employer s non-matching 401(k) plan or a Roth IRA is dependent upon the same facts and circumstances as the traditional IRA versus the Roth IRA. With the 401(k) plan, the individual is receiving a current tax deduction in the year of contribution, but the total amount of the distributions will be subject to income tax. However, if the individual s 401(k) offers an employee match, the individual should consider contributing first to the 401(k) to the extent of the employer match, then to a Roth IRA and then any remainder to the 401(k) that is not matched. Roth Conversion Individuals who have a traditional IRA may either rollover or convert their IRA to a Roth IRA. Conversion Eligibility In order to convert a traditional IRA to a Roth IRA, the individual s modified adjusted gross income must not exceed $100,000 in the year of conversion. Married taxpayers must file a joint return with their spouse in the year of conversion. Therefore, if a mar- 6

4 Table 3. Traditional IRA vs. Roth IRA: Distribution in 35 Years Traditional (Deductible) IRA Higher Tax Rate Tax Rates Lower Tax Rate Contribution Yr Unchanged Contribution Yr Roth IRA Marginal Tax Rate: Contribution Year 25% 25% 25% 25% Marginal Tax Rate: Distribution Year 15% 25% 28% N/A IRA Contribution Amount: Year 1 $3,000 $3,000 $3,000 $3,000 Tax Benefit: Year 1 $750 $750 $750 N/A Tax Benefit: Investment Fund (after 35 years) $4,526 $4,496 $4,487 N/A IRA Account Balance (after 35 years) $32,030 $32,030 $32,030 $32,030 Taxes on IRA Distribution: Year 35 $(4,804) $(8,007) $(8,968) N/A Net Assets After Taxes: Year 35 $31,751 $28,518 $27,549 $32,030 Assumptions: $3,000 contributions made in Year 1 Rate of return of IRAs: 7% Rate of return of Investment Fund: 7% less each year s marginal tax rate No distributions made until Year 35, complete distribution in year 35 Marginal tax rate for each year is 25%, with the exception of distribution year ried couple decides to file separate tax returns, they will not be eligible for a Roth conversion regardless of their modified adjusted gross income. The amount of the traditional IRA that is converted in a tax year is included in the taxpayer s gross income, but it is not included in the $100,000 modified adjusted gross income limitation for conversion eligibility. In order to convert to a Roth IRA, an individual may either convert a traditional IRA to a Roth IRA, or rollover IRA funds to a new Roth IRA. Regardless of the method of conversion, the conversion or rollover is afforded the same treatment for income tax purposes. Does It Make Sense? Evaluating a Conversion Many good full-length articles have been written on whether it makes sense to convert in previous issues of the (see accompanying box on page 8). Here are a few key factors that an individual should consider when deciding whether to convert their traditional IRA to a Roth IRA. One main consideration is where to obtain the necessary funds required to pay the tax upon conversion. As mentioned above, when an individual converts a traditional IRA to a Roth IRA, the amount converted to a Roth IRA will be included in the individual s taxable income in the year of conversion. Generally, from an income tax standpoint, a conversion to a Roth IRA only makes sense if the individual has the ability to pay the income taxes on the conversion from a taxable investment account, not the IRA itself. Although the individual may use part of their traditional IRA to pay the taxes, this will reduce the amount of funds that will be converted to the Roth IRA and eliminate the ability for those funds to grow in a tax-free environment. In addition, the funds used from the IRA to pay the taxes will be treated as a withdrawal and may be subject to income taxes and possibly a 10% penalty for a premature distribution. Another significant factor to consider is the IRA owner s current and future expected income tax rates. If the IRA owner anticipates that they will be in a higher tax rate bracket when IRA withdrawals are made as compared to the tax bracket in the year of conversion, converting to a Roth IRA will provide the owner an overall lower tax cost on IRA withdrawals. However, if the IRA owner anticipates that they will be in a lower tax bracket when IRA withdrawals are made, converting to a Roth IRA may not make the best income tax sense. Finally, if the IRA owner anticipates no change in their tax rates between conversion and withdrawal, the income tax effect of converting to a Roth IRA should be neutral. Another consideration is the amount of time that the individual intends on either holding or taking distributions from the IRA. If an individual anticipates withdrawing funds from their IRA within five years of conversion to a Roth IRA, converting to a Roth IRA would likely not be advantageous. A distribution from the Roth IRA within the five-year period that was included in income during the conversion, likely will cause the distribution to be subject to the 10% penalty on premature distributions. The age and life expectancy of the IRA beneficiaries may be an important factor to consider when evaluating a conversion. Although the Roth IRA owner is not required to take any distributions from their Roth IRA during their lifetime, the IRA beneficiary is not provided the same luxury, unless the beneficiary is a spousal beneficiary. If a spousal beneficiary is named, the surviving spouse may be able to treat the IRA as their own or rollover the inherited IRA into their own Roth IRA. Under either method, the surviving spouse is now treated as the owner of the Roth IRA. Therefore, the surviving spouse s Roth IRA would not be subject to the required minimum distribu- September

5 Previous Articles on Roth IRAs The following are accessible at AAII.com by linking through this article in the area or using the Search tool. IRA Conversions: Older Taxpayers Need to Consider Special Factors, by Paul Erickson, May 2001 A Look at Roth IRA Conversions and Other Taxing Issues, By William Reichenstein, May 2000 Roth IRA Distributions: A Review of the Rules, by Gary Trock, October 1999 Planning Considerations With the New Roth IRA, by Clark M. Blackman, October 1998 tion rules. This would potentially extend the period of time that the IRA could grow in a tax-free manner. In addition, the surviving spouse would have the ability to name their own beneficiaries. If the beneficiary of the Roth IRA is a non-spousal beneficiary, the beneficiary will be required to take distributions from the IRA after the owner s death. The beneficiary can choose to take the distributions under the life expectancy method or the five-year rule. The life expectancy method allows the beneficiary to take the IRA distributions over their remaining single-life expectancy. These distributions must begin no later than December 31 of the year following the year of death. Under the five-year rule, the beneficiary must distribute all funds prior to December 31 of the fifth-year anniversary of the IRA owner s death. In addition to the aforementioned issues, individuals should also consider the following factors when contemplating a conversion of a traditional IRA to a Roth IRA: The IRA owner s current age and life expectancy; The IRA owner s other sources of retirement assets and their anticipated living expenses during retirement; and The IRA owner s other sources of income and taxable investments. Conclusion The tax-free growth of the Roth IRA makes it an extremely attractive retirement planning option. Every individual who is eligible to make contributions to a Roth IRA or eligible to convert a traditional IRA to a Roth IRA should consider whether a Roth IRA would be beneficial to their overall retirement planning and wealth transfer goals. It is strongly encouraged that individuals consult with a professional tax adviser or financial planning professional to assist in the conversion analysis due to its complexities as well as the corresponding tax ramifications. Mark H. Gaudet, CPA, CFP, is a senior manager of Private Client Advisors for Deloitte & Touche, LLP, in Cincinnati. SAVE THE DATE for 2005! AAII Investor Conference Wednesday ednesday, November 2 Friday, November 4, 2005 Las Vegas Riviera Hotel & Casino The conference taught me how to alter my investment strategy for the better. A. Brewer, Past Attendee 8