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Roth IRAs differ from other tax-favored retirement plans, including other IRAs (called "traditional IRAs"), in that they promise complete tax exemption on distribution. 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
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 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.
The 2013 annual contribution limit to a Roth IRA is $5,500 (up from $5,000 in 2012). An additional "catch-up" contribution of $1,000 (same as 2012) is allowed for persons age 50 or over bringing the contribution total to $6,500 for certain taxpayers. To make the full contribution, you must earn at least $5,500 in 2013 from personal services and have income (modified adjusted gross income or MAGI) below $112,000 if single or $178,000 on a joint return in 2013. The $5,500 limit in 2013 phases out on incomes between $112,000 and $127,000 (single filers) and $178,000 and $188,000 (joint filers). Also, the $5,500 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 $11,000, up to $11,000 ($5,500 each) can go into the couple's Roth IRAs. As with traditional IRAs, there's a 6% penalty on excess contributions. The rule continues that the dollar limits are reduced by contributions to traditional IRAs.
You may withdraw money from a Roth IRA at any time; however, taxes and penalty could apply depending on timing of contributions and withdrawals.
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 the following conditions:
To discourage the use of pension funds for purposes other than normal retirement, the law imposes an additional 10% tax on certain early distributions from Roth IRAs unless an exception applies. Generally, early distributions are those you receive from an IRA before reaching age 59 1/2.
Exceptions. You may not have to pay the 10% additional tax in the following situations:
Part of any distribution that is not a qualified distribution may be taxable as ordinary income and subject to the additional 10% tax on early distributions. Distributions of conversion contributions within a 5-year period following a conversion may be subject to the 10% early distribution tax, even if the contributions have been included as income in an earlier year.
Ordering Rules for Distributions
If you receive a distribution from your Roth IRA that is not a qualified distribution, part of it may be taxable. There is a set order in which contributions (including conversion contributions) and earnings are considered to be distributed from your Roth IRA. Order the distributions as follows.
Disregard rollover contributions from other Roth IRAs for this purpose.
Aggregation (grouping and adding) rules.
Determine the taxable amounts distributed (withdrawn), distributions, and contributions by grouping and adding them together as follows.
Add any recharacterized contributions that end up in a Roth IRA to the appropriate contribution group for the year that the original contribution would have been taken into account if it had been made directly to the Roth IRA.
Disregard any recharacterized contribution that ends up in an IRA other than a Roth IRA for the purpose of grouping (aggregating) both contributions and distributions. Also disregard any amount withdrawn to correct an excess contribution (including the earnings withdrawn) for this purpose.
Distributions after Owner's Death
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.
The conversion of your traditional IRA to a Roth IRA was the feature that caused most excitement about Roth IRAs. Conversion means that what would be a taxable traditional IRA distribution can be made into a tax-exempt Roth IRA distribution. Starting in 2008, further conversion or rollover opportunities from other eligible retirement plans were available to taxpayers.
You can convert a traditional IRA to a Roth IRA. The conversion is treated as a rollover, regardless of the conversion method used.
You can convert amounts from a traditional IRA to a Roth IRA in any of the following three ways.
Prior to 2008, you could only rollover (convert) amounts from either a traditional, SEP, or SIMPLE IRA into a Roth IRA. You can now roll over amounts from the following plans into a Roth IRA. A qualified pension, profit-sharing or stock bonus plan (including a 401(k) plan),
Any amount rolled over is subject to the same rules for converting a traditional IRA into a Roth IRA. Also, the rollover contribution must meet the rollover requirements that apply to the specific type of retirement plan.
There is a cost to the rollover. The amount converted 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.
Starting in 2010, conversion is now allowed to all taxpayers. The prior income restriction allowing conversion only for taxpayers of income (again, MAGI) of $100,000 or less in the conversion year has been terminated. All taxpayers are able to convert a regular IRA to a Roth IRA starting in 2010. The conversion is a taxable distribution, which can be taken into income in the conversion year or averaged over the next two years. The conversion will not be subject to the 10% early distribution penalty.
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. Re-characterization can be done any time until the due date for the return for the year of conversion.
Can you undo one Roth IRA conversion and then make another one-a reconversion? Yes-once, subject to these requirements: Reconversion must take place in the tax year following the original conversion to Roth IRA, and the reconversion date must also be more than 30 days after the previous recharacterization transfer from the Roth IRA back to the traditional IRA.
You are not required to take distributions from your Roth IRA at any age. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply to traditional IRAs also apply to Roth IRAs
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.
Also known as the saver's credit, this credit helps low and moderate income workers save for retirement. Taxpayers age 18 and over who are not full-time students and can't be claimed as dependents, are allowed a tax credit for their contributions to a workplace retirement plan, traditional or Roth IRA if their modified adjusted gross income (MAGI) in 2013 for a married filer is below $59,000 ($57,500 in 2012). For heads-of-household MAGI is below $44,250 ($43,125 in 2012) and for others (single, married filing separately) it is below $29,550 ($28,750 in 2012). These amounts are indexed for inflation each year. The credit, up to $1,000, is a percentage from 10-50% of each dollar placed into a qualified retirement plan up to the first $2,000. The lower the MAGI is, the higher the credit percentage, resulting in the maximum credit of $1,000 (50% of $2,000).
The following table details the percentage of Saver's credit based on Adjusted Gross Income (AGI):
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.
Long-term planning with Roth IRAs. If you would be allowed a deduction for a contribution to a traditional IRA, contributing to a Roth IRA means surrendering current tax reduction for future tax reduction (to zero) for qualified distributions. This can be presented as an after-tax return-on-investment calculation involving assumed future tax rates. The higher the projected tax rate at withdrawal, the more tax Roth IRA saves.
Comparable considerations apply to conversions to Roth IRAs. Here the taxpayer incurs substantial current tax cost (directly or indirectly reducing the amount invested) for future tax relief to the taxpayer or an heir. So the return on investment resulting from conversion increases as projected future rates rise.
A key element in making such projections is the possibility that current and future federal deficits will lead to future tax rate increases-a factor which would tend to encourage current Roth IRA investment and conversion. On the other hand, there's the question whether Roth IRA benefits currently promised will survive into future decades.
Highly sophisticated planning is required for Roth IRA conversions. Consultation with a qualified advisor is a must. Please call us if you have any questions.
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