What is a Roth IRA? Created by the Taxpayer Relief Act of 1997, the Roth IRA became effective beginning with tax year 1998. It is designed to provide complete relief from taxes on retirement funds. Furthermore, it allows for greater flexibility than the traditional IRA. Finally, it enables qualifying taxpayers to secure these benefits by converting an existing IRA to a "Conversion Roth IRA".

How does it work? A Roth IRA must be maintained as a separate fund, similar to the other IRA alternatives. It may be set up as a bank account, a brokerage account, mutual funds, or trust. Assuming the individual qualifies, he or she may contribute each year the lesser of a) $2,000, or b) his/her earned income (wages, business income). Married taxpayers are allowed up to $4,000 (or combined earned income). The allowable amount must be reduced by any contributions made to any other IRA plans of the taxpayers for the year.

The contributions are not deductible by the taxpayer, an obvious disadvantage when compared to the traditional deductible IRA, and no different from the more recent "nondeductible" IRAs. But the advantage of the Roth IRA is clear: neither the contributed amounts nor the earnings on those contributions are taxed on withdrawal. (In contrast, all amounts withdrawn from deductible IRAs are taxed, as are withdrawals from the earnings portion--calculated under a complicated accounting system--of the nondeductible IRAs.)

Similar to traditional IRAs, distributions made on or after attaining age 591/2, or upon death or disability are not subject to penalty for early withdrawal. In the case of a Roth IRA, as long as the Roth IRA is in effect for at least five tax years, these distributions will also avoid income tax. The case for the Roth IRA gets better. A withdrawal from a Roth IRA to buy one’s first house will not be taxed.

Even those distributions which do not qualify under these rules get preferential treatment: "other" distributions will be treated as first coming from contributions made (nontaxable), then after all contributions are withdrawn, from the earnings (taxable).

Example 1:

Bob put $2,000 per year into his Roth IRA for six years. His $12,000 contributions grew to a value of $18,000 when Bob turned 50. Bob withdrew $15,000 from the Roth IRA (for general use). The first $12,000 is nontaxable; $3,000 is taxable. (Assuming Bob makes no more contributions, all withdrawals from that point will be taxed.)

Why not run to set up a Roth IRA now? Hold everything! Not everyone can qualify. Each year, taxpayers must perform an "income test" to determine eligibility for the Roth IRA. Single taxpayers can contribute the maximum amount (the lesser of $2,000 or 100% of earned income) if Adjusted Gross Income (AGI) is $95,000 or less. Between AGI of $95,001 and $110,000, the single taxpayer must reduce the maximum allowed by a ratio of the excess of AGI over $95,000 divided by $15,000. If AGI exceeds $110,000, no contribution to a Roth IRA can be made for the tax year. Any contribution made above the allowed amount will be subject to a 6% penalty for "excess contribution".

Example 2:

Susan, a single taxpayer, has an AGI of $92,000 in 1998, $105,000 in 1999, and $120,000 in 2000. Her earned income in each year was $75,000. Assuming she made no contributions to other IRAs for these years, her allowable contributions would be: 1998 1999 2000 $2,000 $667 ($2,000 - [$2,000 x ($105,000 - $95,000) / $15,000]) $0

Married taxpayers filing jointly can contribute the maximum amount if AGI is $150,000 or less. Between AGI of $150,001 and $160,000, joint filers must reduce the maximum allowed by a ratio of the excess of AGI over $150,000 divided by $10,000. If AGI exceeds $160,000, no contribution to a Roth IRA can be made for the tax year.

Example 3:

Mike and Jill, joint filers, have an AGI of $135,000 in 1998, $155,000 in 1999, and $170,000 in 2000. Their earned income in each year was $125,000. Assuming they made no contributions to other IRAs for these years, their allowable contributions would be: 1998 1999 2000 $4,000 $2,000 ($4,000 - [$4,000 x ($155,000 - $150,000) / $10,000]) $0

Married taxpayers filing separately might as well forget about the Roth IRA. Their maximum amounts are phased out between AGI of $ -0- and $15,000. With income at those levels, individuals are not usually looking to "tie up" money on a long-term basis.

All taxpayers who have the allowable amounts reduced, but not completely eliminated (i.e., AGI is still within the "phaseout" range), are not required to reduce below $200. This is a small benefit.

In contrast to the deductible IRA, there is no limitation to contribution based on participation in employer-provided retirement plans. This makes the Roth IRA especially attractive where the taxpayer does participate in his/her employer’s plan, makes more than the AGI threshold used for deductible IRAs, but less than the Roth IRA AGI threshold. Note: it appears that there is absolutely no sense in funding a nondeductible "non-Roth" IRA if one qualifies for Roth IRA contribution, since the earnings on the former will be taxed on withdrawal whereas all withdrawals go tax-free from the Roth. (One would only fund the nondeductible non-Roth IRA if, as a participant in an employer plan, AGI was too high for a Roth plan. There is no limit to AGI for the nondeductible non-Roth IRA.)

Does it make sense to convert an IRA to a "Conversion Roth IRA"? Only for some, and only if they act fast. But even they must be sure to look before they leap.

In the normal cases where money is withdrawn from a non-Roth IRA, the recipient pays income taxes, and penalties, if younger than 591/2, on amounts distributed. In the case a nondeductible non-Roth IRA, tax liabilities apply only to the earnings portion. The most significant exception to this treatment is a rollover to another IRA of the same type (within the applicable 60 days from withdrawal period). Under the exception, a "qualified rollover" continues the tax deferred/penalty avoided treatment of the IRA from which the funds were withdrawn.

Touted as an incentive to adopt Roth IRAs (but more likely an opportunity for the government to accelerate tax revenues), the 1997 Act included a provision to allow some regular IRA planholders to convert such IRAs to Roth IRAs without incurring the penalties associated with premature withdrawal. The originating IRA can be either a deductible IRA or a nondeductible non-Roth IRA. Only taxpayers whose AGI does not exceed $100,000 in the tax year can make the conversion. Married taxpayers filing separately cannot make a conversion penalty-free, regardless of AGI. Amounts rolled from an IRA to a Roth IRA are not counted towards the $2,000/$4,000 annual limit.

Assuming one can avoid the penalties, what about the income taxes? Unfortunately, the generosity of the "Tax Collectors" has its limits. Since converting IRA funds to Roth IRA means changing a tax-deferred investment to a tax-free investment, the government is looking for its up-front payment of tax. Once that payment is made, the "Conversion Roth IRA" will be treated in the same manner as any other Roth IRA, regardless of the future growth in the fund.

You might be thinking that paying tax on income in the year of rollover is a tough price to pay for the benefit of avoiding taxes in the future. Congress thought so too, so they provided an "installment arrangement" which expires at the end of 1998. Here’s how it works: a taxpayer who makes the conversion during 1998 can report one-fourth of the income in each of the four years beginning with 1998.

Example 4:

Mary, whose AGI is $72,000 has an old deductible IRA account with a value of $24,000. On December 15, 1998, she converts the IRA into a "Conversion Roth IRA". Mary will include $6,000 in her income in each of the tax years 1998, 1999, 2000 and 2001.

Example 5:

Same facts as Example 4, but Mary waits until January 10, 1999 to make the conversion. The entire value, $24,000, is included in her 1999 income.

1. Consider how your tax bracket in the four income inclusion years compares to the bracket anticipated for retirement. Ideally, the rolled IRA should be taxed in the lower brackets and withdrawn tax-free while in higher brackets at retirement. (Note: this is opposite of the thinking generally applied to retirement planning. Most planners expect to be in lower tax brackets in the retirement years.)
2. Fund balances sometimes decrease. While the stock market has been very rewarding lately, the trend could reverse. Clearly, one would hope not to pay tax on the value of the fund as of a given date, then withdraw the funds at a lesser value without a corresponding tax write-off for the loss. You’d need to feel pretty confident that your investments were likely to increase in value before making an early tax payment.
3. Tax laws change. The political and fiscal climates of 1997 were just right for the Roth IRA and the conversion "privilege". Before your retirement, you may see many other changes in the retirement plan arena. Maybe the one-time four-year income spread opportunity will be available again. Or maybe it will become a permanent opportunity. Or maybe tax rates will fall, making it favorable to defer income rather than accelerate income. These are, of course, subject to speculation. But, then again, tax planning always is. I am not against converting to Roth IRAs, but I do believe caution should be exercised, even if it means missing the 1988 year-end deadline for spreading the income.

In one case, conversion seems clearly to make sense. If you have been putting away an IRA for your child who earns a minimal salary (e.g., through your business), and that child is at least fourteen years old by the end of 1998, you probably should convert that IRA to a "Conversion Roth IRA". Although balances could drop and modification of tax laws could change things, it is very likely that the tax bracket in the year of conversion (probably in the 15% Federal bracket) will be less than in any later year.

And since we’re considering a young taxpayer, what is the likelihood that the fund balances will be less upon retirement? I think I would take my chances.