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How They Work And How To Use Them
Roth IRAs differ from other tax-favored retirement plans, including other IRAs (called "traditional IRAs"), in that they promise complete tax exemption on distribution. But 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.

How Contributions Are Treated
How Withdrawals Are Treated
Converting From a Traditional IRA
Undoing a Conversion to a Roth IRA
Withdrawal Requirements
Use in Estate Planning

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.


Except for conversion of traditional IRAs to Roth IRAs—and that’s a huge exception, as we’ll see—no more than $3,000 can go into a Roth IRA. To put in even that much, you must earn $3,000 from personal services and have income (technically, modified adjusted gross income or MAGI below $95,000 if single or $150,000 on a joint return. The $3,000 limit phases out on incomes between $95,000--$110,000 (single) and $150,000--$160,000 (joint). Also, the $3,000 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 $6,000, up to $6,000 ($3,000 each) can go into the couple’s Roth IRAs. As with traditional IRAs, there’s a 6% penalty on excess contributions. Contribution dollar limits for your own Roth IRA rise to $4,000 for 2005-7, and $5,000 for 2008 and after (double these amounts for Roth IRAs of a couple). Additional "catch-up" contributions are allowed persons age 50 or over, of $500 (2003-5) and $1,000 (2006 and after). The rule continues that the dollar limits are reduced by contributions to traditional IRAs.

Credit for low-income Roth IRA investors. "Lower-bracket" taxpayers age 18 and over are allowed a tax credit for their contributions to a plan or traditional or Roth IRA. Credit is allowed on joint returns of couples with modified adjusted gross income (MAGI) below $50,000, heads-of-household below $37,500 and others (single, married filing separately) below $25,000. Credit is a percentage (10%, 20%, 50%) of the contribution, up to a contribution total (considering all contributions to all plans and IRAs) of $2,000. The lower the MAGI, the higher the credit percentage: the maximum credit is $1,000 (50% of $2,000).


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 59 ˝ .
  • 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% 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.


Opportunity. Cost. Risk. These features of your option to convert your traditional IRA to a Roth IRA are what’s caused most of the excitement about Roth IRAs. Conversion means that what would be taxable traditional IRA distributions can be made tax-exempt Roth IRA distributions. That’s the Opportunity. The Cost—tax cost—is that 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. (In 1998—only—there was the option to spread the income from the conversion equally over 1998—2001.)

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.) The risk is 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% excess contribution penalty and maybe a 10% early withdrawal penalty (on the traditional IRA withdrawal).

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 (the 60-day deadline can be extended in hardship cases).

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.

You can’t convert retirement assets from a company or Keogh plan to a Roth IRA. 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.


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.

TIP TIP: One reason to do this would be where you find you’ve exceeded the $100,000 income ceiling for Roth IRA conversions.
TIP TIP: Another reason to do this, dramatized by a volatile stock market, is where the value of your portfolio drops sharply after the conversion.
Note Example: If your assets are worth $180,000 at conversion and fall to $140,000 later, you’re taxed on up to $180,000, which is $40,000 more than you now have. Undoing—re-characterization—avoids the tax, and gets you out of the Roth IRA.

Re-characterization can be done any time until the due date for the return for the year of conversion. Unfortunately, there’s no current protection against the case where a taxpayer is later—say, on audit—found to exceed the $100,000 income ceiling because of overlooked income or mistaken deductions—one more example of conversion’s high risk.

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. (Reconversion rules were easier before 2000).


Since tax-favored retirement plans are for retirement, there’s a general requirement that plan withdrawals must begin when the owner reaches age 70 ˝, 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.

Use In Estate Planning 

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.























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