IRAs after the TRA '97 - what hath Congress Roth?The new Roth IRA Roth IRA
An individual retirement plan that bears many similarities to the Traditional IRA. Contributions are never deductible, and qualified distributions are tax-free. A qualified distribution is one that is taken at least five years after the taxpayer established his/her first allows nondeductible contributions Nondeductible contribution
A contribution to either a traditional IRA or Roth IRA. Income tax is due on the contribution in the tax year for which the contribution is made. and tax-free tax-free
Not subject to taxation; tax-exempt.
not needing to have tax paid on it: a tax-free lump sum
Adj. 1. withdrawals, if the rules are met. Further, for taxpayers who qualify, regular (i.e., deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). ) IRAs can be converted to Roth IRAs. Should tax advisers tell eligible clients to convert? Through detailed examples, this article examines a multitude of considerations in determining the answer to this question.
The enactment of the Taxpayer Relief Act of 1997 (TRA TRA Training
TRA Tennessee Regulatory Authority
TRA Telecommunications Regulatory Authority (Oman)
TRA Tax Reform Act (1976, 1984, or 1986)
TRA Teachers Retirement Association '97) significantly increased the ability of retirement plan participants Plan participants
Employees or other beneficiaries who are eligible to receive benefits from a company's employee benefit plan. to accumulate Accumulate
Broker/analyst recommendation that could mean slightly different things depending on the broker/analyst. In general, it means to increase the number of shares of a particular security over the near term, but not to liquidate other parts of the portfolio to buy a security wealth and reduce taxes. It created a new type of IRA--the Roth IRA--and expanded retirement planning Retirement financial planning refers to a collection of systems, methods, and processes which, in their aggregate, support a family unit's (client's) desire to achieve a state of financial independence, such that the need to be gainfully employed is optional. opportunities for current, regular (i.e., deductible) IRA Ira, in the Bible
Ira (ī`rə), in the Bible.
1 Chief officer of David.
3 Two of David's guard.
All of the new IRA provisions became effective on Jan. 1, 1998. This article explains how tax advisers can use the new IRA laws to provide maximum tax benefits for their clients.
For regular IRAs, much of the pre-TRA '97 law still applies, but there are enhancements. Under Sec. 219(b)(1)(A), a taxpayer may still contribute up to $2,000 per year, provided earned income Sources of money derived from the labor, professional service, or entrepreneurship of an individual taxpayer as opposed to funds generated by investments, dividends, and interest. is at least that high. If the taxpayer is not an active participant in an employer-sponsored retirement plan (active participant), the contribution is fully deductible. If the taxpayer is an active participant, the maximum $2,000 deduction deduction, in logic, form of inference such that the conclusion must be true if the premises are true. For example, if we know that all men have two legs and that John is a man, it is then logical to deduce that John has two legs. is reduced proportionately pro·por·tion·ate
Being in due proportion; proportional.
tr.v. pro·por·tion·at·ed, pro·por·tion·at·ing, pro·por·tion·ates
To make proportionate. over a new adjusted gross income (AGI (Artificial General Intelligence) A machine intelligence that resembles that of a human being. Considered impossible by many, most artificial intelligence (AI) research, projects and products deal with specific applications such as industrial robots, playing chess, ) phaseout phase·out
A gradual discontinuation. range, under Sec. 219(g)(3), as follows:
AGI limits Other than Tax Year married filing jointly Married filing jointly 1997 (pre- TRA'97) $25,000-$35,000 $40,000-$50,000 1998 $30,000-$40,000 $50,000-$60,000 1999 $31,000-$41,000 $51,000-$61,000 2000 S32,000-$42,000 $52,000-$62,000 2001 $33,000-$43,000 $53,000-$63,000 2002 $34,000-$44,000 $54,000-$64,000 2003 $40,000-$50,000 $60,000-$70,000 2004 $45,000-$55,000 $65,000-$75,000 2005 $50,000-$60,000 $70,000-$80,000 2006 $50,000-$60,000 $75,000-$85,000 2007 and thereafter $50,000-$60,000 $80,000-$100,000
Prior to the TRA '97, the spouse spouse A legal marriage partner as defined by state law of an active participant was also treated as an active participant. Under post-TRA '97 Sec. 219(g)(1) and (7), if the taxpayer is not an active participant, but his spouse is, there is no IRA deduction if their combined AGI equals or exceeds $160,000. The maximum $2,000 deduction is reduced proportionately, under Sec. 219(g)(7)(B), if combined AGI is between $150,000 and $160,000.
Example 1: H's and W's combined 1998 AGI is $140,000; H is an active participant. W can make a fully deductible IRA contribution of $2,000 for 1998. H cannot make a deductible IRA contribution, because he is an active participant and their combined AGI exceeds the applicable phaseout limit. As will be discussed, H could make a $2,000 contribution to a Roth IRA for 1998; W could make a $2,000 contribution to either a Roth IRA or a regular IRA.
The TRA '97 also increases an IRA owner's ability to withdraw funds before age 59 1/2 without incurring in·cur
tr.v. in·curred, in·cur·ring, in·curs
1. To acquire or come into (something usually undesirable); sustain: incurred substantial losses during the stock market crash.
2. the 10% penalty. Under Sec. 72(t)(2)(E), the penalty can be avoided if the funds are used to pay for qualified higher education expenses Qualified Higher Education Expense
Expenses such as tuition and tuition related expenses that an individual, spouse, or child must pay to an eligible post-secondary institution. of the taxpayer, his spouse, or a child or grandchild. Early withdrawals of up to $10,000 are also permitted under Sec. 72(t)(2)(F) if used within 120 days to pay the costs of a first-time home purchase, including, under Sec. 72(t)(8)(C), costs incurred for the acquisition, construction or reconstruction of a first-time homebuyer's principal residence, or financing, settlement or closing costs Closing Costs
The numerous expenses (over and above the price of the property) that buyers and sellers normally incur to complete a real estate transaction. Costs incurred include loan origination fee, discount points, appraisal fee, title search, title insurance, survey, taxes, . According to according to
1. As stated or indicated by; on the authority of: according to historians.
2. In keeping with: according to instructions.
3. Sec. 72(t)(8)(A), such withdrawals can be used by the IRA owner, his spouse, child, grandchild or ancestor ANCESTOR, descents. One who has preceded another in a direct line of descent; an ascendant. In the common law, the word is understood as well of the immediate parents, as, of these that are higher; as may appear by the statute 25 Ed. III. De natis ultra mare, and so in the statute of 6 R. , or ancestor of the IRA owners spouse.
Excise Tax Excise Tax
1. An indirect tax charged on the sale of a particular good.
2. A penalty tax applied to ineligible transactions in retirement accounts. This penalty is assessed by and paid to the IRS.
1. Repeal The Annulment or abrogation of a previously existing statute by the enactment of a later law that revokes the former law.
The revocation of the law can either be done through an express repeal
For many active participants, one of the most profound law changes was the repeal of the 15% excess distribution and excess accumulation Excess accumulation
The amount of a required minimum distribution that an IRA holder fails to remove from an IRA in a timely manner. Excess accumulations are subject to a 50% IRS penalty tax. taxes by TRA '97 Section 1073(a), for tax years after 1996. The excess distribution tax was imposed on taxpayers who received substantial retirement plan and IRA distributions. The excess accumulation tax was levied against the estates of IRA owners who had substantial retirement account balances at death. Some tax advisers had encouraged their clients with significant IRA balances to make early withdrawals to avoid these taxes; now, most clients will be best served by retaining their IRA accumulations instead of making taxable distributions before (1) the funds are desired or (2) required by the minimum distribution rules.
However, it may be wise to take taxable IRA distributions earlier than required when there will be significant estate taxes and the IRA holds the only funds available to pay them. The taxpayer would take an IRA distribution, pay the income tax and give the after-tax af·ter-tax also af·ter·tax
Relating to or being that which remains after payment, especially of income taxes: after-tax profits. proceeds to the beneficiaries. Methods of leveraging gifts with second-to-die life insurance policies, grantor An individual who conveys or transfers ownership of property.
In real property law, an individual who sells land is known as the grantor.
grantor n. retained annuity annuity: see insurance.
Payment made at a fixed interval. A common example is the payment received by retirees from their pension plan. There are two main classes of annuities: annuities certain and contingent annuities. trusts, grantor retained unitrusts, family limited partnerships and other techniques may be appropriate for wealthy individuals. The strategy of prematurely incurring income taxes on IRAs and gifting after-tax proceeds will, in limited circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact.
2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or , be beneficial by reducing the estate and providing beneficiaries funds to pay estate taxes. Because this strategy will maximize family wealth in only limited circumstances, tax advisers should run the numbers to determine whether the family would benefit.
Named for Senator Roth (R-Del.), the new Roth IRA does not allow a deduction when contributions are made, but allows tax-free withdrawals of both contributions and earnings. Thus, unlike regular IRAs, which only defer de·fer 1
v. de·ferred, de·fer·ring, de·fers
1. To put off; postpone.
2. To postpone the induction of (one eligible for the military draft).
v.intr. taxes, the Roth IRA allows the tax-free accumulation of wealth. Contributions are capped by Sec. 408A(c) at the lesser of $2,000 per year or 100% of earned income for the year; as is discussed below, AGI phaseouts apply. Generally, withdrawals can occur tax-free under Sec. 408A(d)(1) and (2) if the Roth IRA account has been established for five years and (1) the owner is at least age 59 1/2, (2) the owner is deceased deceased 1) adj. dead. 2) n. the person who has died, as used in the handling of his/her estate, probate of will and other proceedings after death, or in reference to the victim of a homicide (as: "The deceased had been shot three times. or disabled or (3) the distribution will be used for first-time homebuyer First-Time Homebuyer
An IRA owner who is exempt from the early-distribution penalty (which applies to IRA distributions that occur before the IRA owner reaches age 59.5) for distributing funds from his or her IRA to buy, build, or rebuild a home when having had no interest in a expenses.
Under Sec. 408A(c)(2)(B), the maximum contribution a taxpayer can make to all IRAs is $2,000 per year ($4,000 if married filing Jointly Married Filing Jointly
A filing status for married couples that have wed before the end of the tax year. They can record their respective incomes, exemptions and deductions on the same tax return. Married filing jointly is best if only one spouse has a significant income. ) or 100% of earned income, whichever is less. While a taxpayer can contribute to a Roth IRA even if he is an active participant, the following AGI phaseout ranges apply under Sec. 408A(c)(3)(C): $95,000 to $110,000 for single taxpayers and $150,000 to $160,000 for joint filers.
Example 2: N is single and an active participant. His 1998 AGI is $100,000. The maximum contribution he can make to a Roth IRA for 1998 is $1,333, computed as follows:
Maximum contribution = $2,000 - [((AGI - $95,000)/$15,000) x $2,000] = $2,000 - [(($100,000 - $95,000)/$15,000) x $2,000] = $2,000 - [$5,000/$15,000 X $2,000] = $2,000 - [$667] = $1,333
Above the phaseout levels, taxpayers can still contribute to a regular, nondeductible non·de·duct·i·ble
Not deductible, especially for income-tax purposes.
Adj. 1. nondeductible - not allowable as a deduction
deductible - acceptable as a deduction (especially as a tax deduction) IRA, even if their AGI exceeds the phaseout amounts for deductible or Roth IRAs.
If the Roth IRA owner takes a distribution before five years has passed or before age 59 1/2, it is tax-free under Sec. 408A(d)(1)(B) only to the extent of the previously contributed amounts (i.e., only the earnings are taxable). This rule also applies to the beneficiary beneficiary
Person or entity (e.g., a charity or estate) that receives a benefit from something (e.g., a trust, life-insurance policy, or contract). A primary beneficiary receives proceeds from a trust or insurance policy before any other. of a Roth IRA whose owner dies before the five-year period has ended. The beneficiary may withdraw funds tax-free as long as they do not exceed the amount contributed, but must wait until the five-year period has passed before being able to make a tax-free withdrawal of the Roth IRAs earnings.
Sec. 408A(d)(1)(B) and (2)(A) provide that distributions from Roth IRAs before age 59 1/2 are subject to the Sec. 72(t) 10% penalty imposed on premature distributions Premature distribution
A distribution from an IRA before the owner reaches age 59-1/2. Generally, a 10% penalty tax is owed on such a distribution. Also known as an early distribution or an early withdrawal. from regular IRAs. No penalty applies if the owner is deceased or disabled, or the distribution is for a first-time home purchase.
Roth IRA owners are not subject to the minimum distribution rules that normally require regular IRA owners to begin taking taxable distributions at age 70 1/2. In addition, Sec. 408A(c)(4) permits taxpayers to contribute to a Roth IRA beyond age 70 1/2. The rules requiring distributions after a Roth IRA owner's death are apparently the same as the rules for regular IRAs, except that the beneficiary's distributions from a Roth IRA (including the amounts appreciated after the IRA owner's death) will be taxfree. Thus, a Roth IRA owner can designate des·ig·nate
tr.v. des·ig·nat·ed, des·ig·nat·ing, des·ig·nates
1. To indicate or specify; point out.
2. To give a name or title to; characterize.
3. his spouse as the account beneficiary; on the account owner's death, the surviving spouse would have the option of postponing minimum distributions until death. After the surviving spouse's death, the subsequent beneficiary (usually a child) would be required to take nontaxable adj. 1. Not subject to taxation; - of goods imported into a country or sold at retail outlets; as, most laws imposing sales taxes make food nontaxable s>. Opposite of taxable nt>.
Adj. 1. minimum distributions based on his own life expectancy Life Expectancy
1. The age until which a person is expected to live.
2. The remaining number of years an individual is expected to live, based on IRS issued life expectancy tables. .
Regular IRA versus Roth IRA
Many taxpayers who are active participants will choose to make a Roth IRA contribution because their high AGIs preclude pre·clude
tr.v. pre·clud·ed, pre·clud·ing, pre·cludes
1. To make impossible, as by action taken in advance; prevent. See Synonyms at prevent.
2. them from deducting regular IRA contributions. However, if a regular IRA deduction is available, to which type of IRA should contributions be made? As was discussed, an eligible taxpayer can contribute to both types of IRAs each year, as long as the total contributions do not exceed $2,000 (or earned income, if lower). The analysis in this article indicates that a Roth IRA would be preferable in most situations.
Many financial planners Financial Planner
A qualified investment professional who assists individuals and corporations meet their long-term financial objectives by analyzing the client's status and setting a program to achieve these goals. have been using a simplified analysis to illustrate which IRA would be more beneficial, as reflected below. This table(1) compares contributing $2,000 to a regular IRA versus a Roth IRA. Both IRAs grow for 10 years at 10% annually. The owner is in the 28% tax bracket Tax Bracket
The rate at which an individual is taxed due to a particular income level.
Each income class is taxed at a different level. Generally, the more you make the more you are taxed. until the final year (when all of the accumulated ac·cu·mu·late
v. ac·cu·mu·lat·ed, ac·cu·mu·lat·ing, ac·cu·mu·lates
To gather or pile up; amass. See Synonyms at gather.
To mount up; increase. funds are withdrawn); the IRA owner is shown in various tax brackets when the funds are withdrawn.
Regular (deductible) IRA Roth IRA Contribution tax rate 28% 28% 28% 28% Withdrawal tax rate 15% 28% 31% tax-free Amount contributed $2,000 $2,000 $2,000 $2,000 Tax savings ($2,000 x 0.28) 560 560 560 0 Tax savings fund (after 10 yrs.) 1,136 1,122 1,119 0 IRA fund 5,187 5,187 5,187 5,187 IRA taxes (at Withdrawal) 778 1,452 1,608 0 Net assets $5,545 $4,857 $4,698 $5,187
The first conclusion that can be drawn from by this oversimplified o·ver·sim·pli·fy
v. o·ver·sim·pli·fied, o·ver·sim·pli·fy·ing, o·ver·sim·pli·fies
To simplify to the point of causing misrepresentation, misconception, or error.
v.intr. analysis is that contributing to a Roth IRA will be advantageous when the tax rate at retirement will equal or exceed the tax rate when contributions are made. The second conclusion is that contributing to a Roth IRA will not be advantageous when the tax rate at withdrawal will be lower than when the contributions were made. However, this conclusion is not true if a longer timeframe is used. The table below uses the same assumptions as in the table above, but shows the net assets Net assets
The difference between total assets on the one hand and current liabilities and noncapitalized long-term liabilities on the other hand.
See owners' equity. available after the IRA has been retained for a greater number of years and before all of the funds are withdrawn.
Withdrawal tax rate Net assets After 20 years 15% $13,714 28% 11,937 31% 11,527 Roth 13,455 After 30 years 15% $34,227 28% 29,636 31% 28,576 Roth 34,899 After 40 years 15% $86,086 28% 74,209 31% 71,469 Roth 90,519
The primary problem with using a 10-year analysis is that a lower tax rate in retirement does not necessarily mean that contributing to a regular IRA will be more beneficial than contributing to a Roth IRA. Roth IRAs have other advantages--they are not subject to the minimum distribution rules during the owner's life and longer investment periods will be common (especially for wealthy taxpayers).
The above analysis can also be applied to employees who have a choice of making non-matching contributions to either an employer plan (e.g., a Section 401 (k) plan) or a Roth IRA. Employees should consider investing in retirement plans in the following priority: (1) employer-matched contributions, (2) Roth IRAs for employee and spouse and (3) non-matched contributions.
Conversion to a Roth IRA
Perhaps the most significant feature of the TRA '97 for taxpayers with IRA accumulations is the ability under Sec. 408A(d)(3) to convert a regular IRA to a Roth IRA. Although generally, income taxes must be paid on the amount converted at the time of the conversion, Sec. 408A(d)(3)(A)(iii) allows the owner to include the income ratably over four years, if the conversion occurs in 1998.
Example 3: B converts $100,000 from her regular IRA to a new Roth IRA in 1998. In each of 1998, 1999, 2000 and 2001, she will include $25,000 in gross income. If the conversion occurred in 1999 or thereafter, the entire $100,000 would be included in B's income in the year of conversion.
The Tax Technical Corrections technical correction
A temporary downturn in the price of a stock or in the market itself following a period of extensive price increases. A technical correction takes place in a generally increasing market when there is no particular reason that the Act of 1997(2) Would impose a 10% penalty on amounts converted from a regular IRA to a Roth IRA that are subsequently withdrawn before the expiration EXPIRATION. Cessation; end. As, the expiration of, a lease, of a contract, or statute.
2. In general, the expiration of a contract puts an end to all the engagements of the parties, except to those which arise from the non- fulfillment of obligations created of the four-year income inclusion period. (This is in addition to the 10% penalty imposed on the withdrawal of earnings before the five-year holding period.) If the IRA owner dies before the end of the four-year spread period and named a nonspouse as the beneficiary, the unreported balance must be included as income on the IRA owner's final return. A spouse named as the beneficiary can continue including the amounts ratably in gross income.
The conversion strategy has a significant drawback--Sec. 408A(c)(3)(B)(i) provides that a regular IRA can be converted to a Roth IRA only if the owner's AGI (computed before the conversion) does not exceed $100,000 (whether married or single). Sec. 408A(c)(3)(B)(ii) bars conversion by married taxpayers filing separately. IRA owners whose AGIs exceed $100,000 should consider tax-planning strategies with the goal of reducing AGI below $100,000 (preferably pref·er·a·ble
More desirable or worthy than another; preferred: Coffee is preferable to tea, I think.
pref in 1998) to create a one-year adj. 1. completing its life cycle within a year.
Adj. 1. one-year - completing its life cycle within a year; "a border of annual flowering plants"
phytology, botany - the branch of biology that studies plants window of opportunity to convert.
Often, active participants have the option at retirement to roll over their plan accumulations into an IRA. In most circumstances, currently employed active participants will not be allowed to roll over their accumulations in employer plans into an IRA. This puts an employee with a significant accumulation in his employer plan in a worse position than one who has an identical balance in an IRA. Many employees, however, may have IRAs as well, that will be eligible for conversion before the owner's retirement or termination.
Factors to Consider
The potential for tax-free growth is so compelling that all taxpayers who have substantial IRA balances and qualify for conversion should consider whether to convert at least a portion of their IRAs. Because the decision contains many variables, clients likely will seek advice from their CPAs in deciding whether the conversion will be beneficial. A Roth IRA conversion Roth IRA Conversion
A reportable movement of assets from a Traditional, SEP or SIMPLE IRA to a Roth IRA. The movement of assets may be taxable.
A conversion may be accomplished by a rollover of assets directly between the trustees of the Traditional and Roth IRAs, is one of the rare situations in which a CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. may recommend prepaying income taxes; however, many factors must be considered, including:
* The IRA owner's current and future income tax rates.
* The IRA owner's age and life expectancy.
* The IRA owner's anticipated spending needs during retirement.
* The IRA owner's other sources of retirement funds (including pension plans).
* The IRA owner's other sources of after-tax money and investments.
* The age and life expectancy of the IRA owner's beneficiary.
* The beneficiary's planned use of the IRA funds on inheritance inheritance, in law
inheritance, in law: see heir.
inheritance, in biology
inheritance, in biology: see heredity.
Devolution of property on an heir or heirs upon the death of its owner. .
* The beneficiary's future income tax rates.
* The rate of return on investment.
Example 4 in the box above demonstrates that a regular-to-Roth IRA conversion will result in greater net assets than if there is no conversion. In this example, net assets are measured in after tax dollars (i.e., at the different measuring ages, it is assumed that all of the IRA funds are withdrawn and income taxes paid on the withdrawals). Additionally, the conversion occurs in 1998, so the four-year income spread is available.
Example 4: Balance in IRA account Assumptions: G's (IRA owner's) current and future Federal income tax rate 28% Current and future state income tax rate (state taxes apply to investment earnings on after-tax funds, but not to retirement plan distributions) 3% Income tax rate on additional income generated by the conversion and taxed in 1998-2001 31% G's age at conversion 55 Beneficiary's age at conversion (used to calculate life expectancy factors) 53 Withdrawal income tax rate 28% Regular IRA fund amount converted $100,000 After-tax funds available (used only to pay income taxes) $100,000 Interest earned on invested funds 10% Method of calculating required minimum distributions Joint lives, recalculated Balance on G reaching age: 56.08 65 75 Regular IRA: Balance in regular IRA $110,865 $259,374 $531,652 Balance in after-tax funds 107,480 194,884 475,801 Total assets 218,344 454,258 11007,453 Income tax on regular IRA (31,042) (72,625) (148,862) Net assets $187,302 $381,633 $858,591 Conversion to Roth IRA: Balance in Roth IRA $110,865 $259,374 $672,750 Balance in after-tax funds 91,937 143,610 279,873 Total assets 202,802 402,984 952,623 Deferred tax liability (15,500) 0 0 Net assets $187,302 $402,984 $952,623 Roth IRA net assets exceed regular IRA net assets by: $ 0 $ 21,351 $ 94,032 Balance on G reaching age: 85 95 Regular IRA: Balance in regular IRA $692,780 $509,096 Balance in after-tax funds 1,361,611 3,460,417 Total assets 2,054,391 3,969,513 Income tax on regular IRA (193,978) (142,547) Net assets $1,860,413 $3,826,966 Conversion to Roth IRA: Balance in Roth IRA $1,744,940 $4,525,926 Balance in after-tax funds 545,429 1,062,956 Total assets 2,290,369 5,588,882 Deferred tax liability 0 0 Net assets $2,290,369 $5,588,882 Roth IRA net assets exceed regular IRA net assets by: $429,956 $1,761,916
Example 4 shows the amount that would be inherited inherited
received by inheritance.
inherited achondroplastic dwarfism
see achondroplastic dwarfism.
inherited combined immunodeficiency
see combined immune deficiency syndrome (disease). by the beneficiary if G (the IRA owner) dies at the stated age and the beneficiary immediately withdraws the entire IRA balance, or the after-tax dollars available to G if he withdraws all funds from the account at the stated age. In the example, G is required to take minimum distributions from his regular IRA at age 70 1/2, which are taxed and added to the after-tax funds balance. Thus, the regular IRA net asset balances are much lower than the Roth IRA balances when G reaches age 75, 85 and 95. Distributions need not be taken from the Roth IRA, allowing for continued tax-free growth. Although the after-tax funds from the Roth IRA are less than the pretax pre·tax
Existing before tax deductions: pretax income.
pretax adj [profit] → vor (Abzug der) Steuern funds from the regular IRA, the net combined assets from the Roth IRA exceed that of the regular IRA almost immediately, because the Roth IRA's earnings are tax-free.
In this example, the benefit of making the conversion occurs 1.08 years after conversion, and continues to grow over time. The conversion is slightly detrimental det·ri·men·tal
Causing damage or harm; injurious.
detri·men in the first 1.08 years, because it is assumed that G and his spouse are in the 31% bracket In programming, brackets (the [ and ] characters) are used to enclose numbers and subscripts. For example, in the C statement int menustart  = ; the  indicates the number of elements in the array, and the contents are enclosed in curly braces. In the conversion year (1998) and the following three years (1999-2001), because of the four-year income inclusion. Thus, when G is age 78.9, his Roth IRA's total assets exceed those in a regular IRA. Comparing total assets, however, is useful only in limited circumstances (e.g., when the beneficiary is a charity). A dollar in a regular IRA is generally worth less than an after-tax dollar, and a dollar in a Roth IRA is worth more than an after-tax dollar because of the continued tax-free growth of the funds. The different values of a dollar in the Roth and regular IRAs and after-tax funds could become quite substantial.
Example 4 assumes complete withdrawal of the IRA funds at the stated ages. A more realistic assumption is that G will leave the funds in the Roth IRA until they are needed or desired, and then withdraw only the amount needed, not the entire balance. In general, the longer the funds are invested, the more valuable the Roth IRA becomes compared to either after-tax money or a regular IRA. Because the timeframe used to compare a Roth IRA to a regular IRA could be as long as G's and the beneficiary's lives, with only minimum distributions based on the beneficiary's life expectancy throughout, determining the relative value of a dollar in these different environments is quite complex.
In certain circumstances, a Roth IRA may still be beneficial, even if G did not have sufficient after-tax funds to pay the income taxes due on conversion of a portion of a regular IRA. The remaining, unconverted IRA funds are used to pay the income tax liability on the converted portion. However, the conversion is not as beneficial as when after-tax funds are available to pay the income taxes on the converted funds.
Effect of Different Income Tax Rates in Retirement
What is the effect of G having a lower or higher income tax rate in retirement?
Example 5: The facts are the same as in Example 4, except that G's tax bracket changes during retirement. The table below illustrates the difference in net assets after conversion.
G's tax bracket in retirement Amount by which Roth IRA net assets exceed (age 66 and up) regular IRA net assets when G is age: 65 75 85 95 15% $21,351 $61,139 $201,872 $853,376 15% ages 66-70, 28% ages 71-95 21,351 87,808 417,824 1,738,271 28% (as in Example 4) 21,351 94,032 429,956 1,761,916 31% 21,351 101,305 477,503 1,939,934 36% 21,351 113,168 552,875 2,213,866
Thus, for a taxpayer in the 28% bracket, converting to a Roth IRA will always be advantageous if the funds are invested for 10 years or more, even if the IRA owner's tax bracket will decline from 28% at the time of conversion to 15% at retirement. Converting to a Roth IRA will be even more advantageous if the IRA owner's bracket will increase during retirement.
Effect of Investment Appreciation and Capital Gains on After-Tax Investments
Some critics of the above analysis suggest that it is not realistic to assume that all after-tax investments will generate an increase in value by only the amount of regular income; rather, some of the increase in value will be capital appreciation that is not currently taxed and some win be current capital gain.
Example 6: The facts are the same as in Example 4, except that (1) only 30% of the investment income (e.g., interest and dividends) are taxed at regular rates; (2) capital appreciation occurs on 70% of the investment income and is not taxed currently; (3) capital gains result each year based on a 15% portfolio turnover rate (i.e.,15% of the beginning year's cumulative capital appreciation not previously taxed); such gains will be taxed at 18%. In addition, the accumulated after-tax appreciation that has not been taxed may be taxed at a capital gains rate (if the investments are sold) or represent a step-up in basis Step-Up In Basis
The readjustment of the value of an appreciated asset for tax purposes upon inheritance. With a step-up in basis, the value of the asset is determined to be the higher market value of the asset at the time of inheritance, not the value at which the original party for heirs (if held until death), completely avoiding taxation.
After-tax investment Amount by which Roth IRA net assets income (10% rate of return) exceed regular IRA net assets when G reaches age: 57 65 75 Regular income tax rates (as in Example 4) $2,345 $21,351 $94,032 Capital gains and appreciation, capital gains tax paid in last year 2,275 17,385 71,980 Capital gains and appreciation, stepped-up basis after death 2,177 14,783 63,331 After-tax investment Amount by which Roth IRA net assets income (10% rate of return) exceed regular IRA net assets when G reaches age: 85 95 Regular income tax rates (as in Example 4) $429,956 $1,761,916 Capital gains and appreciation, capital gains tax paid in last year 319,130 1,297,430 Capital gains and appreciation, stepped-up basis after death 278,128 1,155,100
This example demonstrates that when the investor achieves more favorable fa·vor·a·ble
1. Advantageous; helpful: favorable winds.
2. Encouraging; propitious: a favorable diagnosis.
3. capital gains tax treatment on after-tax investments, the advantage of a Roth IRA conversion is mitigated mit·i·gate
v. mit·i·gat·ed, mit·i·gat·ing, mit·i·gates
To moderate (a quality or condition) in force or intensity; alleviate. See Synonyms at relieve.
To become milder. somewhat, but still remains.
When to Convert
Is it better to convert to a Roth IRA earlier or later?
Example 7: In 1998, Y and Z are each 30 years old; each has a $100,000 regular IRA. Y converts his IRA to a Roth IRA at age 30; Z converts his IRA at age 55. By waiting until age 55, Z will not have the four-year spread period for paying tax on the conversion. The table below illustrates the different results.
Y Z Balances at age 55. IRA funds $1,083,471 (Roth) $1,083,471 (regular) After-tax funds 390,706 530,204 Total assets 1,474,177 1,613,675 (before conversion) Income tax on IRA 0 (379,215) Net assets $1,474,177 $1,234,460 (after conversion) Balances of age 70: Roth IRA funds $4,525,926 $4,525,927 After-tax funds 1,062,956 477,374 Total and net assets $5,588,882 $5,003,301
Making the conversion at a younger age is more beneficial, because the Roth IRA has more time to grow tax-free (as opposed to tax-deferred tax-de·ferred
1. Of or relating to an investment that is not liable to taxation until income is withdrawn or an appointed date is reached.
2. in a regular IRA). Another advantage of an earlier conversion is that Congress could repeal the ability to convert; however, converted IRAs should be grandfathered.
The results in Example 4 can understate un·der·state
v. un·der·stat·ed, un·der·stat·ing, un·der·states
1. To state with less completeness or truth than seems warranted by the facts.
2. the advantages of a Roth IRA, because they do not consider the beneficiary's timeframe for making distributions from the inherited IRA. The analysis does not consider the potential benefits a beneficiary may receive from withdrawing less than all of the funds immediately after the IRA owner's death. Tax-free growth is maximized only if the beneficiary takes the required minimum distributions. Decreasing the rate at which distributions are taken from a inherited regular IRA will only defer taxes, while slowing distributions from an inherited Roth IRA will provide greater tax-free growth.
Example 8: W, age 45, inherits a $100,000 regular IRA. His Federal income tax rate is 28%; his state income tax rate is 3% (on after-tax investment income). All after-tax and IRA funds earn 10% annually. Only required minimum distributions are taken, and they are equal for both the Roth and regular IRA. These distributions are added to the after-tax funds.
W's age 45 55 Inherited regular IRA: Balance in regular IRA $100,000 $196,068 Balance in after-tax funds 0 40,240 Total assets $100,000 $236,308 income tax on regular IRA 28,000 54,899 Net assets $ 72,000 $181,409 Inherited Roth IRA: Balance in Roth IRA $100,000 $196,068 Balance in after-tax funds 0 56,559 Total and net assets $100,000 $252,627 W's age 70 85 Inherited regular IRA: Balance in regular IRA $403,820 $ 0 Balance in after-tax funds 356,691 1,947,311 Total assets $760,511 $ 1,947,311 income tax on regular IRA 113,070 0 Net assets $647,441 $ 1,947,311 Inherited Roth IRA: Balance in Roth IRA $403,820 $0 Balance in after-tax funds 510,055 2,832,613 Total and net assets $913,875 $2,832,613
Example 8 clearly illustrates the advantage of inheriting in·her·it
v. in·her·it·ed, in·her·it·ing, in·her·its
a. To receive (property or a title, for example) from an ancestor by legal succession or will.
b. a Roth IRA versus a regular IRA; the difference results from the lack of income tax on the Roth IRA.
Example 9: The facts are the same as in Example 4, except that G dies at age 75. His total assets at death (assuming he converted to a Roth IRA) are less than if he had not converted. G's beneficiary spends $48,000 per year (indexed for 4% inflation) of the after-tax funds inherited.
Beneficiary's age at inheritance 45 55 Regular IRA: Balance in regular IRA $ 531,652 $1,042,402 Balance in after-tax funds 475,801 365,585 Total assets 1,007,453 1,407,987 Tax on regular IRA, if withdrawn (148,863) (291,873) Net assets $ 858,590 $1,116,114 G converts to Roth IRA 20 years before death: Balance in Roth IRA $ 672,750 $1,319,051 Balance in after-fox funds 279,873 145,807 Total and net assets $ 952,623 $1,464,858 70 85 Regular IRA: Balance in regular IRA $2,146,917 $ 0 Balance in after-tax funds 55,704 1,287,303 Total assets 2,202,621 1,287,303 Tax on regular IRA, if withdrawn (601,137) 0 Net assets $1,601,484 1,287,303 G converts to Roth IRA 20 years before death: Balance in Roth IRA $2,716,699 $ 0 Balance in after-fox funds 453,364 6,303,362 Total and net assets $3,170,063 6,303,362
Example 9 demonstrates the long-term Long-term
Three or more years. In the context of accounting, more than 1 year.
1. Of or relating to a gain or loss in the value of a security that has been held over a specific length of time. Compare short-term. implications of tax deferral tax deferral
The delay of a tax liability until a future date. For example, an IRA may result in a tax deferral on the amount contributed to the IRA and on any income earned on funds in the IRA until withdrawals are made. (i.e., a regular IRA) versus tax-free growth (i.e., a Roth IRA), and the significant advantage that accrues to a beneficiary who inherits a converted Roth IRA.
Disadvantages of Converting
The most apparent disadvantage of converting to a Roth IRA is that income taxes will have to be paid on conversion. The benefits to be received are long-term and hard to measure. In addition, if the income tax rates for investment income or IRA distributions are reduced or repealed, the advantages shown in the above examples may not be realized. If the Federal income tax system is radically changed (or abolished in favor of upon the side of; favorable to; for the advantage of.
See also: favor a national flat or sales tax sales tax, levy on the sale of goods or services, generally calculated as a percentage of the selling price, and sometimes called a purchase tax. It is usually collected in the form of an extra charge by the retailer, who remits the tax to the government. ), IRA owners who converted could suffer a reduction in funds without an equivalent reduction in taxes. In addition, making the conversion is not advisable ad·vis·a·ble
Worthy of being recommended or suggested; prudent.
ad·visa·bil if the beneficiary is a charity. Further, differing income tax laws in some states may result in the Roth IRA earnings being taxed as ordinary investment income. Although several states may change their laws to exempt Roth IRA income (and some intend to do so), this could remain a disadvantage in other states. Finally, if an IRA owner's future tax rate will be significantly lower, converting now at a higher rate may not be as beneficial as waiting until later and converting at a lower rate. Nonetheless, despite all of these potential disadvantages and the uncertainty of the assumptions made, all eligible taxpayers should give serious consideration to converting at least a portion of their regular IRAs to a Roth IRA.
Estate Tax Implications
For Federal estate tax purposes, $1 in a regular IRA is taxed the same as $1 in after-tax funds or a Roth IRA. Example 9, above, demonstrated the additional value available to the beneficiary by inheriting a Roth IRA instead of a regular IRA; such value is not subject to estate taxes because it is not reflected in the dollar value of the taxable estate Taxable Estate
The total value of a deceased person's assets that are subject to taxation - minus liabilities and minus the prescribed tax-deductible portion of assets left behind by the deceased. . Also, when a regular IRA owner incurs income tax to convert to a Roth IRA and subsequently dies, his estate will be reduced by the income taxes paid on conversion. This estate tax savings was not taken into account in the previous examples.
Unified Credit unified credit
A credit used against federal taxes due on estates and large gifts. Under current law, the unified credit is sufficient to offset taxes on values of approximately $1 million in estates and large gifts. Shelter Trust
A unified credit shelter trust (UCST UCST Upper Critical Solution Temperature (physical chemistry)
UCST Ukrainian Center for Simultaneous Translation ) will typically provide a surviving spouse with trust income and the right to invade in·vade
v. in·vad·ed, in·vad·ing, in·vades
1. To enter by force in order to conquer or pillage.
2. trust principal for health, maintenance and support. After the surviving spouse's death, the amount in the trust passes to named beneficiaries (usually, the couple's children). The purpose of a UCST is not only to provide the surviving spouse with income, but also to protect trust principal from estate taxes. If properly drafted and executed, the balance of a UCST at the second death will not be subject to estate taxes because the first decedent An individual who has died. The term literally means "one who is dying," but it is commonly used in the law to denote one who has died, particularly someone who has recently passed away. used, instead of wasted, his unified credit (the "exemption equivalent" amount). It is preferable to create a UCST with discretionary, not mandatory, income distributions to the surviving spouse; because UCSTs do not have to qualify for the marital deduction marital deduction n. when one spouse dies, the survivor may take a tax deduction of half of the value of the estate of the dying spouse. Thus, the minimum value of the estate before there is a possible federal estate tax rises from $600,000 to $1,200,000 at the death , income distributions are not required. The purpose of making income distributions discretionary is to create a post-mortem post-mortem adjective After death noun A popular term for an autopsy, see there option of allowing the trust to grow. After the surviving spouse's death, the trust (with additional accumulations) would pass to heirs (usually children) free of estate taxes.
Traditionally, tax advisers have preferred to fund their clients' UCSTs with after-tax dollars and/or and/or
Used to indicate that either or both of the items connected by it are involved.
Usage Note: And/or is widely used in legal and business writing. life insurance proceeds. Some tax and estate planning Estate Planning
The overall planning of a person's wealth, including the preparation of a will and the planning of taxes after the individual's death.
Contrary to popular belief, estate planning involves much more than preparing a will, and it is not only for the attorneys, however, customarily draft intricate IRA and retirement plan beneficiary designations that have the effect of funding UCSTs with IRA or other retirement accounts if they are needed to fund the trust fully. The strategy of using IRAs and retirement plans to fund a UCST will become more popular as the post-TRA '97 Sec. 2010(c) exemption equivalent increases from $600,000 in 1997 to $1 million by 2006,(3) and the contributions and growth in IRAs and retirement plans continue.
Use of disclaimers: These sophisticated IRA and retirement plan beneficiary designations should consider the use of disclaimer (networking) disclaimer - Statement ritually appended to many Usenet postings (sometimes automatically, by the posting software) reiterating the fact (which should be obvious, but is easily forgotten) that the article reflects its author's opinions and not necessarily those of the provisions. The disclaimer strategy will typically name the surviving spouse as the primary beneficiary and the UCST as the secondary beneficiary of the retirement plan or IRA. The disclaimer strategy allows a "free second look" for a surviving spouse to decide whether to retain all of the IRA proceeds outright (using the marital deduction) or to disclaim dis·claim
v. dis·claimed, dis·claim·ing, dis·claims
1. To deny or renounce any claim to or connection with; disown.
2. To deny the validity of; repudiate.
3. all or a portion of the IRA proceeds into the UCST The surviving spouse makes this decision after the first death, when the financial picture of the survivor and the family is known.
If the disclaimer strategy is used in both the will (or revocable trust Revocable Trust
A trust whereby provisions can be altered or cancelled dependent on the grantor. During the life of the trust, income earned is distributed to the grantor, and only after death does property transfer to the beneficiaries. ) and the IRA with integrated language between the will and IRA beneficiary designation, the surviving spouse would be able to choose which assets (if any) would be used to fund the trust. Having disclaimers in both the will and the IRA is referred to as a "double disclaimer" strategy. In many cases, this strategy will yield a better result than drafting wills and IRA beneficiary designations based on projections about who will die first, when they will die, the family's needs, and the amount of after-tax and IRA funds available to fund the UCST.
Advisers usually prefer funding a UCST with after-tax funds, if available, instead of pre-tax pre-tax adj → anterior al impuesto
pre-tax adj → avant impôt(s)
pre-tax adj → al lordo d'imposta funds, because an after-tax dollar is worth more to an heir than a pre-tax dollar. The income in respect of a decedent associated with pre-tax funds diminishes the value of the UCST to the heir; however, Sec. 691 does not apply to a Roth IRA. Thus, advisers should at least consider whether funding the UCST with Roth IRAs is preferable to using after-tax accumulations. If the marital Pertaining to the relationship of Husband and Wife; having to do with marriage.
Marital agreements are contracts that are entered into by individuals who are about to be married, are already married, or are in the process of ending a marriage. bequest bequest: see legacy. or the surviving spouse's independent assets suffice suf·fice
v. suf·ficed, suf·fic·ing, suf·fic·es
1. To meet present needs or requirements; be sufficient: These rations will suffice until next week. to make the surviving spouse financially secure, children or grandchildren GRANDCHILDREN, domestic relations. The children of one's children. Sometimes these may claim bequests given in a will to children, though in general they can make no such claim. 6 Co. 16. should be named as the beneficiaries of Roth IRAs to the extent of the exemption equivalent. The long life expectancy of a young beneficiary would require smaller minimum distributions in early years, thereby resulting in significant tax-free growth of the Roth IRA. Although this strategy is good for regular IRAs, it provides an estate planning bonus with Roth IRAs.
Naming children instead of the surviving spouse as the primary beneficiaries will be advisable only in larger estates. When the security of having the principal and income of the exemption equivalent amount available to the surviving spouse is desired, the adviser should consider recommending a double-disclaimer strategy. The client could take a "wait and see" approach and allow the surviving spouse to determine the optimal strategy after the first death, when more information is available.
The Roth IRA provides significant opportunities for tax-free growth. In most cases, annual contributions should be made to Roth IRAs instead of regular IRAs. Further, the benefits of the Roth IRA are so substantial that practically all clients who qualify should consider whether it would be beneficial to convert at least a portion of their existing IRAs to a Roth IRA. Because the analysis of whether to make this conversion is so important and complex, there is an opportunity for tax advisers to provide substantial assistance to their clients.
(1) All tables in examples were calculated using Microsoft[R] Excel A full-featured spreadsheet for Windows and the Macintosh from Microsoft. It can link many spreadsheets for consolidation and provides a wide variety of business graphics and charts for creating presentation materials. 97.
(2) See Joint Committee on Taxation (JCT JCT Junction
JCT Jerusalem College of Technology
JCT Joint Contracts Tribunal (UK build contracts governing body)
JCT Journal of Coatings Technology
JCT John Christner Trucking
JCT Journal of Curriculum Theorizing ), JCT Description of the Chairman's Mark of the Tax Technical Corrections Act of 1997 (JCX-56-97), Section C.1.
(3) See Soled and Arnell, "Planning Implications of the TRA '97's Increase in the United Credit," 28 The Tax Adviser 704 (Nov. 1997).
RELATED ARTICLE: EXECUTIVE SUMMARY
* Roth IRAs are not for everyone; AGI limits determine who can create and contribute to such an account or convert an existing regular IRA.
* If conversion from a regular IRA to a Roth IRA occurs in 1998, the taxpayer can spread the income inclusion (i.e., the regular IRA balance) over four tax years.
* A lower tax rate in retirement does not necessarily mean that contributing to a regular IRA will be more beneficial than contributing to a Roth IRA.