Roth IRAs 101

in

Roth IRAs 101
Laurie A. Belew, MS, MBA

Unlike the traditional IRA, the Roth IRA provides no tax deduction for contributions, but instead provides for tax free withdrawal of earnings. For many individuals, the Roth IRA is an excellent financial planning tool because it provides a vehicle for shielding your long term investments from taxes. However, because of limiting eligibility requirements, many of our clients have been unable to take advantage of the Roth’s benefits. That will change in 2010, when a window of opportunity opens, enabling more people to participate in Roth IRA accounts.

First, it is important to understand the Roth IRA rules established by the Internal Revenue Code.

Eligibility

In 2009, individuals with modified adjusted gross income (MAGI) under $105,000 for single individuals, and $166,000 for married couples filing jointly, are eligible to contribute to a Roth IRA. Above these limits, contributions are phased out. Additionally, individuals must have earned income at least equal to the amount contributed.

Contributions

Contributions are allowed up to $5,000 in 2009 (plus a $1,000 catch-up for individuals age 50 or older). You may contribute to a Roth IRA as late as your tax return due date, April 15th (or October 15th if on extension). An advantage of a Roth IRA over a traditional IRA is the ability to make contributions beyond when the account holder turns age 70½.

Conversions

If you file taxes as single, married filing jointly, or head of household, you may qualify for a Roth IRA conversion. Modified adjusted gross income must be $100,000 or less, and the amount converted must meet the definition of a qualified rollover contribution (made within 60 days of an IRA distribution, transferred in a trustee-to-trustee transfer, or moved to a Roth account maintained by the same trustee).

The following account types can be converted into a Roth IRA:

  • Traditional, SEP, or SIMPLE IRA
  • Qualified pension, profit-sharing, or stock bonus plan (including a 401(k))
  • An annuity plan
  • A tax-sheltered annuity plan (403(b) plan)
  • A deferred compensation plan of a state or local government (457 plan)

Conversions are treated as a distribution from the traditional IRA, and any amount that is not a return of basis is includable as income. The 10% early withdrawal penalty (see below) does not apply.

Distributions

Distributions from a Roth IRA are tax free as long as they are “qualified.” Additionally, non-qualified distributions are generally not taxable to the extent that total distributions do not exceed total contributions and conversions (i.e. tax basis).

Qualified distributions must satisfy both of the following tests:

1. Occurs at least five years after the account is established and funded.

2. Distribution must meet one of the following:

  • Made after account owner attains age 59½.
  • Made to a beneficiary or estate of the owner on or after the owner’s death
  • Is attributable to the owner being disabled
  • For first-time home purchase (lifetime cap of $10,000 for first time home buyers includes taxpayer, spouse, child, or grandchild who has not owned a house for at least two years)

 

Distributions of earnings that are taxable, but not subject to penalty:

  • Higher education expenses
  • Medical expenses
  • Medical insurance premiums while unemployed
  • Substantially equal periodic payments

 

Penalties

The IRS imposes a 10% early withdrawal penalty on any distribution that is includible in gross income. Additionally, the penalty applies to distributions attributable to conversions (not includible in gross income) if the five year rule is not met. The early withdrawal penalty does not apply to Roth IRA conversions.

Unlike a traditional IRA, minimum distribution rules do not apply to Roth IRAs while the account owner is alive.

2010 Law Change

In 2010, individuals who have largely been unable to benefit from Roth IRAs will have an opportunity to take advantage of this unique type of retirement account. For one year only, the income test for a Roth conversion ($100,000 MAGI) will no longer apply. Thus, upper income taxpayers will finally be allowed to enjoy the benefits of a Roth IRA. Converted amounts will still be treated as a distribution, and hence, subject to income taxation. However, the law includes a provision to help with the tax bite: conversions in 2010 will be allowed to have half of the amount converted taxed in 2011 and half taxed in 2012. So, while not everyone will be eligible to fund a Roth IRA, anyone can convert to a Roth IRA.

We encourage you to talk with us, as well as your tax professional, regarding how you may take advantage of the 2010 conversion opportunity and what steps you can take now to maximize the benefits.