RECENT DEVELOPMENTS

Affecting Oil & Gas Investment, Securities Laws and Taxation

March/April, 1998 - Vol. 3, No. 2

THE ROTH IRA

Part One:  A Roth IRA Primer

By Phillip S. Stenger, Esq., and David A. Tutas, Esq.

Stenger & Stenger

What Is A Roth IRA?

The Taxpayer Relief Act of 1997 (the "1997 Act") was applauded by many taxpayers for its reduction in the capital gains rate. Perhaps as significant as the reduction in capital gains rate is the introduction of the Roth IRA.¹ In this first part of our series on the Roth IRA, we will examine the general provisions of Roth IRAs. In future articles we will explore planning opportunities with Roth IRAs.

Prior to the 1997 Act, there was only one type of Individual Retirement Account ("IRA"). The standard IRA has the following characteristics:

• Contributions must be made from W-2 or self-employment income;
• Generally the taxpayer can deduct up to $2,000 per year ($4,000 for married taxpayers filing joint returns provided both spouses have earned income);²
• Earnings on the money in the IRA are tax deferred as long as the money remains in the IRA;
• Earnings on contributions are includible in gross income when distributed;
• Distributions are allowed penalty free after age 59 ½; and
• Mandatory distributions must commence by April 1 of the year after a taxpayer reaches the age of 70 ½.

There is good news and bad news when it comes to Roth IRAs.  We will start with the bad news. The bad news is that contributions to Roth IRAs are not deductible. The good news is really good news  the earnings on Roth IRAs are not taxed  ever  not even when the money is taken out of the IRA.  That is powerful! In addition, the Roth IRA does not have a mandatory withdrawal requirement. As a result, an individual does not ever have to tap into the account.

Contributions

Like the regular IRA, the maximum contribution to a Roth IRA is $2,000 per year per individual (for a married couple, each spouse can contribute $2,000). A phase-out on the maximum contribution begins for taxpayers whose adjusted gross income ("AGI") exceeds $95,000 on a single return and $150,000 on a joint return. Taxpayers are not eligible to make Roth IRA contributions once their AGI reaches $110,00 (single) or $160,000 (joint).³ Conceivably, an individual can make contributions to both an ordinary IRA and a Roth IRA in the same year. The total maximum amount, though, that an individual can contribute to all of his or hers IRAs is $2,000. Senator Roth has been lobbying to increase the maximum annual contribution limit and to remove the income limits on Roth IRAs.

Distributions

Withdrawals from a Roth IRA are not includible in gross income if the withdrawal meets the definition of a "qualified distribution" under Section 408A(d)(1)(A) of the Tax Code. A qualified distribution is one made after the five-tax-year period beginning with the first tax year in which the individual (or individual's spouse) made a contribution and which is made:

• On or after the individual becomes 59 ½;
• After the death of the individual;
• After the individual becomes disabled; or
• For a "qualified special purpose distribution" which includes $10,000 of first time home buyer expenses.

 As is the case for an ordinary IRA, an individual has until the due date for filing his or her federal income tax return (normally April 15^th) to establish and fund a Roth IRA for the previous tax year. The first tax year in which contributions can be made is 1998. The five-year holding period is considered to start on January 1 of the year in which the first contribution to a Roth IRA is made.  The holding period, therefore, does not necessarily begin on the date of actual contribution.  Consequently, if a taxpayer made a contribution on April 15, 1999, he or she could make a tax free earnings withdrawal anytime after December 31, 2002 (assuming that the taxpayer was over the age of 59 ½ at the time of the withdrawal).

Unlike an ordinary IRA, where distributions from the account must begin no later than age 70 ½, there is no mandatory age when distributions must begin for a Roth IRA.  

For retirees who have ample savings to live on, a Roth IRA can act as an estate planning device.  They can leave their Roth IRA accounts untouched and when they die the balances transfer to the named beneficiaries income-tax free.

Moreover, because contributions are not deductible, they can be withdrawn anytime tax free and penalty free. Consequently, Roth IRAs can be used for pre-retirement savings. For instance, if a husband and wife, who file jointly, together contribute $4,000 a year for 10 years, in year 10 they can pull out the $40,000 in contributions tax and penalty free, while the earnings continue to grow tax and penalty free.

Nonqualified distributions of earnings are subject to income tax.  Further, like ordinary IRAs, distributions of earnings before the age of 59 ½ are subject to a 10% penalty/excise tax.

Conversion

Taxpayers are allowed to convert ordinary IRAs into Roth IRAs. However, to be eligible to convert, the taxpayer's AGI, whether a single or joint filer, must not exceed $100,000.⁴ (Individuals who are married and file separately are not eligible to convert).  If all of the contributions to the ordinary IRA were deducted, the full amount of the conversion is subject to income tax in the year of the conversion. While the conversion amount is includible in taxable income, it does not count towards the $100,000 AGI threshold.  Congress has provided some relief for those who convert quickly. For conversions made prior to January 1, 1999, the conversion amount that would have been includible in gross income for 1998 can be reported and paid ratably over 4 years beginning with 1998.  For many taxpayers, future tax free gains in a Roth IRA may far outweigh the income tax cost of conversion from an ordinary IRA.

Conclusion

The Roth IRA is a taxpayer friendly creation that is certain to garner more scrutiny in the future. Some employers are already considering letting employees contribute to Roth IRAs via payroll deductions.  Assuming Congress does not materially alter Roth IRAs, ordinary IRAs may become an anachronistic relic of the past.

The information contained in this article is not tax or legal advice and the authors recommend that you consult your legal or tax adviser to determine whether and how a Roth IRA can benefit you.

¹Named after current Senate Finance Committee Chairman, William Roth (R-Del.).

²Contributions are only partly deductible (or not deductible at all) for taxpayers who are active participants in an employer-sponsored pension plan (e.g., a 401(k) plan) and whose incomes fall within a specified phase-out range (for single taxpayers the deduction is phased out if AGI is between $125,000 and $135,000 and for married individuals, deductions are phased out if AGI is between $140,000 and $150,000). Subject to certain limitations, taxpayers who cannot make the full deductible contribution can make a nondeductible contribution as long as the total contribution for a tax year does not exceed $2,000.

³Editor's Note: For a discussion of the use of drilling investments to avoid this phase-out, see Jeanne Stilwell's article on "Don't Let Your Clients Be Left Out in the Cold," in the "Marketing Strategies" portion of this "Oil & Gas Investment" section of the Newsletter.

⁴Editor's Note: Again, for a discussion of avoiding such AGI phase-outs, see Jeanne Stilwell's article cited in note 3.

For Further Information, contact:

Phillip S. Stenger, Esq.

4141 Embassy S.E.

Grand Rapids, MI 49546

616-940-1190

616-940-1192 (fax)

Website: www.stengerlaw.com

E-mail: mail@stengerlaw.com

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