Is the Hoopla Contributing to Your IRA ‘Conversion’ Confusion?

Confused about the new Roth IRA? You’re not alone. Although this fledgling retirement account--authorized by last year’s tax law and in effect since January--is being widely touted, advertised and talked about, many people still don’t know whether they can contribute to one or how to evaluate whether they’d be better off with an old-style IRA or a Roth.

Part of the confusion stems from the fact that the 1997 tax law actually created two types of Roth IRAs--one for new contributions and one for “conversions”--money rolled over from a traditional IRA into a Roth IRA.

Here’s what you need to know if you are contributing to a Roth or thinking about converting your traditional individual retirement account into a Roth.

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Q: What is a Roth IRA?

A: It is a retirement account that offers all its tax breaks on the back end. Qualifying taxpayers can contribute up to $2,000 annually. These contributions are not tax-deductible for anyone. However, the investment income earned in the account is not taxed while it’s building up; and, if the money is left alone for at least five years and then withdrawn for a qualifying purpose--retirement after age 59 1/2, disability or a first-time home purchase--none of the investment earnings are taxable--ever.

Q: Who qualifies to contribute?

A: Single taxpayers who earn less than $95,000 and married couples who file jointly and have combined income of less than $150,000 can make full contributions to Roth IRAs. However, the amount you can save in a Roth declines as your income rises above those thresholds and evaporates completely for singles earning more than $110,000 and married couples earning in excess of $160,000. If you are married and filing separately, you cannot contribute to a Roth IRA.

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Q: How does that compare to the rules relating to traditional IRAs?

A: With a traditional IRA, you can take a current-year tax deduction for contributions up to $2,000 made before April 15, provided that you don’t have a company pension, or if your income falls below set thresholds--$25,000 for singles, $40,000 for married couples. Partial IRA deductions are available to singles earning less than $35,000 and couples earning less than $50,000.

The income thresholds have been boosted for tax years starting with 1998. Those earning up to $30,000 when single and $50,000 when married can take full deductions for the 1998 tax year. Deductions are phased out completely, however, once income rises above $40,000 for singles and $60,000 for married couples. Pension participants whose income falls between the deduction limits can take partial federal tax deductions.

If you are in the 28% federal tax bracket, a $2,000 tax deduction saves you $560 in taxes.

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Q: Exactly how much does the Roth IRA save you in taxes?

A: The answer will vary based on how long you save and the rate of return on your money. But let’s look at two hypothetical examples:

* John Smith, 35, contributes $2,000 a year for five years--a total of $10,000. He invests the money in stocks, which return 10% on average over his working career. He retires 30 years later at age 65 and finds that his Roth IRA is worth $132,294. He can take that money out in one lump sum or withdraw it on a monthly or annual basis over his lifetime. Either way, however, the investment earnings of $122,294 are not taxable.

Assuming he’s in the 28% tax bracket and pulls the money out in a lump sum at retirement, that saves him $34,000 in federal income tax. (If he pulls out the money over time, the additional investment income he earns on the balance is not taxed either. His tax savings are even greater.)

* Jane Jones, 24, contributes $1,000 a year for five years, but then decides she wants to take the money out of her Roth IRA to buy her first home. Her contributions amount to $5,000. But she’s enjoyed generous investment earnings of 20% annually. Her account is worth $7,442. Because she’s had the account for five years and she’s withdrawing the money for a qualified purpose, the $2,442 in investment income is not taxable. She saves $684 in federal income taxes, assuming she’s in the 28% tax bracket.

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Q: What would the tax savings amount to if these people had contributed to traditional IRAs?

A: If Smith was in the 28% tax bracket while working, he would have saved $2,800 in federal income taxes over the five-year period that he contributed. He’s clearly better off with the Roth, where his savings exceed $34,000.

Jones’ $1,000 annual deductions would have netted $280 in yearly federal tax savings--a total of $1,400. But with a regular IRA, the distribution she took would be fully taxable at her ordinary income tax rate. That costs her $2,084 (28% of $7,442) in federal income taxes. Thanks to the new rules passed in last year’s tax bill, her federal tax bill would not include a 10% penalty for pulling out the money before retirement. However, she still would have been better off with the Roth.

On the other hand, with the traditional IRA, if Smith and Jones were eligible to contribute on a tax-deductible basis, they would receive their tax deductions upfront, when they are making contributions. For those who don’t have a lot of spare cash, that could mean they can contribute more.

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Q: What about converting a traditional IRA into a Roth?

A: First, the income restrictions are different. You can roll an existing IRA over into a Roth IRA only if your income is less than $100,000, regardless of whether you are married or single.

If you meet that income limitation, you may roll all or part of an existing IRA over into a Roth, but you must pay tax on the proceeds. If you are rolling a nondeductible IRA into a Roth, the investment earnings--but not your contribution amounts--are taxable. If you are rolling a deductible IRA into a Roth, the entire value of the account is taxable.

However, if you elect to do this rollover in 1998, you must spread the distribution income equally over your next four tax returns.

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Q: I don’t earn more than $100,000, but I have a substantial IRA. If I roll the IRA over into a Roth, will the rollover amount add to my taxable income and make me ineligible to roll into a Roth? In other words, am I in a Catch-22?

A: No. The rollover amount does not count for purposes of figuring your eligibility for the Roth IRA rollover. However, you should know that it does count when figuring deduction and personal exemption “phaseouts,” which limit the ability of high-income individuals to claim their itemized deductions and tax credits for their dependents. It also counts in determining whether you qualify for other tax breaks that take effect in 1998. In some cases, if you have a substantial IRA and are considering a rollover, you should consult a tax advisor.

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Q: Is there a simple way to figure out if it makes sense to convert my traditional IRA into a Roth?

A: Unfortunately, no. But there are some rules of thumb:

First, if you convert, you should know that all or a large part of your IRA is likely to be considered taxable income and that this must be declared over a four-year period (for those converting in 1998). If you have the cash to pay the tax generated by that extra income--in other words, if you don’t have to use funds from the IRA account to pay the tax--and you’ve got lots of time to let the IRA money grow, it might make sense. However, if you are likely to need the money in 10 years or less or if you’re likely to be in a lower tax bracket when you retire, you are probably better off leaving your traditional IRA alone.

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Q: Can I contribute to both a Roth IRA and a traditional IRA?

A: Yes, but the contribution amounts are aggregated. The maximum amount you can contribute to either or both accounts is $2,000 annually.

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Q: What about access to my money? What happens if I want to withdraw my IRA funds before retirement?

A: Penalty- and tax-free withdrawals are allowed from accounts that have been open for at least five years and that are either made after age 59 1/2; on the death or disability of the account holder; or for a qualified first-time home purchase (subject to a $10,000 lifetime limit) for the taxpayer, spouse, child or grandchild.

With a traditional IRA, withdrawals for purchasing a home or paying for education are penalty-free, but you still must pay income tax on the proceeds.

If you withdraw money for any other purpose, the proceeds are taxable and you are subject to a 10% tax penalty on the amount withdrawn.

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Q: What’s a qualified first-time home purchase?

A: That is the purchase of a home by a taxpayer who has not owned a home for at least two years, says Don Roberts, spokesman for the Internal Revenue Service.

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Q: What if I want to withdraw the money to go back to school, or to pay for a child’s education?

A: New provisions in the 1997 tax act eliminated tax penalties if you withdraw any IRA money to pay for education. But because this is not one of the authorized purposes for Roth distributions, the investment earnings in the account would be taxable. (Under past law, you would have owed 10% tax penalty too.)

However, with a Roth account, you are assumed to be taking principal out first. So any amount you withdraw is not taxed until it exceeds your principal amount. So, let’s say you need to pay $10,000 for school, and, coincidentally, you’ve got $10,000 in a Roth account to which you’ve contributed $6,000. The other $4,000 represents investment earnings. When you pull the money out, only the $4,000 in earnings would be taxable.

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Q: Is that how it works with traditional nondeductible IRAs?

A: No. With a traditional IRA, you are assumed to be taking “ratable” portions of both principal and interest. So, in the above example, the first dollar withdrawn would be 40% taxable. With the Roth, 60% of that account could be withdrawn without tax consequences. Only the final 40% would be fully taxable, says IRS spokesman Roberts.

Note that with this example, that technical distinction doesn’t cause a difference in the amount of tax that’s payable. However, in other cases it would. Consider a family that only needed $6,000 for school. If $6,000 came out of a Roth--all the contributions--none of the proceeds would be taxable.

If the $6,000 was taken out of a traditional nondeductible IRA, 40% of the $6,000, or $2,400, would be taxable at the ordinary income tax rate.

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Q: What about deductible IRAs?

A: With a deductible IRA, you have no tax basis in the account, since your contributions were deducted on the front end. So every dollar you withdraw is 100% taxable.

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Q: I’ve heard that a Roth is good for estate planning. Why is that?

A: Because there is no age when you need to take minimum distributions. So, if you don’t need the money, you can allow the money in your Roth continue to accumulate indefinitely. Indeed, as the law is currently written, the account can pass directly to your heirs when you die. At that point, the account could be subject to estate taxes but not to income taxes. However, some experts believe Congress might restrict the ability to leave Roth IRAs to heirs if, as expected, it passes a technical corrections bill later this year.

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Q: How do I open a Roth?

A: It’s just like opening a regular IRA. You can go to virtually any financial institution--bank, savings and loan, brokerage firm or mutual fund company. They’ll have you fill out some paperwork to establish the account. (Copies of your IRA documents, incidentally, are shared with the IRS to keep you honest.) You give them a check. They open an account. You direct how the money is invested.