Using The Roth IRA for Current-Year Tax Relief?
By Richard T. Grenci and Anthony F. GrenciJANUARY 2007 - Although the primary benefit of the Roth IRA usually is considered to be its tax-free growth, Roth contributions also can provide current-year tax relief via the Retirement Savings Contributions Credit. Furthermore, this secondary, current-year benefit can be realized even if a Roth contribution is subsequently withdrawn in an early distribution that carries no penalty or tax on the original contribution. The interrelationship between the Roth and the Retirement Savings Contributions Credit is complicated by numerous factors, including phase-outs, but such complexities can be simplified by hand-calculated worksheets or pre-programmed spreadsheet models. Ultimately, it is important for tax professionals to be aware of the potential benefits of the Retirement Savings Contributions Credit, and how they can be realized.
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) created a nonrefundable credit for elective deferrals and IRA contributions under IRC section 25B. The tax credit is based on an applicable percentage of the retirement savings contributions as tabulated in accordance with the taxpayer’s adjusted gross income (AGI) to a maximum rate of 50%, but not to exceed $1,000 per taxpayer (or $2,000 per married couple filing jointly). EGTRRA also amended IRC section 219 with a modification of IRA contribution limits, incrementally increasing the 2001 annual maximum of $2,000 to a current annual maximum of $4,000, which remains in effect through 2007. This addition and modification combine to allow an IRA contribution—inclusive of a Roth contribution—to account for the full amount of the $2,000 credit maximum. The interrelationship between the relatively liquid Roth IRA and the current-year benefit of the Retirement Savings Contributions Credit provides the opportunity for a useful tax vehicle.
A Secondary Benefit of the Roth IRA
A Roth IRA often is seen as a vehicle that does not provide immediate tax advantages because contributions to a Roth IRA are not tax-deductible, as contributions to a traditional IRA are. The primary advantage of a Roth is to enable retirement funds to grow tax-free, as opposed to the tax-deferred growth in a traditional IRA. Basically, if the investment in a Roth is left to grow for at least five years and the taxpayer is 59 Qs years old, withdrawals of both the original investment and the earnings are tax-free. In contrast, withdrawals from a traditional IRA are taxable in their entirety, assuming the taxpayer received a tax deduction on the original investment.
Even though the Roth IRA was designed to provide these future tax advantages, it also can be used to provide current tax relief. As noted above, this secondary benefit of a Roth is due to the fact that contributions to a Roth IRA are eligible for the Retirement Savings Contributions Credit. Even though an immediate tax deduction is not available, low- and middle-income taxpayers can receive a credit for their Roth IRA contribution. Furthermore, taxpayers can realize the current-year benefit of the credit while still having almost immediate access to the funds, because contributions may be withdrawn from a Roth IRA without penalty or tax.
A Different Type of Analysis
Analyses and advice concerning the benefits of a Roth IRA as it relates to the Retirement Savings Contributions Credit would be quite different from the usual types of analyses and advice. Most analyses of the benefits of Roth IRAs focus on potential returns as compared to traditional IRAs. The analyses consider several factors, including the future tax rate when the IRA funds are distributed, the number of years before distribution, and the growth rate of the investment. For the most part, these factors are unknowns, and a what-if analysis of the future is what drives the decision.
In contrast, the effect of a Roth IRA on the Retirement Savings Contributions Credit is not a future projection but rather the result of the interrelationship of several known, or reasonably estimated current-year factors. First, because the Retirement Savings Contributions Credit is nonrefundable, the relative tax effect of a contribution to a Roth IRA depends upon income, and it may be offset by other credits (quite often the Child Tax Credit), as well as distributions from retirement accounts. In addition, a Roth IRA contribution is limited by contributions to other IRAs. Such factors are especially complicated by a phase-out of the credit based upon the taxpayer’s filing status and AGI. All of these factors can have very different implications for each taxpayer. Exhibit 1 shows how three similar scenarios for a married couple filing jointly can result in three different tax implications.
All of the examples in Exhibit 1 assume married taxpayers filing jointly in the 10% tax bracket and making $2,600 in total Roth IRA contributions. The first example shows, as a base case, a Retirement Savings Contributions Credit that hits the maximum of 50% of the Roth IRA contributions. The second example shows that with a slight increase in income, the credit is partially phased out, thus resulting in a credit of only 20% of contributions. The third example shows that with an additional dependent under age 17, the Child Tax Credit offsets most of the tax liability, thus greatly limiting the extent to which the Retirement Savings Contributions Credit can be utilized. Collectively, these scenarios show the difficulty in deciding whether a Roth contribution is worthwhile with respect to its effect on the Retirement Savings Contributions Credit.
The key to the interrelationship between the Roth IRA and the Retirement Savings Contributions Credit depends upon individual taxpayer eligibility for the credit. The eligibility of low- or middle-income taxpayers should be tested. This can be accomplished during the preparation of a tax return simply by entering a Roth IRA contribution as if it had occurred and allowing the tax preparation software to determine any potential effects of the contribution. This is not, however, an efficient tool for preliminary tax planning or for a what-if analysis in consultation with taxpayers. Tax preparation software requires relatively complete information, and tax planning may be better served by software that is specific to tax-planning purposes.
If tax planning software is not available to an advisor, then worksheets or spreadsheet models can be used effectively when individual taxpayer situations require some type of analysis. Even if tax planning software is available, a worksheet or spreadsheet may prove easier to use if the goal is to test the taxpayer’s eligibility for the Retirement Savings Contributions Credit, and specifically to analyze the Roth IRA’s ability to generate the credit. Exhibit 2 presents such a worksheet that could be used by a tax advisor to easily calculate the effect of a contribution on the Retirement Savings Contributions Credit.
Although the worksheet in Exhibit 2 would be quite useful as a guide for estimating the current-year tax implications of a contribution to a Roth IRA, it would require reference to tax tables and phase-out levels in order to complete the calculations. Such an effort for a single calculation might not be troublesome; however, testing for entire groups of taxpayers (e.g., all taxpayers with an estimated AGI less than $50,000, the current maximum for eligibility) would be more efficiently done using a preprogrammed spreadsheet model. Exhibit 3 illustrates a sample spreadsheet model that automatically calculates the Retirement Savings Contributions Credit for an individual taxpayer’s situation (a copy of the spreadsheet can be downloaded from www.cpaj.com).
The model in Exhibit 3 requires only four estimates: filing status; number of exemptions, including dependents under age 17; AGI; and the estimated retirement contribution. All other figures are automatically computed. Upon selection of filing status, conditional formatting highlights the figures in the tables that will be used in the model. The model uses look-ups to retrieve these highlighted figures from the three tables in the second column. Of those tables, the retirement credit and tax schedule tables are automatically populated by using the filing status to look up numbers from the tables in the third column.
Timing Is Everything
In addition to determining the impact of a Roth IRA contribution on the Retirement Savings Contributions Credit, there are several factors to consider before advising a taxpayer to use a Roth IRA as a vehicle for current-year savings. In particular, although a Roth IRA contribution can be withdrawn with very few limitations, there are specific factors relevant to the short-term treatment. These factors should be considered in conjunction with all applicable tax laws and regulations.
Filing prior to contribution. As per IRC section 219(f)(3), the deadline for IRA contributions is the due date of the return (not including extensions). IRS Publication 590 (2005, p. 11) notes the deadline for contributing to a traditional IRA is not affected by the actual filing date:
Given no further stated qualifications for a Roth IRA, the deadline for contributing would be the due date.
Implications for tax preparation. The ability to file a tax return before making a Roth IRA contribution has two important implications. First, the current-year benefits of a Roth IRA contribution can be considered even during the preparation of the return, as long as there is time for the taxpayer to establish an account or make a contribution prior to the due date. Second, if the taxpayer files the return sufficiently early, she will be able to use an increase in her current-year refund (where attributable to the Retirement Savings Contributions Credit) to help fund the Roth IRA contribution. Because the Retirement Savings Contributions Credit is only available to low- and middle-income taxpayers, the partial self-funding of the contribution may be an important factor.
Distribution waiting period. IRC section 408(d)(4) specifies a technical waiting period, based upon the due date of the return, for the distribution of a regular (nonconversion) contribution to a Roth IRA. As summarized in IRS Publication 590 (2005, p. 60):
In addition, under IRC section 25B(d)(4), the rules concerning the Retirement Savings Contributions Credit make ineligible a current-year Roth IRA contribution that is withdrawn prior to the due date (including any extensions). This waiting period would be relevant if a Roth IRA generated a Retirement Savings Contributions Credit and the taxpayer then decided to take a distribution from that IRA too soon thereafter, thus disqualifying the credit. Ultimately, if a regular contribution to a Roth is withdrawn prior to the due date of the return (including any extensions), then even though there would be no penalties or taxes due on that withdrawal, it would negate the tax credit and could require an amended return.
Distribution from combined funds. Aside from the restriction concerning the due date, the distribution rules relevant to a Roth IRA allow for the immediate withdrawal of funds without penalty or tax on the portions pertaining to the regular contributions. In addition, the order in which funds are distributed from a Roth IRA would enable a regular contribution to be withdrawn regardless of prior or concurrent Roth IRA activity by the taxpayer. The order of distribution is a relevant factor, because all Roth IRA accounts and contributions for a taxpayer are lumped together. Regular contributions are considered to be the first of the funds to be distributed, followed by conversion contributions, and then earnings on contributions. With respect to nonqualified (early) distributions, regular contributions, unlike earnings, are not subject to tax or penalty; conversion contributions are bound by their own set of rules as discussed below.
Conversions not eligible. Conversion contributions to a Roth IRA (i.e., the result of converting funds from a traditional IRA) are treated differently in that they may be bound by a five-year waiting period before they are eligible to be a qualified distribution. Not only are conversion contributions treated differently from regular contributions, but under IRC section 25B(d)(2), conversions (or rollovers) also are not included as eligible contributions with respect to the Retirement Savings Contributions Credit (see IRS Form 8880 for a summary of eligible contributions).
Reduction by distributions. The Retirement Savings Contributions Credit calculation is negatively affected by distributions from a Roth IRA (or from any eligible contribution) that fall within a specific testing period. As summarized in IRS Publication 590 (2005, p. 71):
Ultimately, if a contribution to a Roth IRA is made and then withdrawn, any contribution made the following two years will be offset by the amount of the prior withdrawals with regard to how the contribution will affect the Retirement Savings Contributions Credit.
Although withdrawals from a Roth IRA will negatively affect the Retirement Savings Contributions Credit calculation, if an increasingly greater amount is contributed to a Roth IRA in consecutive years, the effect of prior withdrawals will be to only partially offset the later contributions. For example, Roth IRA contributions and the subsequent withdrawal of $2,000, $4,000, and $8,000 (the combined maximum for married taxpayers filing jointly) over three consecutive years would, for all three of those years, effectively create $2,000 of eligible contributions for the Retirement Savings Contributions Credit calculation. In other words, such contributions could result in a $1,000 tax credit for three consecutive years while maintaining the immediate availability of the funds that generated those credits.
Currently, very few low- and middle-income taxpayers contribute to Roth IRAs, thus presenting an opportunity to exploit the relationship between the Roth and the Retirement Savings Contributions Credit. These planning opportunities represent a largely unrealized source of current-year tax relief. A Congressional Budget Office (CBO) tabulation of individual income tax returns for 2000 (“Utilization of Tax Incentives for Retirement Saving: An Update,” February 2006) showed that the participation rate for Roth IRAs was 2% to 3% of taxpayers earning less than $40,000 and only 5% of those earning between $40,000 and $80,000. Furthermore, the CBO figures showed that only 50% to 60% of participants in these salary ranges contributed the maximum amount to their Roth IRAs. Very similar figures for traditional IRAs also emphasize the possibility that taxpayers could make contributions to Roth IRAs in addition to, or even instead of, traditional IRAs to potentially receive some current-year relief, by way of the Retirement Savings Contributions Credit, while benefiting from the long-term advantages of a Roth IRA. Given a choice, the Roth IRA would be especially beneficial if the traditional IRA contribution would reduce the taxpayer’s AGI such that the tax liability becomes less than the Retirement Savings Contributions Credit; the Roth IRA contribution would not have the same effect.
As noted above, the implications of a tax vehicle can go beyond its primary benefits. In such cases, the secondary benefits can be complicated by various interrelated factors that in turn complicate tax advice and decisions. In an industry flooded with tax preparation software, there appears to be a scarcity of decision analysis tools, tools that are critical given the complexities of interrelated tax rules and vehicles. Accountants must make do primarily with an awareness of these complexities and the use of tax preparation software, spreadsheet models, or worksheets as a means for providing consultative advice.
Tax professionals should be prepared to offer advice concerning the Retirement Savings Contributions Credit available to certain low- and middle-income taxpayers. An advisor would be remiss not to suggest that a Roth contribution could result in up to $2,000 of tax savings. Underlying this advice is the fact that a regular Roth contribution can be withdrawn at any time after the due date of the return without penalty or tax, so the taxpayer can contribute, receive the credit, and then withdraw the funds as needed.
While the liquidity of retirement contributions should be considered in light of their effect on the long-term financial position of the taxpayer, if the tax advisor does not inform the taxpayer of the interrelationship between the Roth IRA and the Retirement Savings Contributions Credit, it will represent a potential missed tax savings opportunity for the taxpayer. Perhaps more important, because low- and middle-income taxpayers have fewer avenues to pursue for tax relief, such opportunities can result in relatively substantial savings for these taxpayers.
Richard T. Grenci, PhD, is an assistant professor of management at the Boler School of Business, John Carroll University, University Heights, Ohio.
Anthony F. Grenci, PhD, CPA/PFS, CMA, CFA, CIA, CISA, is a professor of accountancy at the College of Business Administration, Clarion University of Pennsylvania, Clarion, Penn.