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Making the right choice


By Kenneth A. Hansen and Steve Carlson

In Brief

Which One to Use? Or Both?

The basic question facing most taxpayers is whether to contribute or convert to a Roth IRA. Contributions to Roth IRAs are subject to limitations based on adjusted gross income and tax free withdrawals of earnings can only begin after a five year period. In addition to this tax free withdrawal, Roth IRAs have other advantages including not being subject to mandatory distribution rules.

The answer depends on the tax bracket the taxpayer will have on retirement and the ability of the taxpayer to accumulate funds over a lifetime. In certain cases, the use of both a Roth and regular IRA can be advantageous.

To switch or not to switch to a Roth IRA, that is the question. If you are sure you will retire in the same or higher tax bracket, the Roth IRA yields a higher after tax cash flow upon retirement. If you are sure you will retire in a lower 15% tax bracket, and you want to use up your IRA during retirement, the regular deductible IRA yields a higher after tax cash flow upon retirement. However, some taxpayers are not sure what their retirement tax bracket will be or whether they will want to use the Roth IRA to accumulate funds during their lifetime to pass on tax free to their heirs. Taxpayers can also use a Roth IRA and regular deductible IRA in combination. This combination uses the respective strengths of both kinds of IRAs by timing distributions to maximize the benefits of both IRA options.

Mechanics of the Roth IRA

Beginning in 1998 married taxpayers having AGI not exceeding $150,000 ($95,000 for singles) can annually contribute $2,000 to a Roth IRA. Married taxpayers filing separate tax returns are not eligible. Eligible Roth IRA contributions are phased out for taxpayers with AGI from $150,000 to $160,000 ($95,000 to $110,000 for singles). To allow IRA contributions, a special rule treats a husband and wife filing separate returns and living apart at all times during the tax year as not married.

Roth IRAs are more flexible in allowing contributions than regular deductible IRAs. Working taxpayers, age 70 wQ or older, can still contribute to a Roth IRA. Similarly, taxpayers with AGI not exceeding $150,000 ($95,000 for singles) can still contribute $2,000 each to a Roth IRA, even if they are active participants in an employer's pension plan.

Upon the death of the Roth IRA owner, distributions must be made by the end of the tax year containing the fifth anniversary of the date of death or over the life expectancy of the designated beneficiary starting by December 31 of the year following the Roth IRA owner's death. If distributions do not commence by Dec. 31 of the year following the Roth IRA owner's death, the first distribution method is considered chosen.

During the taxpayer's life, mandatory distribution rules do not apply to Roth IRAs. The taxpayer's spouse may be the sole beneficiary of the Roth IRA. In that case, upon the taxpayer's death, the surviving spouse is treated as the Roth IRA account owner. The surviving spouses can name a new beneficiary and accumulate tax-free income over the surviving spouse's life. Upon the surviving spouse's death, the Roth IRA passes tax-free accumulations to the newly named beneficiary. The beneficiary of the surviving spouse then distributes the Roth IRA tax free over his or her lifetime.

In computing the maximum contribution to Roth IRAs, taxpayers must subtract from $2,000 all contributions made to deductible and nondeductible regular IRAs. Though employers' "qualified plans" don't reduce the amount an individual can contribute to a Roth IRA, contributions made by or on behalf of an individual under a SEP or SIMPLE IRA are treated as contributions to an IRA. Thus an individual who makes elective contributions and receives matching contributions to a SIMPLE IRA equal to $2,000 for the year is not eligible to contribute to a Roth IRA for that tax year.

The Roth IRA Provides Tax-Free Distributions

In contrast to the tax deferred benefits of regular nondeductible and deductible IRAs, the Roth IRA provides an accumulation of earnings that are never taxed if qualified distributions are made. Qualified distributions include distributions--

    * on or after the individual becomes 59 wQ ;

    * after the death of the individual;

    * for disabilities or

    * for a qualified first time home buyer expense.

Waiting Period. Additionally, for taxpayers to have qualified distributions, they must wait until a five-year period ends. The five-year period begins with the first tax year the individual applies a Roth IRA contribution. This five-year period also applies to a qualified rollover from a regular IRA to a Roth IRA.

Contributions to a Roth IRA must be made by the due date of the tax return, not including extensions. If contributions are made by April 15 of year two and designated as a contribution for year one, the taxpayer need only wait till January 1 of year six for tax free distributions, a period less than four years.

Qualified First Time Home Buyer. After the normal five-year qualified-distribution wait, a first-time home buyer can withdraw tax free a lifetime maximum of $10,000. Withdrawals for the first time homebuyer apply to the taxpayer, the taxpayer's spouse, any child, grandchild, or ancestor of the taxpayer or the taxpayer's spouse. The term "first-time home buyer" means any of these named individuals, and if married their spouses. For example, should a husband and wife each have separate Roth IRAs, the husband and wife could both distribute $10,000 income tax free and penalty tax free for a total of $20,000 to purchase a first time home for a qualified son or daughter. First time homebuyers must have had no present ownership interest in a principal residence during the two-year period ending on the date of acquisition of the qualified new purchase.

Taxation of Withdrawals. Even if the Roth IRA owner makes nonqualified distributions, no taxable income and no early withdrawal penalties apply until the owner withdraws all the original after tax contributions made to the Roth IRA. Thus, nonqualified distributions are tax free until all the individual's adjusted basis in the Roth IRA is first returned to the owner. For distribution purposes, Roth IRAs and regular IRAs are treated separately.

Roth IRA Distributions and the 10% Early Withdrawal Penalty

Except as provided otherwise, a Roth IRA is treated in the same manner as a regular IRA. Therefore, nonqualified Roth IRA distributions can still qualify under regular IRA distribution rules that avoid the 10% penalty tax on early withdrawals before age 59 wQ .

The 10% IRA early withdrawal penalty only applies to distributions before age 59 wQ that the taxpayer has to include in gross income. The 10% penalty on early withdrawals of IRA funds only applies to Roth IRAs after the individual's adjusted basis consisting of after tax contributions are first returned to the owner. In other words, the 10% penalty only applies to the untaxed earnings that have accumulated in the Roth IRA.

The 10% early withdraw penalty is waived if distributions are--

    * part of a series of substantially equal periodic payments made over the life of the employee;

    * for amounts paid during the taxable year for deductible medical expenses greater than 7.5% of adjusted gross income (AGI) regardless of whether or not the taxpayer itemizes deductions;

    * for medical insurance premiums paid during the tax year for the taxpayer, a spouse or dependents (the taxpayer is eligible for the current and succeeding tax year if the taxpayer has received 12 consecutive weeks of unemployment compensation) or

    * to pay for higher education expenses.

Traditional Deductible IRA vs. Roth IRA

Computations demonstrate that taxpayers in the same or higher tax bracket at retirement benefit most by using a Roth IRA. The longer the investment, the more Roth IRAs benefit taxpayers over regular IRAs.

Ignoring Minimum Distribution Rules. Taxpayers should never forget that before applying the required minimum distribution (RMD) rules at age 70 wQ , traditional deductible IRAs always allow taxpayers to accumulate more before tax dollars than the Roth IRA. The same $2,000 contribution limit applies to both the Roth IRA and regular deductible IRA. In addition, the deductible IRA gives the taxpayer annual tax savings each year. All the examples assume the taxpayer invests the deductible IRA tax savings to make a tax benefit comparison to a Roth IRA.

Computations show that regular deductible IRAs benefit taxpayers more than Roth IRAs if taxpayers retire in a lower 15% bracket, compared to their work life. Taxpayers can invest the tax savings from a deductible IRA. Deductible IRAs, taxed in the 15% bracket at retirement, plus invested after tax savings from regular IRA contributions deducted in the 28% bracket, generally exceed tax-free returns from nondeductible Roth IRAs.

Considering Minimum Distribution Rules. This analysis holds true when comparable distributions are made from Roth IRAs and regular deductible IRAs over the RMD mandate for regular IRAs. The taxpayer may have a goal to pass the largest accumulation of funds to the taxpayer's heirs by accumulating funds during the taxpayer's lifetime and at death, distributing the funds over the life of a young beneficiary. Then generally, whatever the taxpayer's bracket, the Roth IRA will win overwhelmingly. This results from Roth IRAs compounding tax-free future values without any RMD rules during the taxpayer's and any surviving spouse beneficiary's lifetime. Unlike regular IRAs, the future value of Roth IRAs are only limited by--

    * the age of the taxpayer;

    * the age of the taxpayer's inheriting surviving spouse and

    * the life expectancy of the newly named beneficiary for the surviving spouse at the taxpayers death.

Example. The examples below assume $2,000 annual investments at the end of the year and eight percent annual before tax growth rates. A 28% federal tax bracket applies for contributions and withdrawals, unless a 15% bracket is indicated for withdrawals.

Assume Bob, age 34, saves in a regular IRA to age 62. The value of regular annual contributions for the deductible IRA invested to age 62 is $190,678. The value of the deductible IRA annual $560 tax savings, invested at an after tax rate of 5.76% until age 62 is $36,919.

At age 62 Bob retires and starts withdrawing payments from the deductible IRA and taxable savings account. Bob wants annual distributions so that at age 70 he has $200,000 remaining in his deductible IRA.

Bob receives after tax annual payments from age 62 to 70 from his deductible IRA of $10,352. Bob can save $40,000 from his tax savings account at age 70 and still receive after tax annual payments from age 62 to 70 from his tax savings account of $1,812.

Commencing in the year Bob turns 70 wQ , RMD rules require Bob to distribute remaining deductible IRA funds over his life expectancy or Bob and his spouse's life expectancy. Here Bob chooses to distribute the remaining $200,000 over Bob and his spouse's joint life expectancy of about 21 years. Bob also elects not to recalculate. The after tax annual payments Bob or his heirs would receive over the next 21 years is $14,378. Bob also receives 21 annual payments from his tax savings account of $3,332. Bob spends his annual disbursements. He has total distributions during retirement from his deductible IRA and tax savings account of $469,178.

Now assume, at age 34, Bob chose to make payments to a Roth IRA instead of a regular deductible IRA. At age 62 Bob would then have accumulations in his Roth IRA of $190,678, the same amount calculated for the deductible IRA above. If Bob at age 62 commenced nontaxable payments from his Roth IRA so that at age 70 he has $50,000, Bob would receive annual income tax-free payments of $14,378. Then at age 70, to make a comparison with the deductible IRA, Bob chooses to make distributions from his Roth IRA over the same 21 years. Bob would receive annual tax-free payments of $19,966. Assume Bob spends his annual disbursements from retirement. Bob has total Roth IRA distributions of $534,318. Bob is $65,140 ahead, roughly 14% more, if he contributes to a Roth IRA.

However, if Bob retired in the 15% bracket, the deductible IRA beats the Roth IRA. Assuming the same facts, but substituting a 15% retirement tax rate and an after retirement rate of 6.8% for non-IRA tax savings, Bob would be $13,797 ahead with a deductible IRA, roughly 2.5% more than if he contributed to a Roth IRA.

Converting to a Roth IRA

During the 1998 tax year, taxpayers have the option to rollover or convert regular nondeductible and deductible IRA's to Roth IRAs. A 1998 conversion is taxed rateably over four tax years, beginning with the tax year in which the conversion is made. Conversions made after 1998 require taxing all deferred IRA income in the conversion year.

If the conversion is made by an actual withdrawal, followed by a rollover contribution to a Roth IRA, the withdrawal must occur in 1998 for the four-year income inclusion to apply. The four-year income inclusion begins in 1998, even if the rollover to the Roth IRA does not occur until 1999. The rollover to the Roth IRA must be made within 60 days of the IRA withdrawal.

These conversions or rollovers escape the 10% penalty for early distributions. To qualify for a conversion, the taxpayers' AGI, whether married or single, must not exceed $100,000 and if married they must file a joint return.

The IRS has issued instructions that allow the taxpayer to check a box on Form 5305-R or Form 5305-RA to designate the account as a Roth conversion IRA. If the account is so designated, only regular IRA conversions to the Roth IRA can be accepted by that account during the same tax year. The forms simplify the identification of funds converted from regular IRAs to Roth IRAs. The IRS can identify converted funds that may be subject to penalties if withdrawn earlier than the normal five-year holding period. This allows the IRS to enforce the technical corrections bill that has passed the House.

It is always beneficial to contribute to an IRA, even if the individual is only eligible to contribute to a nondeductible regular IRA. In any subsequent year the same taxpayer has an AGI of $100,000 or less, the individual can convert all nondeductible regular IRA contributions and earnings to a Roth IRA. Roth IRAs always have superior performance over regular nondeductible IRAs. The taxpayer is eligible to receive tax-free distributions from the Roth IRA on any future earnings. These same earnings are taxable for regular nondeductible IRAs.

Additionally, a regular IRA conversion to a Roth IRA can alleviate circumstances for a taxpayer with poor health that failed to elect out of recalculating at age 70 wQ . Also, the same conversion can allow a taxpayer who failed to name the proper beneficiary at age 70 wQ , to name a new heir for distribution calculation purposes.

By electing to convert the regular IRA to a Roth IRA in 1998, the same taxpayer can designate a new beneficiary, and pay the taxes on deferred IRA income over four years, and upon her death the Roth IRA can distribute tax-free earnings over the life expectancy of the newly designated beneficiary. Preferably the newly designated beneficiary is a child or grandchild with a long life expectancy. The taxpayer with the grandchild can then use the one million-dollar generation skipping tax exemption.

Example. Bill, age 40, wants to determine whether he should stay with a traditional deductible IRA or convert it to a Roth IRA. Assume before tax rates of return of eight percent and 28% federal tax brackets at times of conversion and distribution. The traditional deductible IRA reflects tax deferred growth with amounts taxed upon distribution. The tax due at the date of conversion is paid from funds outside the IRA.

To make a valid comparison with the Roth IRA, traditional IRA accumulations will include the invested tax savings on funds that would otherwise have to be paid for a Roth IRA conversion. (It could be argued that this should be treated as a negative cash flow for the IRA that converted to a Roth, however the net result is the same.) The tax savings for staying with the traditional IRA are invested over four years for conversions made in 1998. The tax savings account of Bill has after tax rates of return of 5.76% when Bill is in the 28% tax bracket and 6.8% return when in the 15% bracket.

Bill, age 40, plans on retiring at age 62 and taking distributions to age 70 so that he has $200,000 left at age 70 to distribute over his 21-year joint life expectancy with his spouse. Bill has $40,000 in his deductible IRA. His deductible IRA accumulation at age 62 would be $217,462. The tax savings for not converting to a Roth IRA is $2,800 over the next four years totaling $12,205. The tax savings accumulation if invested to retirement age 62 is $33,445. Reinvesting this amount to age 70 gives $52,349.

At age 62 Bill receives after tax payments for eight years from his deductible IRA of $13,708. At age 70 Bill commences receiving payments over 21 years from the remaining $200,000 deductible IRA of $14,376 and his taxable savings account of $4,327. By staying with the deductible IRA for Bill's retirement, his total after tax disbursements are $502,426.

Now consider Bill's conversion from the regular deductible IRA to a Roth IRA at age 40. He pays the taxes with non-IRA funds. At age 62 Bill's Roth IRA is $217,462. Annual disbursements from age 62 to 70 are $19,039. Then commencing at age 70, to make a valid comparison, Bill takes disbursements over the same 21 years of $19,966. Thus using the Roth IRA conversion, Bill would have after tax payments of $571,604. In these facts, Bill is $69,178 ahead with the conversion to a Roth IRA, roughly 13.8% more than he would have with the undisturbed regular deductible IRA.

Using the same conversion example with a 15% retirement bracket and a 28% bracket when Bill was working, gives Bill total payments of $593,824 from his deductible IRA versus total payments of $571,604 by converting to a Roth IRA. With the assumption of a 15% retirement bracket, Bill would be $22,220 ahead with the regular IRA, roughly 3.9% more than he would have by converting to a Roth IRA.

Using Both

Taxpayers may be uncertain of their retirement savings objectives and the tax bracket they may finally wind up in at retirement. The best tax planning for uncertainties combines the use of the deductible IRA and the Roth IRA.

Using tax deferral methods such as stock growth mutual funds, EE bonds, retirement annuities, and tax exempt mutual bonds, the taxpayer can force his or her tax bracket to decrease upon retirement. After age 59 wQ , retirement distributions can be made from the deductible IRA to the extent the taxpayer has a lower marginal bracket than when the taxpayer was working.

After the taxpayer exhausts deductible IRA funds, he or she should start to recognize tax deferred investment income from savings. Roth IRA payouts can then be made to the extent funds are needed, preferably when the tax bracket is the same or higher than when contributions were made. Should the Roth IRA still have funds in it at the taxpayer's death, heirs inherit tax-free payouts over their expected life. The use of both the deductible IRA and the Roth IRA give the taxpayer needed flexibility to take advantage of future uncertainties. *

Kenneth A. Hansen, LLM, CPA, and Steve Carlson, PhD, CPA, are associate professors at the University of North Dakota.

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