|Choosing Between a Roth IRA
and Regular IRA
There are three factors that will influence your decision as to which kind of IRA to choose: Eligibility, Flexibility, and Value. These three factors are discussed below. Many financial planners and institutions with products to sell are pushing Roth IRAs as a wonderful new investment product that everyone should have. You probably have seen their "IRA Calculators", perhaps on the web. No matter what question you ask, the answer always seems to be "Roth IRA." To put some perspective on the choice and to give you a more objective opinion, I have listed some points that may have been overlooked in your analysis. This financial planning tool was originally supposed to be a simple device for individuals to use to save for retirement. However, my professional tax reference service now lists 77 pages of analysis for the Roth IRA. The IRS has announced more changes in several. Notices and Announcements as well as issuing proposed regulations responding to questions, among others, regarding whether an amount may be recharacterized and later reconverted from a traditional IRA back to a Roth IRA. A detailed discussion of these updates, the mechanics of compliance with the Roth IRA rules, and examples can be found at Kaspercpa.com on Taxation of Roth IRA Distributions. There is also a site, www.rothira.com.
You may also purchase my "IRA
Analyzer" to answer questions such as which type of IRA offers the best tax
advantage. It computes the anticipated tax on the rollover (if any). Learn how much money
will accumulate from your contributions for any retirement age, and what will be your
required minimum distributions over your expected lifetime if you have a regular
(traditional) IRA. Several options provide real "what if" scenarios. You may
choose your retirement date, distribution beginning date, vary your life expectancy
assumption to recompute your life expectancy each year or keep the expected life value at
the time of your first distribution. You select the earnings rate for your IRA, and the
marginal tax rate during accumulation and retirement. Finally, the program helps you to
decide how to pay the tax on the rollover, by liquidating existing funds, borrowing, or
the IRA itself.
Eligibility. Conversions. Assuming the taxpayer meets certain Adjusted Gross Income requirements discussed below, amounts held in a SEP IRA or a SIMPLE IRA may generally be converted to a Roth IRA. Amounts held in retirement plans other than IRAs (e.g. 401(a), 401(k). and 403(b) Plans) cannot be directly converted to a Roth IRA. They can be transferred to a Roth only after first obtaining a tax-free transfer to a regular IRA as a conduit IRA.
To rollover (convert) your investments from a regular IRA to a Roth IRA, you must have (Modified) Adjusted Gross Income (MAGI) of less than $100,000 for the year of the rollover (determined before any amount is included in income as a result of the rollover), and if married, file a joint return. Single filers and Head of Households are also subject to this same AGI limit. Unfortunately for married taxpayers, this limitation applies to the MAGI on the joint return, and not the incomes of the individual spouses. Thus even though neither spouse may have MAGI of this amount, if the combined MAGI exceeds the $100,000 limit, no conversion is allowed. However, married taxpayers who lived apart the entire year will not be treated as married for the year of the conversion and will each be subject to the $100,000 limit if a separate return is filed (Reg. §1.408A-4, Q&A-2). The $100,000 MAGI limit applies to the MAGI of the year the distribution or rollover from a regular IRA is made. This MAGI limitation for conversions should not be confused with the AGI limits for making contributions. ( But see Updates.)
Modified Adjusted Gross Income (MAGI). Modified Adjusted Gross Income is defined the same as the taxpayer's AGI for purposes of the regular IRA for determining the maximum income for deductions. It is the taxpayer's AGI, excluding the amount recognized as a result of rollover conversions to the Roth IRA (408A(d)(3)). Any required minimum distribution from an IRA is included in income but any deductible contribution is disregarded (Reg. §1.408A-3, Q&A-5). Taxable Social Security is determined without regard to the IRA deduction to a regular IRA, foreign income and housing exclusion, or the exclusion for interest from Series EE savings bonds.
Contributions. For married couples filing a joint return, a spouse who is not an active participant in a company plan, may contribute up to $4000 to a regular deductible IRA if the MAGI of the joint return does not exceed $150,000. There is a phase-out of roughly $200 of deductible contribution for each $1000 above $150,000 until no deduction is allowed for MAGI of $160,000. (The phase-out begins at $95,000 and is completely gone at $110,000 for single filers.) If a spouse is covered by an employer plan, the phase-out for the employed and covered spouse begins at a combined MAGI of $75,000 in 2006 and is completely eliminated at a MAGI of $85,000; for single taxpayers, $50,000 in 2006). Note that even if one spouse is covered, the other nonparticipating spouse may take a deduction as long as the MAGI is less than $160,000. Either spouse may make a nondeductible contribution to a Roth IRA as long as the joint MAGI is less than $160,000. There is no AGI limit for a nondeductible regular IRA contribution. If a spouse is a nonworking spouse, the MAGI limits for the regular deductible IRA is $150,000 as if he or she were not covered by a plan. It is irrelevant for Roth contribution income limits whether a spouse or the taxpayer is covered by an employer plan. However, single taxpayers have a higher income limit ($95,000-110,000) to a Roth IRA than for a deductible traditional IRA.
However, the most that can be contributed is the combined compensation earned by the couple reduced by the contribution by the working spouse. The total cannot exceed $8000 for the couple. The contribution for a nonworking spouse may be made to either a Roth or regular IRA. The deductibility depends upon the MAGI as above. The most (base) that can be contributed to all IRAs for any one spouse is $4000. Thus, if a taxpayer is limited by either the deductible IRA or Roth limits, the balance of the $4000 can be contributed to a nondeductible IRA. Contributions to SEP IRAs, SIMPLE IRAs, and Education IRAs are disregarded entirely in determining the $4000 limits.
For married persons filing separate returns, a limited option of making a
contribution to a regular IRA exists, but the maximum deductible contribution of $4000 is
phased-out for AGI between 0 and $10,000 MAGI. The Act conforms the Roth to the regular
IRA for separate returns.
The five-year holding period begins with the first day of the tax year that the contribution relates and not the actual date of the contribution. Contributions as late as April 15 (due date of return, excluding extensions) will be considered as contributions for the prior year if so designated. For a more detailed discussion, see Taxation of Roth IRA Distributions.
Probably the most valid of the touted benefits of the Roth IRA is the ability to permanently defer the recognition of any income while the owner is alive. Many people simply wish to accumulate wealth and do not ever need to withdraw funds from the IRA. The earnings continue to accumulate tax-free until death. With a traditional, regular IRA, these same people would delay the first distribution to the first tax year after they reach age 70½ and recompute the life expectancy each year. Now, with a Roth IRA, distributions do not have to be made during the owners lifetime. However if one does wish to make distributions during the owners (and a beneficiarys) lifetime, all income will be tax-free with a Roth IRA (assuming the Roth IRA was held for the 5-year period). With a regular IRA, only a pro rata amount is tax-free depending upon the amount of nondeductible contributions (basis in tax terms) in the account at the time the distributions are made (The technical calculations are somewhat more precise than this.). This may or may not be a benefit as discussed below.
With a Roth IRA, contributions may be made after age 70 ½ as long as an individual has earned compensation or receives alimony. With a regular IRA, contributions cannot be made after the latest time for making distributions. This benefit is likely to appeal mostly to self-employeds, or individuals who continue to work.
Taxation of Distributions from Roth IRA
Qualified distributions from a Roth IRA are not includible in income or subject to the 10% early withdrawal penalty. A qualified distribution is a distribution to an owner after the owner has reached age 59 1/2 (or who is disabled, a first-time home buyer, or in the case of a beneficiary of the estate, death) and the Roth IRA has been funded for a 5-year period, beginning on the first day of the tax year in which a conversion from a regular IRA is made or for which a contribution is made, and ending with the last day of the 5th year from the beginning year . If the distribution is made to a beneficiary of the estate of the owner, the period held by the decedent is included in the period held by the beneficiary to determine whether the 5-year period is satisfied (408A(d)(2)(A) and Reg. §1.408A-6, Q&A-1(b)).
A withdrawal from a Roth IRA is treated as made first from direct contributions to the Roth IRA, then from conversion contributions (first-in first-out, or FIFO, basis), and then from earnings in the Roth IRA in the order specified below under Nonqualified Distributions.
Holding Periods. Each Roth owner has only one 5-year period for purposes of determining qualified distributions (Reg. §1.408A-6, Q&A-2). An individual's 5-year period begins with the first tax year for which a contribution is made for any Roth IRA (408A(d)(2)(B))). A conversion of a regular IRA into a Roth IRA after the five-year period has begun will not start the running of a new 5-year period for purposes of determining whether the distribution is a qualified distribution (S Rept No 105-174 (P.L. 105-206, i.e, the '98 Act). See Taxation of Roth IRA Distributions for additional detail and examples.
Penalties: If the distribution is a qualified distribution, i.e., both the distribution conditions (age 59½, disability, death, or special purpose) and 5-year holding period for the conversion are met, no penalty is assessed because it is a qualified distribution. See Taxation of Roth IRA Distributions for additional detail and examples.
Nonqualified distributions are taxable to the extent the amount of the
distributions, added to all prior distributions less prior amounts that were includible in
income, exceed the direct Roth contributions. See Taxation
of Roth IRA Distributions for additional detail and examples.
Value. Most financial planners view the Roth IRA as the ultimate tax shelter; a "no-brainer" situation. Even professional literature seems to embrace this opinion. Commerce Clearing Houses Tax Week, October 15, 1997 advises, "Therefore, while some of your clients may lose the tax deduction that they might otherwise obtain by making a contribution to a regular IRA, over the long run they will probably achieve a greater tax savings because their withdrawals from the Roth IRA will be tax-free." The truth is, it is not that automatic. It depends upon the tax-brackets one assumes will be in effect during the period of employment (and hence contributions) and withdrawal (retirement distributions), and whether the contributions were deductible. If for instance, one assumes that the contributions to a regular IRA are fully deductible, and that one intends to withdraw the funds over the lifetime of the owner, then there is no tax advantage to either IRA if the marginal tax-brackets are the same during the period of accumulation and distribution. What does happen however is the tax burden is shifted to the heirs with a regular IRA, if one dies before living ones "expected life, which might be just fine with a lot of people. On the other hand if you want to pay your heirs taxes while you are alive, then a Roth may make sense to you. On the other hand, depending upon your tax bracket, it may also make economic sense to pay those taxes (see below).
Most financial planners and "Roth IRA Calculators" make some assumptions that slant the calculations and assumptions in favor of the Roth IRA. For instance, one well-known institutions assumption is that contributions are made at the beginning of the year, but any tax benefit occurs at the end of the year. This assumption will always show the Roth IRA better, exactly by the amount of a one-period compound growth factor. In other words, it is not the Roth IRA, but the compounding assumption that makes the difference. A more realistic assumption is that the contribution and tax savings occur at the same time. Most people wait to the last moment to make the contribution. Alternatively, if one assumes that one were savvy and reduced the withholding or estimates to anticipate the tax saving from investing in a regular IRA, and invested at the beginning of the year, the compound interest effect is also removed. Again, if the taxpayer were in the same tax bracket before and after retirement, there would be no benefit or advantage to either IRA.
Another method that financial planners use to distort the benefits of the Roth IRA is to show the terminal values accumulated at a particular point in time. Although theoretically correct, to show a fair comparison, this method must provide for the reinvestment of the annual tax savings each year for the deductible IRA, which is usually not done, or only footnoted as a possibility.
A better method of comparing the Roth and deductible regular IRA, is to look at the present value of the tax savings and compare this figure to the present value of the tax cost during the lifetime of the taxpayer. If the present value of the additional tax paid during accumulation (present value of the tax cost) from making nondeductible Roth IRA contributions is less than the present value of the taxes to be paid in retirement on distributions from a fully taxable regular IRA, then a Roth IRA is better.
What about the Roth conversion? If one decides that a Roth IRA is the best choice, because of the four-year deferral for paying the tax on the accumulation in the regular IRA, one should have done the conversion in the 1998 tax year. Indeed, this may be the only benefit from the rollover. This benefit was available only in 1998. After that there may be no tax advantage to rolling over the funds.
Many people are reluctant to rollover the funds because they will need to use some of their funds to pay the tax, which intern will cause them to incur the penalty for an incomplete rollover. There are two solutions to this dilemma. First, one can use other funds to pay the tax if the after-tax cost of the funds is less than the penalty. This could be accomplished by selling low income producing investments, or borrowing the money at a low rate of interest. The second solution is to reserve enough of the regular IRA funds to pay the tax and penalty on the funds reserved to pay the tax. You will need to reserve approximately 110% of the anticipated tax on the rollover in the regular IRA. Do not plan to withdraw funds from the Roth IRA to pay the tax because the withdrawal will be subject to a 10% penalty in addition to the tax on the rollovera disaster. Did your advisor warn you of this?
My IRA Analyzer (see below) will calculate how much your can rollover if you intend to
pay the tax and penalty from the funds left in the regular IRA thereby avoiding the 10%
penalty from withdrawing funds form your new Roth IRA.
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