Roth IRA Basics

The Taxpayer Relief Act of 1997 introduced a new Individual Retirement Account (IRA) called the Roth IRA. The primary inducement to make contributions to the new Roth IRA is that distributions are tax-free if certain conditions are met. One drawback to the Roth IRA is that contributions to the account are never deductible. Let's take a look at this new IRA and some of the rules that go along with it.

For 2006 an individual may contribute up to $4,000 a year to a Roth IRA (less any contribution made to a traditional IRA) PLUS a catch-up contribution of $1,000 if over 50. Contributions to Roth IRAs are not deductible and must be in cash when made. In addition, unlike regular IRAs, there is no age restriction on making contributions. The Adjusted Gross Income (AGI) threshold for contributing to a Roth IRA is $95,000 for single individuals and $150,000 for married individuals filing a joint return. For single filers, the allowed contribution is phased out for AGI between $95,000 and $110,000. For married individuals, the allowed contribution is reduced proportionately if AGI is between $150,000 and $160,000. No Roth IRA contributions are allowed if an individual is married and files separately.

The earnings attributable to contributions accumulate on a tax-deferred basis and become tax free and penalty free upon withdrawal providing the Roth IRA has been in effect for at least five years and the taxpayer:

• has attained the age 59 ½,
• dies or becomes disabled, or
• is a "qualified first-time home buyer" using the distribution in the purchase of a primary residence.

Distributions from a Roth IRA that has been in effect for at least five years and are taken for any of the above reasons are known as "qualified distributions." Qualified distributions are not includible in taxable income. Now for the tricky part, distributions that are taken from Roth IRAs before any of the events specified above are met are deemed "non-qualified distributions." Non-qualified distributions will be taxable and potentially exposed to the 10% penalty to the extent the distribution includes earnings.

Unlike traditional IRAs, there is no requirement to begin distributions from a Roth IRA at age 70 ½. An individual can continue to defer tax on Roth IRA earnings for their entire lifetime. The traditional IRA required minimum distribution rules do apply to the beneficiary of a Roth IRA following the passing of the Roth IRA participant. Thus, a beneficiary can continue to defer tax on Roth IRA earnings but the beneficiary is subject to minimum distribution requirements.

A traditional IRA may roll over (or simply convert) all or part of the assets into a Roth IRA if an individual's Adjusted Gross Income (AGI) is not more than $100,000 for the year of the conversion (or rollover). The $100,000 AGI limit is determined without regard to any amount included as a result of the conversion and is applicable to single and joint taxpayers. Withdrawals from a traditional IRA that are converted into a Roth IRA are not subject to the 10% penalty tax. However, the full amount of the conversion may be subject to taxation.

In deciding whether to make contributions to a traditional IRA or a Roth IRA, a taxpayer should take into account a number of factors. Some of these factors are eligibility to make contributions, the number of years to accumulate earnings, the time projected to begin distributions and current versus future tax brackets. A taxpayer must consider whether the current deduction of contributions to a traditional IRA is more valuable than the future recovery of earnings tax free.

Features and Benefits

• All earnings accumulate tax-free, provided certain distribution requirements are met.
• Contributions can continue after the investor reaches age 70 1/2
• Can be established in conjunction with a Traditional IRA or a Coverdell Education Savings Account (formerly the Education IRA).
• No taxes or penalties on withdrawals will be assessed if the account has been opened at least five years and the individual is at least age 59 1/2, is permanently disabled, is using money for a first home purchase ($10,000 life time cap), or has died. Penalty free withdrawals can also include higher education expenses.

Eligibility Requirements

• Any wage earning individual, even if over age 70 1/2, whose adjusted gross income (AGI) is under $110,000 (single) and $160,000 (married filing jointly) may contribute. Individuals with AGIs between $95,000-$110,000 (single) and $150,000-$160,000 (married filing jointly) can make partial contributions.
• You may be eligible to convert a Traditional IRA to a Roth Conversion IRA if your AGI is $100,000 or less (single or married). Those who are married but file separate tax returns are not eligible to make a conversion.

Contributions

• Between 2005 and 2008, limits on annual contributions for participants under age 50 are scheduled to increase from $4,000 to $5,000. The new limits will apply to the total annual contribution that a participant makes to a Traditional or Roth IRA or both.
  

  Contribution Limits Table Click here

  Employed and non-employed spouses filing joint tax returns can each contribute up to the maximum contribution limit for that year in separate IRA accounts, provided their total earned income is not less than their total joint contribution.
• Participants who are age 50 or older, can take advantage of additional catch-up contributions to their IRA plans.
• Contributions are not tax deductible.
• Eligible lower income tax payers can claim a tax credit for contributions made to the plan for tax years beginning in 2002 and ending in 2006.
• The contribution deadline is your tax filing deadline (usually April 15th), with no extensions.

*Contribution limits were established by the Economic Growth and Tax Relief Reconciliation Act of 2001 (click here) . Several states have not yet passed legislation to confirm their income tax laws with the provisions of the Act, including the increases in benefit and contribution limits. In order to determine whether your state has adopted conforming laws, you should contact us at Advanced Corporate Planning (click here) or your tax or financial advisor .

Distributions

Distributions are not subject to a 10% federal tax penalty if the individual:

• receives the distribution after age 59 1/2;
• uses the distribution (up to $10,000) to purchase a first-time home;
• uses the distribution for qualified education expenses;
• takes lifetime equal periodic payments;
• uses the distribution for health insurance during unemployment lasting at least 12 weeks; or
• uses the distribution for deductible medical expenses.
• becomes permanently disabled; or
• expires.

all other distributions before age 59 1/2 are subject to a 10% tax penalty and federal income tax.

Required distributions must begin no later than April 1 following the year in which the participant reaches age 70 1/2.

Of course, this brief article is no substitute for a careful examination of all of the advantages and disadvantages of this matter in light of your unique personal financial circumstances. Before implementing a financial planning strategy, contact and consult with your Financial Advisor and tax professional.