Roth IRAs: A Good Deal Just Got Better

One of the most pressing problems in the U.S. today is the fate of the Social Security system. Many workers are concerned that it will be bankrupt when they reach retirement age. An alternative is for a taxpayer to provide for his own retirement. However, it is difficult to accumulate substantial sums for retirement during working years and even if savings are possible, they are greatly diminished by taxation.

Financial vehicles, such as traditional IRAs, simplified employee pensions (SEPs), savings incentive match plans for employees (SIMPLEs), and Keogh plans, as well as Sec. 401(k) plans, are available and offer tax deductibility to qualified taxpayers. These methods are very effective in helping taxpayers to accumulate resources to fund their retirement. Income on traditional and nondeductible IRAs, SEPs, SIMPLEs, Keoghs and Sec. 401(k) plans and other deferred accounts are taxed on withdrawal. At the taxpayer's death, if left to nonspousal beneficiaries, deferral ends and these items are fully taxable.

Withdrawal from these types of investments, even after a taxpayer reaches age 59¹/2, should be done only as a last resort. If other sources are available, they should be used before any of these deferred accounts because, if left to accumulate, the tax-deferred accounts will do so tax-free until withdrawal. If a taxpayer has nonretirement savings available, the withdrawal of these funds would not create a taxable event, because the taxpayer has already paid the tax. Given that, the taxpayer should use these funds first.

Effective for tax years beginning in 1998, Congress created a new retirement investment, the Roth IRA, which is treated in the same manner as an IRA, except that contributions are not tax-deductible; after a five-year waiting period, withdrawals of both contributions and income are tax-free. Contributions can accumulate for an unlimited period, earning considerable income, on which nobody will ever pay tax. There are no required minimum withdrawals at age 70¹/2 as with traditional IRAs, allowing a Roth to remain intact as long as desired. In the event of a taxpayer's death, the Roth IRA will be included in his estate for estate tax purposes, but neither he nor his heirs will pay tax on it.

The rules on Roth IRAs are:

1. The maximum contribution is $2,000 per working year, increasing to $5,000 by 2008. The maximum amount that a taxpayer can contribute to a combination of the traditional and Roth IRA is an aggregate of $2,000 in 2001, increasing to $5,000 in 2008.

2. Taxpayers can make contributions after age 70¹/2.

3. For single taxpayers, income limits and phaseouts are adjusted gross income (AGI) of $95,000–$110,000; for married filing jointly, it is an AGI of $150,000–$160,000 and for married filing separately, $0–$10,000.

4. Distributions must be qualified for the nontaxable provisions to apply. The requirements for a qualified distribution are a five-year holding period and:

• The individual attains age 59¹/2 on or after the distribution date;
• A beneficiary (or the individual's estate) receives payments on or after the individual's death;
• The individual is disabled; or
• The individual has "qualified" first-time homebuyer expenses.

Even if the distribution is not "qualified," it may escape the usual 10% early withdrawal penalty if it satisfies one of the exceptions for traditional IRAs, which are medical insurance premiums, educational expenses and first-time homebuyer expenses.

Example 1: B, a widow, is left with an IRA. She is age 62 and has four adult children. She wishes to help her children, but is subject to tax whenever a withdrawal is made from the IRA. Her income is $30,000, including $10,000 Social Security. Her filing status is single and she has no dependents. B's tax is calculated as follows:

   

Example 2: The facts are the same as in Example 1, except B withdraws $9,000 from her traditional IRA to help her children with various needs.

The tax impact on B is substantial. The amount withdrawn is not only taxable, it can push B into a higher tax bracket, and possibly cause some or more of her Social Security benefits to be taxed. In Example 2, B's cost of the $9,000 withdrawal from her traditional IRA was 22.6% of the withdrawal itself. Not only did she have to include the $9,000 withdrawal in her AGI, but she also had to include $4,500 of her Social Security benefits, which otherwise would have been tax-free. Therefore, B increased her AGI by $13,500, not just by the $9,000 withdrawal.

Because a withdrawal from a Roth IRA is tax-free, B could have saved $2,035 or she could have given her children $11,035 instead of $9,000. If MAGI is greater than $34,000, 85% of the Social Security benefits would be taxed.

The true advantage of Roth IRAs is the fact that a taxpayer can create a tax-free pot of money on which he can draw any time after age 59¹/2 (or the exceptions listed), providing he invests the principal for at least five years. This allows the taxpayer to use tax-free money first, leaving his taxable pensions and traditional IRAs beyond the required withdrawal amounts, to accumulate and grow for future use. There is no required minimum withdrawal for Roth IRAs as there is with traditional IRAs and, therefore, the taxpayer can leave his Roth IRA intact for his beneficiaries, with no tax impact on either the taxpayer or his heirs.

In light of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Roth IRAs are even more attractive, because the maximum contributions will continue to increase until they reach $5,000 in 2008. They will also be indexed for inflation in annual increments of $500 thereafter. Additionally, the EGTRRA allows taxpayers, 50 years old and older, with earned income to make "catch-up" contributions, by increasing their contribution to make up for years in which they were able to save only small amounts or nothing. This additional amount will be $500, increasing to $1,000 per year.

Example 3: C, who is 42 years old, invests $2,000 per year in a Roth IRA for 20 years at a rate of 10%. At 62, he will have $126,005.

Example 4: The facts are the same as in Example 3, except C invests $5,000 per year for 20 years. At 62, he will have $315,012.

Example 5: C is 22. He contributes $2,000 to a Roth IRA each year for 40 years at 10% interest. At age 62 he will have $973,704.

Example 6: C is 22 in 2008. He contributes $5,000 a year, at 10% interest for 40 years. Under the EGTRRA, he will have $2,434,259 when he is 62.

Because C is over 59¹/2, he can withdraw any amount from his Roth IRA at any time, with no penalty and no tax impact. He is not required to make mandatory minimum withdrawals at age 70¹/2 and, at his death, both his spouse and any other heirs can leave the account intact and it could continue to grow tax-free.

If C had invested in traditional IRAs, the future values would be the same because of the EGTRRA, but the amounts would be fully taxable. Further, at age 70¹/2, C would have to take minimum withdrawals and, at his death, his nonspousal heirs would have to withdraw the full amount within five years.

The theory is that taxpayers will save taxes on the amounts they invest during their working years, when presumably they will be in a higher tax bracket than when they retire.

Although taxpayers make Roth IRA contributions with after-tax dollars, the future value of tax-free accumulations and distributions far outweigh the value of current deductions. This pool of tax-free money can be used to help children buy homes, finance their education or provide for other needs without creating a tax burden on the parent. The taxpayer also has the option of financing his own retirement tax-free or may use this resource for traveling or other "extras."

Wise planning early can result in many happy and profitable returns later.

From Helen LaFrancois, CPA, MBA, MST, University of Massachusetts, North Dartmouth, MA (Not affiliated with DFK International)