Roth IRA: Back To Basics

by Denise Appleby,CISP, CRC, CRPS, CRSP, APA (Contact Author | Biography)

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Since its introduction under the Taxpayer Relief Act of 1997, the Roth IRA - in which earnings accrue tax free - has become a popular retirement and estate-planning tool among U.S. taxpayers. According to a study done by the Investment Company Institute, Roth IRA assets increased to $178 billion as of December 2006. However, many individuals are prevented from participating in the Roth IRA because of the stringent qualification requirements. Here we revisit some of these requirements and explore some qualification opportunities that may be available to certain individuals.

Ways of Funding a Roth IRA
A Roth IRA may be funded through regular IRA contributions and assets converted from existing Traditional, SEP or SIMPLE IRAs. To make regular IRA contributions, an individual must have eligible compensation for the year and must meet the following requirements:

If an individual's tax-filing status is 'single', his or her modified adjusted gross income (MAGI) must not exceed $116,000. An individual filing single may contribute up to $5,000 + catch-up for 2008 if his or her MAGI is less than $101,000. For individuals whose MAGI is between $101,000 and $116,000, the contribution limit is 'phased out'. This means a special formula must be used to determine the dollar amount that such individuals may contribute to the Roth IRA for the year. (The formula and step-by-step instructions are included in the chapter "Eligibility Requirements" in the tutorial Roth IRAs.)
If an individual's tax-filing status is 'married filing jointly', the combined MAGI of both spouses should not exceed $169,000. Each spouse may contribute up to $5,000+ catch-up if their combined MAGI is not more than $159,000. If the couple's MAGI is between $159,000 and $169,000, the contribution limit is phased out.
If an individual's tax-filing status is 'married filing separately', his or her MAGI must not exceed $10,000. If his or her MAGI is between $0 and $10,000, the contribution limit is phased out.

To fund a Roth IRA by means of Roth IRA conversions, an individual's MAGI must be $100,000 or less. This limit applies to individuals who file as single and those who file as married filing jointly. Individuals who file as married filing separately are not eligible for Roth IRA conversions.

Tip: If you fall within the phase-out range, you may still find it in your best interests to seize the opportunity to fund the Roth IRA. In most cases, analysis shows that the benefit of funding the Roth IRA, at any allowable amount, outweighs the benefits of funding the Traditional IRA.

RMD May No Longer Be Included in MAGI after 2004
Up to the end of 2004, many taxpayers of RMD age were ineligible to convert to a Roth IRA because their RMD amounts were added to their MAGI, causing their MAGI to exceed the $100,000 limit. This rule requiring the MAGI to include RMD amounts from Traditional, SEP and SIMPLE IRAs no longer applies to RMD for tax years beginning Jan 1, 2005.

Tip: If you are unable to determine if your MAGI will exceed $100,000, you may wait until the next year to do your Roth conversion. On the other hand, you may convert the assets in the current year, and if it is determined that you are ineligible, the amount can be recharacterized to the Traditional IRA.

Starting the Five-Year Clock
The benefit of funding a Roth IRA instead of a Traditional IRA is the possibility of tax-free distributions. However, Roth IRA distributions are tax free only if they are qualified. (For more on the definition of a qualified Roth IRA distribution, see Tax Treatment of Roth IRA Distributions.)

To increase the chances of a Roth IRA distribution being qualified, an individual will want to determine the earliest possible start date of the five-year qualifying clock. For an individual who has more than one Roth IRA, the five-year clock usually starts with the Roth IRA that received the earlier funding. The phrase 'to receive earlier funding' means something different than the term 'to be the first that was funded'. The following example illustrates:

Example
Jane established Roth IRA #1 in Jan 2008, and she converted her Traditional IRA assets to Roth IRA #1 in 2008. Jane later established Roth IRA #2 in Apr 2008, and on Apr 15, 2008, Jane made a contribution for 2007 to Roth IRA #2.

Jane's five-year clock starts not in 2008 - the year in which she funded her first IRA - but in 2007, the first year to which the funding of her Roth IRAs applies.

Individuals whose income falls within the phase-out ranges may want to consider still contributing the reduced phase-out amount in order to get the five-year clock started. (For details on the tax treatment of qualified and nonqualified Roth IRA distributions, see the article Tax Treatment of Roth IRA Distributions.)

Tip: Maintaining one Roth IRA for all conversions and contributions instead of multiple Roth IRAs may help reduce administrative and trade-related expenses. However, if you suspect that you may not be eligible to make the necessary type of transaction (a conversion or contribution) in a particular year, before putting the assets into one existing Roth IRA, you can maintain the assets in a separate Roth IRA until the eligibility is determined. Should you find that you are ineligible for the contribution or conversion, maintaining separate Roth IRAs will help eliminate the complex process of determining the net income attributable to the amount that needs to be recharacterized? (You can read more about this in the article Recharacterizing Your IRA Contribution or Roth Conversion?)

Excess Contributions and Recharacterizations Do Not Start the Five-Year Clock
During the year individuals may want to contribute to their Roth IRA but are unsure of whether their income will exceed the limits. These individuals should not be deterred from funding their Roth IRAs: corrections can be made through recharacterization or a removal of excess contributions. Individuals should note, however, that Roth IRA contributions or conversions that are recharacterized or removed as a return of excess contributions do not start the five-year clock. Instead, for tax purposes, these amounts are treated as if they were never contributed to the Roth IRA.

Tip: If you converted your Roth IRA and the value has since declined, you may want to consider recharacterizing the amount and then reconverting the amount at a lower value. This reduces the taxable income from the conversion. There is a risk with this practice, however, because when you become eligible to reconvert, the assets might have since significantly increased in value. Also, if your income exceeds limitations or your tax-filing status changes to married filing separately, you may not become eligible for the reconversion. (For more on conversion and reconversion rules, see Did Your Roth IRA Conversion Pass or Fail?)

Conclusion
During the last quarter of the tax year, when you, like many others, finalize your financial plans for the current year and explore opportunities for the upcoming year, you may want to revisit the eligibility rules for the Roth IRA as well as its features and benefits. But like any financial decision, deciding to own a Roth IRA requires careful consideration. While the Roth IRA is an attractive financial and estate-planning tool, it may not be suitable for everyone. If possible, conduct your own research and talk to at least two financial planners, preferably from different firms, about how the Roth IRA fits into your financial profile. Ask for an analysis, pros and cons, and detailed explanations of any recommendations you are given.

by Denise Appleby (Contact Author | Biography)

Denise Appleby is a retirement plans consultant, freelance writer and editor. Before starting her own business, Appleby Retirement Consulting, Denise worked for Pershing LLC for almost 10 years. While at Pershing, Denise rose to the rank of vice president, and held many positions including retirement plans product manager, manager of the retirement plans technical assistance group and retirement plans training manager. Appleby Retirement Consulting provides technical assistance to financial institutions and financial professionals; content for newsletters, websites and magazines; and technical editing services for books and other retirement plans material. Denise holds several retirement professional designations.

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