Roth IRAs, Roth 401(k)s and Roth 403(b)s represents significant tax planning tools when taxpayers are in the right situations. (Employers can start offering Roth 401(k) and 403(b) plans in 2006.)
Roth accounts are different from traditional IRAs, 401(k) and 403(b) accounts because there are no tax deductions for the amount contributed, and, if certain requirements are met, the distributions from the account will be exempt from tax. Since the income compounds tax-free and the distributions are also free of tax, it can replace some investments in tax-exempt bonds with superior returns of investment that would otherwise be taxable. The after-tax impact of the features of these plans for a young person are staggering.
For example, on an after-tax basis, if a taxpayer made contributions of $2,000 per year to an IRA and earned 8%, and reinvested the tax savings from a regular IRA, subject to a 50% tax rate, after 40 years, the taxpayer would have about $378,600 with a regular IRA and about $559,500 with a Roth IRA. That's 32% more capital (almost one third) available to fund future retirement payments.
The account must be designated as a Roth IRA, Roth 401(k) or Roth 403(b) when it is established. In order for an employer to offer Roth 401(k) or 403(b) accounts, it must provide for them in its retirement plan document.
The contribution limits are coordinated with regular IRAs, 401(k)s and 403(b)s. If an individual cannot or does not make a contribution to a deductible IRA or a Roth IRA, he or she may still contribute to a non-deductible IRA. The maximum contribution for all IRA accounts is $4,000 for 2006 – 2007, $5,000 for 2008.
An individual who will be at least age 50 by the end of a tax year is permitted to make an additional "catch up" contribution to a Roth IRA. Starting 2006, the maximum catch-up contribution will be $1,000.
Unlike deductible IRAs, individuals may continue to make contributions to a Roth IRA after age 70 ½.
Effective in 2006, 401(k) and 403(b) plans may adopt Roth provisions. The maximum contribution for 2006 will be the same as for other 401(k) and 403(b) plans, $15,000 plus a catch up contribution of up to $5,000 for individuals who will be age 50 by the end of the tax year. The Roth accounts will be separately accounted for from the taxable 401(k) and 403(b) accounts.
The maximum contribution to a Roth IRA is phased out for single taxpayers with adjusted gross income (AGI) between $95,000 and $110,000 and for joint filers with AGI between $150,000 and $160,000. Married persons who file separate returns are not eligible to make a contribution. Note that contributions may be made even though the taxpayer or the taxpayer's spouse is a participant in a qualified retirement plan at work.
For Roth IRA purposes, modified AGI does not include income reported from the conversion of a traditional IRA to a Roth IRA.
The adjusted gross income phase out will not apply for Roth 401(k) or Roth 403(b) contributions.
Taxation of distributions.
Qualified distributions from Roth IRA accounts are not included in the taxpayer's gross income and are not subject to the 10% tax for early withdrawals. In order to qualify, the distribution may not be made before the end of the five-tax-year period beginning with the first tax year for which the individual (or the individual's spouse) made a contribution, and must meet one of these requirements:
It was made on or after the date on which the individual attains age 59 ½.
It was made to a beneficiary (or the individual's estate) on or after the individual's death.
It was attributable to the disability of the individual.
It was a distribution to pay for up to $10,000 of "qualified first-time home buyer expenses." (Once in a lifetime exception.)
For payment of deductible medical expenses.
Health insurance payments for an unemployed participant.
To pay for qualified higher education expenses for the taxpayer, spouse, or their children or grandchildren.
Penalty-free distributions of elective contributions from Roth 401(k) or 403(b) accounts are limited to:
Severance from employment with the employer maintaining the plan after reaching age 55.
Hardship distributions. ((1) The participant has an immediate and heavy financial need and (2) other resources are not reasonably available to meet that need.)
Termination of the plan.
Distributions after attaining age 59 ½.
For payment of deductible medical expenses.
Under a qualified domestic relations order (divorce).
Minimum distribution rules.
The minimum distribution rules requiring that distributions should begin no later than April 1 of the year following the year the participant reaches age 70 ½ will not apply to Roth IRAs. However, the rules requiring distribution of the IRA account after the death of the participant do apply. See your tax advisor for details.
The minimum distribution rules for 401(k) and 403(b) plans require that distributions should begin no later than April 1 of the year following the later of (1) the year the participant attains age 70 ½ (always applies to a more than 5% owner) or (2) the calendar year in which the participant retires. This requirement can be avoided or minimized by a rollover to a Roth IRA account.
The 60-day rollover rules relating to regular IRA distributions apply to distributions from Roth IRAs. The recipient account must also be designated as a Roth IRA.
Roth 401(k) and 403(b) accounts will be eligible for rollover to Roth IRA accounts. Direct transfers will usually be preferable to distribution and deposit of account proceeds.
An amount in a regular IRA can be rolled over to a Roth IRA, provided:
the taxpayer's adjusted gross income for the tax year does not exceed $100,000, and
the taxpayer is not married, filing separately.
Adjusted gross income for this test excludes any income that would be recognized as a result of the conversion.
The balance in the regular IRA account on the date of conversion, less the amount of non-deductible contributions to the account, will be taxable income in the year of conversion.
Under the Tax Increase Prevention and Reconciliation Act enacted on May 17, 2006, for tax years beginning after 2009, non-Roth IRAs may be converted to Roth IRAs without an income limitation. In addition, for 2010 conversions only, the taxable income from the conversion may be included in income over a two-year period, beginning in 2011. A taxpayer may alternatively elect to have all of the income taxed in 2010. California has conformed. Different elections can be made for California reporting and for federal reporting.
If a distribution is made from the Roth account during 2010 or 2011, the deferred income from the conversion may be accelerated.
The conversion income withdrawn before the 5-tax-year holding period for qualified distributions is subject to the 10% early distribution tax.
Tax Tips: Remember the current reduced tax rates are scheduled to expire after 2010. Taxpayers who are young with a long life expectancy would have the greatest benefit from making a conversion. Some taxpayers will find it hard to pay the tax from making a conversion, because the cash will be tied up in the Roth account.
Consider making non-deductible IRA contributions for 2006 through 2009 and converting to a Roth during 2010.
The conversion of a regular IRA to a Roth should be seriously considered when a taxpayer who normally has high taxable income has a low income year. The issue, of course, is having to pay the tax when the taxpayer may have a financial hardship. The benefit of the conversion is creating an account for which future earnings accumulation will be tax free.
In some cases, the taxpayer might have deductions that would otherwise be wasted to shelter some or all of the income from the Roth conversion.
Roth accounts represent a significant opportunity for some taxpayers to create tax-exempt retirement accounts. Younger persons who meet the qualifications should seriously consider making the conversion of their regular IRA to a Roth IRA. Your tax advisor can help you make tax planning computations to determine if this is to your advantage. In the event your adjusted gross income exceeds the limits, an election is available permitting you to "undo the deed" and replace the funds in a regular IRA.
It's a shame that married persons who are filing separately, but don't choose to be divorced, can’t convert a regular IRA to a Roth IRA.
Since distributions from Roth accounts are tax-free, they can be viewed as a substitute or supplement for life insurance.
Gift planning opportunity.
Parents or grandparents can significantly help their children or grandchildren by making gifts to help them fund their Roth IRAs in early years.
A grandchild could work at a part-time job and invest the money in their college education. The grandparents could make a gift matching their grandchild's contribution to their college education to the grandchild's Roth IRA. The earnings would compound, tax free, and be available for the grandchild's retirement or to help with a down payment for a first home.