Similar in concept to the traditional IRA, the Roth IRA differs in that contributionsare never deductible, and, if certain requirements are met, distributions from the account may be received free of federal income tax.
Establishing A Roth IRA
Annual contributions: A Roth IRA may be established and funded at any time between January 1 of the current year, up to and including the date an individual’s federal income tax return is due, (generally April 15 of the following year), not including extensions. The account must be designated as a Roth IRA at the time it is established.
Conversion of existing IRA account: IRC Sec. 408A, which provides for Roth IRAs, allows an existing, traditional IRA (either an annual contribution IRA or a "rollover" IRA) to be converted to a Roth IRA. The conversion from the "old" traditional IRA to the Roth IRA results in a taxable event; previously deducted IRA contributions, and all earnings in the account, are added to the taxpayer’s gross income for the year of conversion.
Any 10% excise tax (penalty for withdrawals before age 59½) which might apply to converted amounts is waived. However, if a taxpayer withdraws amounts from the converted Roth IRA within five years of the year of conversion, the 10% excise tax will apply.
The taxpayer making the conversion must have an adjusted gross income (AGI) of$100,000 or less in the year of conversion or no conversion is permitted. The law also prohibits conversion if a taxpayer is using the married filing separate status. A taxpayer who converts amounts from a traditional IRA to a Roth IRA may reverse the transaction and "recharacterize" the converted funds. Only one such conversion and recharacterization is permitted during a tax year. For example, assume that a taxpayer converts and then "unconverts" a Roth IRA in 2000. In general, the taxpayer must wait until tax year 2001 before again converting amounts from a traditional IRA to a Roth IRA. The recharacterization of converted amounts must generally be made within six months of a taxpayer’s unextended due date for filing his or her income tax return.
Type Of Arrangements Permitted
There are currently two types of Roth IRAs:
Individual retirement accounts: A trust with a corporate trustee
Individual retirement annuities: A special annuity issued by a life insurance company
Limits: A wage earner may contribute (but not deduct) the lesser of $2,000 or 100% of compensation earned for the year. If the wage earner is married, an additional $2,000 may be contributed on behalf of a lesser earning (or nonworking) spouse, using a "spousal" account. A husband and wife may contribute up to a total of $4,000, as long as their combined compensation is at least that amount.
Contribution phaseout: The maximum contribution to a Roth IRA is phased out for single taxpayers with adjusted gross income between $95,000 and $110,000. For married couples filing jointly, the phaseout range is an AGI of $150,000 to $160,000. For married individuals filing separately, the phaseout range is an AGI of $0 to $10,000.
Other IRAs: The contribution limits for a Roth IRA are coordinated with those of the traditional IRA; a taxpayer may not contribute more than $2,000 ($4,000 for a married couple) per year into a single IRA or a combination of traditional and Roth IRAs. Excess contributions to a Roth IRA are subject to a 6% excise tax, for each year that any excess remains in the account.
Taxation Of Distributions
Distributions from a Roth IRA which are "qualified distributions" are not subject to federal income tax. Qualified distributions are distributions which are made after afive-year waiting period,1 and which are made:
Distributions which are not "qualified" distributions are subject to tax. Amounts withdrawn are first considered to come from nondeductible contributions (all RothIRAs are aggregated for this calculation), and are not subject to tax. After all original contributions have been withdrawn, remaining amounts are considered to be income earned within the IRA and, if withdrawn, are taxable. If taxable distributions are received prior to age 59½, a 10% penalty tax may be added.
A taxpayer who converted a traditional IRA to a Roth IRA in 1998 could have electedto recognize any taxable income from the conversion ratably, over a four-year period. If such a taxpayer withdraws amounts from the Roth IRA prior to the year 2001, however, the benefits of any remaining deferral will be lost and recognition of any remaining, unrecognized income will be accelerated, up to the amount of the distribution allocable to the 1998 conversion.
There are several other significant differences between the traditional IRA and the Roth IRA:
Factors Favoring Conversion To A Roth IRA
Factors which would favor converting an existing traditional IRA to a Roth IRA include the following:
Tax Disclaimer: To ensure compliance with IRS Rules, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer under the Internal Revenue Code, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.
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Wink Tax Services / Wink Inc.