Beneficiary Withdrawals From a Roth IRA Are Subject to the 5-Year Holding Rule

Q: If I die within five years of opening a Roth IRA, would any of the gain be subject to income tax?

--V.S.

A: Beneficiary withdrawals that do not meet the five-year holding period are subject to regular income tax to the extent that they exceed contributions to the account. If you deposited $6,000 into the account and it grew to $7,500 after three years, at which time you died, your beneficiary would be liable for taxes on $1,500 if it were immediately withdrawn.

However, spousal beneficiaries may roll over the accounts to their own Roth IRAs and delay distributions from the accounts as long as they wish. They may even decline to make withdrawals and allow the funds to be inherited by their own beneficiaries. Non-spousal beneficiaries may elect to hold the accounts in the names of the deceased until the five-year limit has been reached before proceeding with tax-free withdrawals, according to Merrill Lynch.

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Q: If investments in a Roth IRA suffer a disastrous decline and there is a net loss when the account is liquidated, may the taxpayer deduct the loss?

--D.S.

A: There are no tax benefits for losses incurred in Roth IRAs, even if the money in the account was deposited after taxes were levied, says James H. Rivin, partner at the Woodland Hills-based accounting firm Rivin, Wenzel & Kiernan. This makes it all the more imperative that investors treat their retirement accounts with due caution; this is no place to buy options or futures.

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Q: Can you please explain the new law that allows couples earning as much as $150,000 to make a tax- deductible IRA contribution?

--F.E.

A: Beginning in 1998, a nonworking spouse or a spouse who is not an active participant in a retirement plan may make a $2,000 tax-deductible contribution to a traditional IRA as long as the couple’s adjusted gross income does not exceed $150,000. The amount gradually phases out as the adjusted gross income climbs, and ends completely at $160,000.

When both spouses are active participants in retirement plans, the adjusted gross income limit for deductible IRA contributions increases from $50,000 to $60,000 next year; for individual filers, the threshold increases from $30,000 to 40,000. The $100,000 threshold for couples, so highly touted when the new tax legislation was passed in August, does not become effective until the year 2007.

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Q: I am single, in my late 40s and unemployed due to my decision to care for an aged relative. I may not return to the work force for several years. Meanwhile, my IRA funds are topping $700,000. Would it make sense for me to tap my IRA through an annuitized withdrawal to get money for my living expenses? I know this way won’t trigger early-withdrawal penalties.

--B.E.

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A: Assuming that you receive annual distributions from your IRA under one of the annuity-type methods approved by the IRS and that you are willing to take the distributions for the minimum period required, you may begin to tap your IRA now without facing the usual penalties (10% federal and 2.5% state). However, all distributions will be fully taxable, except for portions stemming from after-tax IRA contributions.

Given your employment situation (and assuming that you have no other income), taxes shouldn’t pose much of a problem for you, although it is likely that the amount of your mandatory withdrawal would be large enough to put you in the 28% federal tax bracket.

When state taxes are factored in, you will be paying about a third of your IRA distribution in taxes, an amount perhaps equal to what you paid when you were employed. Of course, you would in all likelihood face the same tax prospect--perhaps a worse one if tax rates increase--if you withdrew the money during your retirement.

The real issue is the government’s insistence that you continue to take the IRA distributions according to the annuitized system you choose for a minimum of five years or until you turn 59 1/2, whichever period is longer. This means you face at least 10 years of distributions whether or not you need the money, whether or not you return to the work force, and whether or not the distributions put you into a greater tax bracket (when coupled with your earnings).

Are you willing to tap into your IRA for the next 10 years--a move that would surely deplete whatever you set aside for your real retirement? If you end the distributions before satisfying the required minimum period, you face retroactive penalties and interest charges. Of course, once you satisfy this requirement, you may stop the distributions until you reach age 70 1/2, at which point mandatory withdrawals begin.

Only you know how much money you need. But perhaps your aged relative would be willing to offer you some financial support, especially if your needs are less than what you would be required to withdraw each year from your IRA. The solution you propose may be more drastic that the situation requires.

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Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or e-mail carla.lazzareschi@latimes.com