TRA 97 & IRAs.

The enactment of the Taxpayer Relief Act of 1997 (TRA 97) moves the individual Retirement Account (IRA) into a new era. Beginning in 1998, three unique IRAs (regular IRA, Roth IRA and Educational IRA), create a number of tax planning opportunities. Why do we need expanded IRA investment opportunities? The House and Senate Conference Committee is concerned about the national savings rate and expressed their belief that individuals should be encouraged to save more than they are currently. The United States personal savings rate, as a percentage of disposable income, is low compared to most industrialized nations, as indicated in Table A.

The Committee Reports, which state the Congressional intent for new tax legislation, stated:

The Committee believes that the ability to make deductible contributions to an IRA is a significant savings incentive. However, this incentive is not available to all taxpayers under present law.

Regular IRA

Under pre-TRA 97, there was only one type of Individual Retirement Account, and the tax law provided only limited advantages for individuals. Maximum contributions of $2,000 were deductible "for AGI" if the participant (or spouse) was not in an employer-sponsored retirement plan. The $2,000 was deductible when the taxpayer (or spouse) was covered under an employer sponsored retirement plan if the joint income was below $25,000 adjusted gross income (AGI) for single taxpayers and $40,000 for taxpayers filing a joint return. The $2,000 deduction was reduced to zero as the AGI increased to $35,000 for single taxpayers and $50,000 for married taxpayers. Taxpayers, however, have always been able to make nondeductible IRA contributions. Total deductible and nondeductible IRA contributions cannot exceed the lesser of $2,000 or the earned income of the individual.

The deductible amounts placed into IRA accounts and income generated from the investment are taxable when withdrawn. Non deductible IRA contributions are excluded from taxation when withdrawn, but earnings from the amounts are taxable at current rates upon withdrawal. Amounts withdrawn before the taxpayer turns 59 1/2 are subject to a 10% early withdrawal penalty. The 10% penalty is waived for death or disability of the taxpayer, if the withdrawal is made in the form of certain annuity payments, or used to buy health insurance if unemployed, or to pay for medical expenses in excess of 7.5% of AGI. Generally, distributions from an IRA must begin when a person reaches the age of 70 1/2. An excise tax was imposed when the minimum required IRA distributions were not met.

Taxpayer Relief Act Changes

The TRA 97 Act makes four important changes to the regular IRA that opens a window of opportunity for increased savings. Beginning in 1998, the restrictive $25,000 and $40,000 limits for single and married taxpayers respectively are loosened significantly. The result is that many taxpayers who were blocked from contributing to a deductible IRA because their income levels exceeded the income limits are now allowed to do so. The new limits are displayed in Table B.

If a married couple has $50,000 AGI in 1998, and at least one of the spouses is covered in an employer-sponsored qualified retirement plan (QRP), they are allowed a $2,000 deductible IRA contribution. In 1997, no deduction would have been allowed. As Table B depicts, beginning in 2004, the old $10,000 phaseout rules jump to $20,000 for joint filers.

The second significant IRA rule change is that the limits on deductible IRA contributions from Table B no longer apply to a non participant spouse of an active participant in an employer-sponsored retirement plan if the couple's combined AGI does not exceed $150,000. The $2,000 potential deduction phases out when combined AGI is $160,000. For example, if only the wife is an active participant in an employer-sponsored retirement plan, while the husband is not, and their joint return shows $147,000 AGI, then the husband may make a $2,000 deductible IRA contribution. However, no deduction is allowed for the wife because their joint AGI exceeds the AGI dollar limit for an active participant filing jointly (e.g., $100,000 for 2004).

TABLE A

International Comparison of Personal Saving Rates

                                          PERSONAL
                                        SAVING RATES
COUNTRY                                   1975-1994

Netherlands                                  2.4%
Sweden                                       2.7%
United States                                6.4%
Australia                                    8.4%
United Kingdom                              10.3%
Canada                                      11.9%
Germany                                     12.6%
France                                      15.3%
Japan                                       17.0%
Belgium                                     18.0%
Italy                                       20.7%

The third major change is that the 10% early withdrawal penalty for IRAs (including the new Roth IRA) does not apply, beginning in 1998, for withdrawals up to $10,000 for first-time home buyer expenses ($20,000 for joint IRA accounts). A first-time home buyer is not necessarily the first time the person or couple buys a home. The term means a taxpayer who has not owned a home for at least two years. Thus, a couple who sold their home on July 10,1998, qualify for the first home IRA withdrawal with no 10% penalty if they purchase another home anytime after July 10, 2000.

The last major change for regular IRAs is that the restrictive (and frequently unknown) 15% excise tax penalty on annuity distributions exceeding $160,000 (or $800,000 if a lump-sum payout) in 1997 is repealed.

Ruth IRA

The most significant IRA change in TRA 97 is the introduction of the Roth IRA. Investment earnings from a Roth IRA are tax-free forever. The Roth IRA provides for a maximum $2,000 per year ($4,000 when a spousal account exists) contribution per taxpayer (or the amount of compensation received, if less than $2,000). The $2,000 is not in addition to the regular IRA, but is part of it. Hence, if $1,400 was placed in a regular IRA, only $600 is available for the Roth IRA. The Roth contributions are not deductible, but both earnings within the account and all funds withdrawn are tax-free when they are held in the Roth IRA for at least five years. The 5-year holding period begins with the taxable year to which the contribution relates, not the year in which the contribution is actually made. So, a $2,000 IRA contribution claimed in 1998, but not paid until April 15, 1999, is eligible for income exclusion withdrawal on January 1, 2004.

TABLE B

AGI Phase-Out Range for Deductible IRA Contributions

                                     PHASE-OUT RANGE

TAXABLE YEAR BEGINNING IN:   SINGLE TAXPAYERS   JOINT TAXPAYERS

1998 & 1999                   30,000-40,000      50,000-60,000
2000 & 2001                   35,000-45,000      60,000-70,000
2002 & 2003                   40,000-50,000      70,000-80,000
2004 & thereafter             50,000-60,000      80,000-100,000

The Roth rules follow many of the regular IRA rules. For instance, the contribution may be delayed until the April 15th due date of the 1040 return, yet be deducted for the prior year. Each taxpayer must have their own IRA account (versus one joint account). The Roth IRA is not dependent upon whether the taxpayer is an active participant in a QRP, and payments are allowed after 70 1/2 years of age. The $150,000 to $160,000 phaseout of the deductible IRA also applies to the Roth.

Currently, penalty-free IRA rollovers into other tax-deferred accounts are allowable. These rules also apply to the Roth IRA. But, TRA 97 provides a special rule for conversions of a regular IRA into a Roth IRA, known as a "conversion rollover." A taxpayer may rollover a regular IRA into a Roth IRA and avoid the 10% tax penalty. The rollover, however, is subject to income taxation. This can cause a taxpayer's marginal tax rate to jump to a higher percentage. For example, a taxpayer with $39,000 taxable income who rolls over a $12,000 regular IRA with a zero tax basis into a Roth IRA will increase his or her taxable income by $12,000, all but about $3,000 of which will be taxed at 28 percent. A one-year window of opportunity exists to mitigate this taxable transaction. If the conversion rollover occurs in 1998, the taxpayer can allocate the increased taxable income equally over the next 4-year period. Thus, in the example, taxable income would increase to $42,000 ($39,000 plus 1/4th of the $12,000 rollover). All of the increased income is in the 15% marginal tax bracket, not the 28%. Estimated cash savings from the special 1998 rule are about $1,170 from the example [(9,000 x .28) - (9,000 x .15)]), plus the time-value of money savings from deferring and paying the increased taxes over four years instead of one.

The conversion rollover is only allowed for taxpayers with an AGI that does not exceed $100,000. The $100,000 applies to individuals or taxpayers filing joint returns. Thus, married couples are at a relative disadvantage in obtaining the benefits of the Roth rollover. Taxpayers may have to do some careful tax planning in 1998, to stay under the $100,000 AGI limit.

There is no single answer as to whether a taxpayer should make the regular IRA rollover into the Roth IRA. Many taxpayers will find it advantageous to do so, and to do so in 1998, but careful planning is needed to know for sure, and to know how much savings or loss might be expected. Key factors include the taxpayer's age, health, IRA holding period, marginal tax rates, etc.

Educational IRA

Another IRA created in TRA 97 is the Education IRA. The rules allow for nondeductible IRA contributions up to $500 per beneficiary beginning in 1998 for each beneficiary who is not 18 years old by the end of the calendar year. The same $150,000 to $160,000 phaseout that applies to the other IRAs apply here too ($95,000 to $110,000 for taxpayers who do not file joint returns). Unlike the regular and Roth IRA, the Education IRA contribution must be made by the end of the tax year. Each $500 contribution reduces the [TABULAR DATA FOR TABLE C OMITTED] amount that can be contributed to the other IRAs, so that the total IRA contributions cannot exceed $2,000. The distribution from an Education IRA may be completely tax-free, and no time limits are required before the withdrawal is allowed. The IRA withdrawal may not exceed the qualified education expenses for the year, or a portion of the amount is taxable.

Roth IRA Planning

Every taxpayer who has an existing IRA should determine what the most advantageous IRA strategy is for them. There are many IRA options and thousands of dollars of potential tax savings available. The key is to determine what is best to do now. The first decision you must make is what kind of IRA to fund. For the majority of people, the Roth IRA is better than a regular IRA that is deductible if they can postpone withdrawals for the minimum of five years.

For example, if you and your spouse were to invest $4,000 in a regular IRA, your net cash outflow is $2,880 if you are in a 28% tax bracket ($4,000 less the $1,120 tax savings). If you consider state taxes, the net outflow is even less. If you allow the $4,000 to accumulate earnings tax deferred at 8% for five years (the minimum time before withdrawals can be made from a Roth IRA), you would be able to withdraw $5,877, pay the tax of $1,646 ($5,877 x .28) and have a net cash increase of $1,351 as shown in Table C. If inflation had averaged 3% during that time, the present value of the decision to fund the IRA is a positive $747.

However, if you invested the $4,000 in a Roth IRA for the same time period, you do not get the immediate tax deduction so your initial cash outflow is $4,000. However, when you withdraw the $5,877, it is tax free so the net cash increase is $1,877 with a present value of $1,039, or $292 higher than a deductible IRA. So whether you consider the present value of the investment or the net cash increase, you are better off with a Roth IRA.

Using the same example, the longer you leave the funds in the IRA the better off you are using the Roth IRA. If you started taking withdrawals after five years but over a five-year period, the present value of the deductible IRA is $1,081, while the Roth IRA is $1,501, a difference of $420. If withdrawals are over a ten-year period, the Roth IRA has a $583 higher present value as summarized in Table D.

Should You Convert Your Current IRA to a Roth IRA?

Individuals may convert their existing IRA, whether they were deductible or not, into a Roth IRA. If they convert, they must pay the tax on conversion but are not subject to the penalty tax for early withdrawals. In addition, if they convert during 1998, they can spread the tax over four years instead of having to pay it all with the 1998 tax return. While they can convert, should they? Will the benefits of having their future withdrawals tax free offset the immediate payment of income tax? The problem is compounded by the variables of how long until withdrawals are started, how much of the current balance in the IRA is taxable, what amount of earnings and inflation do they predict over the time that they maintain the IRA, etc.

IRA's have been around for 23 years. Early in the history of IRAs they were generally deductible. As deductible IRAs, the tax basis is zero since contributions were deducted in arriving at AGI. Therefore all withdrawals become taxable. However, beginning in 1981 they were only deductible for returns with a low AGI, so for many people they were not deductible. However, they could still be funded and the proceeds would grow tax deferred. Withdrawals from a nondeductible IRA have a tax basis equal to the amount contributed, which for most individuals is $2,000 per year and for most joint returns is $4,000. In developing the model to determine if individuals should convert their IRA to a Roth IRA, we assume they file jointly, have made $35,000 of nondeductible contributions and any other contributions were deductible. The funds earn 8% and the present market value of the IRA is $100,000 with a tax basis of $35,000. Since the conversion to a Roth IRA is only available for individuals with an AGI under $100,000 we used current tax rates of 28% and 15 percent. Tax rates over 28% would indicate an AGI of over $100,000, so it is unlikely that will occur. The other variables considered include amount of time until withdrawals begin (minimum of 5 years to satisfy the Roth requirement), how long withdrawals will be made, and the earnings and inflation rates.

TABLE D

                                     DEDUCTIBLE   IRA ROTH IRA

Investment                             $4,000        $4,000

Tax Savings @ 28%                      $1,120          -0-

Net Outflow                            $2,880        $4,000

Earnings @ 8% tax deferred             $1,877        $1,877

Value in 5 years                       $5,877        $5,877

Tax on Withdrawals                     $1,646          -0-

Net Cash Increase                      $1,351        $1,877

Present Value @ 3%
if withdrawn in 5 years                  $747        $1,039

Present Value @ 3%
if withdrawn over the next 5 years     $1,081        $1,501

Present Value @ 3%
if withdrawn over the next 10 years    $1,501        $2,084

The decision to convert from a regular IRA to a Roth IRA involves many factors and a long time period. A net present value model - that computes the after-tax cash flows each year, calculates a present value and then compares the present value of the decision to convert to the decision not to convert - was used to evaluate all of the variables.

Converting to a Roth IRA

If you convert to a Roth IRA you have to pay the tax on the difference between the fair market value and the tax basis of your current IRA on the date of conversion. Should these funds be paid with incremental funds or taken out of the IRA proceeds? If taken out of the IRA proceeds it lowers the amount that can be rolled over into the Roth IRA. Paying the tax with non-IRA funds is a way to increase the amount of nontaxable funds you have invested. If you have these funds available and do not convert, but keep your current IRA, these funds must be considered as an incremental investment to make the two decisions comparable. We have included in the decision not to convert to a Roth IRA the incremental investment of the funds that would have been used to pay the taxes as an additional investment in taxable funds.

The base model includes the following factors:

Fair Market Value of
Current IRA at 1/1/98                          $100,000

Tax Basis of IRA                                 35,000

Current Tax Rate                                    28%

Retirement Tax Rate                                 28%

Earning-Rate                                         8%

Discount (inflation) Rate                            3%

Years until
Withdrawals Start                              10 years

Years of Withdrawals                           15 years

The calculation of the cash flows and the present value computations for the base model are included in Table E and the results are included in Table F.

The present value of not converting to a Roth IRA is $175,195, including the incremental investment. If conversion to a Roth IRA occurs, the incremental funds are used to pay the taxes on earnings at the date of conversion (in this case $65,000 of earnings and $18,200 in taxes paid equally over four years). The present value of converting to a Roth IRA is $207,138 or $31,943 more than the decision not to convert. It is obvious that conversion should occur in this case. But what if the variables change? The critical variables appear to be the time until withdrawals start, how long withdrawals are made, the earnings, tax and inflation rates.

Income Tax Variable - It is unlikely that tax rates would b.e higher than 28% if the individuals are going to meet the $100,000 maximum AGI requirement for converting. If tax rates are changed, it is more likely that they will decrease at retirement time. However, an individual could be in a 15% bracket now and have it increase to 28% during retirement. Using the same model but changing the tax rates did not change the end result as shown in Section I of Table F. In the first column of Section I, the income tax rate during retirement drops to 15% and the present value of the decision not to convert increases to $203,368. The present value of the decision to convert to a Roth IRA does not change, as there are no income taxes when making withdrawals, and the net present value of the decision to convert to a Roth IRA over keeping the current IRA drops to $3,770, however, still in favor of converting. If the person's retirement tax rate were to increase from 15% to 28%, the present values are $172,477 for not converting and $214,991 for converting, an advantage of $42,514 for switching to a Roth IRA. If the person was in a 15% bracket and it did not change at retirement, the net present value of the decision to convert is still a positive $15,078. It would appear that unless a person's retirement tax rate is to decrease to less than 15% at retirement, they are better off converting their current IRA to a Roth IRA during 1998 when they can spread the tax on converting over the next four years.

Earning Rate Variable - In the basic model, it was assumed the fund would average an 8% return over its life. Since this is a smaller return than the average for most stock-based portfolios, the model was modified for a 10% and a 12% return. The results, reported in Section II of Table F, show that as the return rate increases, so does the net present value of the decision to convert from the current IRA to the Roth IRA. At 8%, the net present value is $31,943 in favor of the Roth IRA. When the average return is increased to 10%, the net present value of [TABULAR DATA FOR TABLE E OMITTED] [TABULAR DATA FOR TABLE F OMITTED] converting increases to $48,643, and when increased to 12%, the net present value becomes $70,910 in favor of the Roth IRA. It is only when the rate of return is lower than the inflation rate that the decision not to convert becomes the best.

Discount Rate Variable - The discount rate is used to take into account the changing amount of the dollar from inflation. The original model uses 3% which is the long-term average inflation for the last 30 years. When the rate is increased to 4%, the present value of both decisions decrease and the net present value of the decision to convert drops from $31,943 to $27,010 as reported in Section III of Table E If the rate is changed to 5%, the net present value gets smaller still, dropping to $22,914. In testing the limits of the sensitivity of the inflation rate, because of the time involved, it never changes the decision to convert to a Roth IRA.

Years until Withdrawals Start Variable - One of the requirements of converting to a Roth IRA is a minimum time period of five years before withdrawals can commence. The basic model assumed 10 years and resulted in a net present value of $31,943. Changing that assumption to 5 years and 15 years did not change the results. As reported in Section IV of Table F, starting withdrawals five years after converting has a net present value of $20,875 and starting withdrawals 15 years after converting has a net present value of $45,987. Obviously, the longer the time period until withdrawals start, the better off one is with a Roth IRA. But even at the minimum of five years, the present value of converting to a Roth IRA is significantly better than the decision not to convert.

Years of Withdrawals Variable - The basic model assumes that withdrawals are made over a 15-year period. Since many individuals might want a shorter/or longer) time for withdraws, the years of withdrawals was changed from 15 years to 10, 5 and to 1 year. Increasing the time period of withdrawals only increases the relative advantage of converting to a Roth IRA. The results are reported in Section V of Table E Shortening the period of withdrawals lowers the relative advantage of converting to a Roth but it never makes it the least favorite. Changing from 15 years, with a net present value of $31,943, to 10 years lowered the net present value of the decision to convert to $27,298. Decreasing the years to 5 and then to 1 changed the net present value to $22,608 and then to $18,879, still in favor of converting to a Roth IRA.

Several other variables need to be considered. Instead of investing the incremental funds that are used for taxes in a taxable account as the basic model assumes, what is the impact of investing $4,000 of the incremental tax dollars in a Roth IRA each year for the next four years? It makes the present value of the decision not to convert higher ($181,935) but does not exceed the decision to convert ($207,138), so it does not change the best alternative of converting to a Roth IRA.

If a person waits until 1999 and decides to convert, they have to pay all of the taxes in the year of conversion. This decreases the relative benefits of converting to a net present value of $28,127 in the basic model, a decrease in the net present value of $3,816 ($31,943 - $28,127). It is to the taxpayers benefit, then, to elect to convert to a Roth IRA in 1998 and spread the tax over the next four years.

Conclusions

The examples show that people are better off converting their existing IRA to a Roth IRA in 1998, paying the tax over the four years, and using incremental funds (not funds from the IRA), to pay the taxes. It is apparent that anyone whose IRA situation is similar to the basic model should consider converting to a Roth IRA during 1998. Manipulating all of the variables in the basic model did not change the advantage of converting to a Roth IRA. Individuals will need to consider when to convert during 1998 if they expect the market value of their current IRA to increase or decrease during the time period which will impact the amount of taxes they owe. You need to start planning now for converting one of the most important parts of your retirement funds, your IRA account.

Gordon Pirrong, DBA and William C. Lathen, PhD are professors of accounting at Boise State University.