December 11, 1998

Top 10 Roth IRA Questions

Because of all of the mystery, intrigue, and general confusion regarding the Roth IRA, Dave Braze (a.k.a. TMF Pixy, Keeper of the Retirement Investing message folder) and Roy Lewis (a.k.a. TMF Taxes, who hangs around the Tax Strategies message folder) decided to provide, in question and answer form, the (drum roll please)...

Top 10 Roth IRA Questions (with answers)

These are questions that seem to be causing the most confusion and generating the greatest number of posts in our respective folders. Hopefully, with all of these items in one place, you'll be able to quickly find answers to your most commonly asked Roth IRA questions.

So, in no particular order�

1. Q: I have a company pension plan and contribute as much as I can to a 401(k) plan. Can I still contribute $2000 per year to a Roth IRA?

A: You sure can, as long as your Adjusted Gross Income (AGI) doesn't exceed the limits allowed for a Roth contribution for the year. Your participation in an employer-sponsored retirement plan has no effect on your ability to also contribute to a Roth IRA. Therefore, if your AGI is less than $95, 000 (single filer) or $150,000 (joint filer), you may make a full contribution to a Roth IRA.

2. Q: I converted my regular IRA to a Roth IRA back in January. I've just discovered that my Adjusted Gross Income will exceed the $100k conversion limitation this year. What should I do?

A: You are allowed to "recharacterize" your Roth IRA conversion back to a regular IRA without any penalty or tax. You are simply required to make this recharacterization prior to April 15 of the year following the year of the conversion.You are also required to "un-convert" not only your original conversion amount, but also any of the earnings generated by that original conversion. So, just because you go over the AGI limitation, all is not lost. Contact your broker and he should be able to help you with the recharacterization back to a regular IRA account.

3. Q: My daughter is 16 years old. Can she make a Roth IRA contribution?

A: Age is not a determining factor. As long as you have earned income with which to open the Roth IRA account, and as long as you are under the AGI limitations, you may make an IRA contribution regardless of your age.

4.Q: My father is 73 years old. Can he convert his regular IRA to a Roth IRA?

A: Again, as noted above, age is not a determing factor. If your dad's AGI is under the $100k limitation, he is eligible to make the conversion. Be aware, though, that your father has begun minimum required distributions (MRD) from his traditional IRA. Therefore, before he converts that regular IRA to a Roth, he must receive his MRD for that year. Whatever that amount is, it cannot be transferred to the Roth.

5. Q: I'm retired and drawing Social Security. Can I contribute part of my Social Security benefits to a Roth IRA account?

A: Nope. Sorry. In order to make a Roth IRA contribution, you must have earned income. Earned income is generally income that you receive from working as compensation for your labor in one form or another. It's reported to you on a W-2 form, or you file Schedule C (Business Income) with your normal tax return. Earned income generally does not include Social Security benefits, pensions, interest, dividends, rental income, or capital gains.

6. Q: I intend to retire at age 50. When I do, I'll need income. Can I take money from my Roth IRA without paying any taxes or penalties?

A: Potentially, yes. Under the IRS ordering rules, you are allowed to remove your original contributions at any time without tax or penalty. In addition, after you have waited at least five tax years, you are able to withdraw your original conversion amounts without taxes or penalties. It's only when you get to the earnings generated by the original contributions and conversions that you will have a tax and/or penalty problem.

And, even if you DO determine that you'll have to break into the earnings prior to age 59 �, you may still avoid the penalty (but not necessarily the tax). If you remove the funds from your Roth IRA account using a distribution method that is part of a scheduled series of substantially equal periodic payments made over your life expectancy (and the life expectancy of your beneficiary), you may still be penalty free.

7. Q: For income tax purposes, how do I report a conversion and/or an annual contribution to or a withdrawal from a Roth IRA?

A: Annual contributions to a Roth IRA are not reported on your federal income tax return. Conversions of a traditional IRA to or withdrawals from a Roth IRA during the tax-year are reported on Form 8606. The form and its instructions may be obtained from the Internal Revenue Service online at www.irs.gov.

The law says that if your Roth IRA conversion takes place BEFORE January 1, 1999, the amount required to be included in income as a result of the conversion MAY be included in gross income ratably over the four tax year period beginning with tax year 1998. Or, on the other hand, you may elect to take the conversion income all in 1998. The choice is yours. But remember that this "spread out" option only applies to conversions made on or before December 31, 1998. If you decide to make a Roth IRA conversion in 1999 or later, you are free to do so. But you'll be required to report the conversion income in the year of conversion in total. You'll lose the potential tax saving benefit of the "spread out" of the income.

And, finally, remember that spreading out the income is NOT the same as spreading out the "tax" on the conversion. This is a distinction with a big difference. Make sure that you are clear on the procedures prior to making your conversion.

8. Q: If I spread out my conversion income, will that income increase my Adjusted Gross Income (AGI) for the current and following years?

A: Absolutely. This income (spread out or not) WILL impact any and all tax issues that are based upon AGI� except for any current or future Roth contribution and/or conversion issues. But your medical expenses (7.5% AGI floor), miscellaneous deductions (2% AGI floor), taxability of social security (based upon AGI), passive loss limitations (based upon AGI) and many other tax provisions that use AGI as a guidepost will be affected. And, in some cases, severely affected. So this must all be taken into consideration when you decide if you want to "spread" your income or not, or even if you want to make a Roth IRA conversion at all.

9. Q: If I have a large tax balance due next April because of my Roth IRA conversion, will I be able to avoid the underpayment penalties?

A: No. There is no exception to the underpayment penalty just because the balance due was caused by a Roth IRA conversion. There are other exceptions to the underpayment penalty that you might want to review that may allow you to "dodge" the penalty, but there is no "safe harbor" simply because the underpayment was caused by a Roth IRA conversion.

10. Q: Should I convert my regular IRA to a Roth IRA?

A: That is a difficult question to answer. The conversion question is so personal that each and every individual must really look at the issues, understand the tax pros and cons, and realize that there are other "non-tax" and even "non-financial" reasons to convert or not to convert. So that will require some additional reading and study on your behalf.

In addition, the conversion decision rests on a number of factors such as tax rates today versus those of tomorrow, how you would pay taxes due on the conversion, how long the money can stay in the converted account, and the size of your estate. It's a unique situation for everyone for which there is no "one size fits all" answer. See TMF Pixy's analysis on The Motley Fool website to look at some factors that you need to consider. It will give you food for thought as you work through this decision.

And finally, since we are Fools, and we're all about giving, here is your free, bonus question and answer:

Q: I've heard from a friend that the Roth IRA AGI limitation is $100K. I've heard from other friends that the actual AGI limitation is much greater. Which is it?

A: It depends if you are talking about a "conversion" or "contribution."

If you are talking about converting your regular IRA to a Roth IRA, then the AGI limitation is $100K for all filing categories (except for married-separate, which is effectively prohibited from making a conversion regardless of the size of AGI, unless the couple is separated and has lived apart for the entire tax year).

But if you are talking about making a contribution, then the rules are a bit different. The AGI limitations are different based upon your filing status. They are as follows:

Single and Head of Household Filers:
Income: AGI = $95,000 or less
Rule: $2,000 contribution to a Roth IRA is fully allowable (assuming that the earned income rules are met).

When AGI rises above $110,000, no Roth IRA contribution is allowable. Between the $95,000 and $110,000 "phase out" range, only a partial Roth IRA contribution will be allowed.

Joint Filers:
Income: AGI = $150,000 or less
Rule: $2,000 contribution to a Roth IRA for each of the joint filers is fully allowable (again, assuming that the earned income rules are met).

When AGI rises above $160,000, no Roth IRA contribution is allowable. Between the $150,000 and $160,000 "phase out" range, only a partial Roth IRA contribution will be allowed.

Married Filing Separately:
For married persons filing separate returns, the AGI limitation is so severe as to virtually prohibit a Roth IRA contribution. For married/separate filers, the "phase out" range is between $0 and $10,000. This means that a married/separate filer will never be able to take a full Roth IRA contribution, and when AGI rises above $10,000, no Roth IRA contribution will be allowed whatsoever.

We hope that these questions and answers will help you out with your Roth IRA research. Of course, if you have any additional questions regarding any of the above, or any other Roth IRA issues for that matter, you can always visit us in either the Retirement Investing or the Tax Strategies message folder. We look forward to seeing you there.

-Dave Braze (TMF Pixy)
-Roy Lewis (TMF Taxes)

[Want to learn more about taxes and investing? The Motley Fool Investment Tax Guide is now available through FoolMart. There is still time available to do that tax planning (and tax saving) before the end of the year. Click here to read more about this Investment Tax Guide.]

Please note that Roy and Dave cannot answer individual questions via e-mail. If you have tax questions, please ask them on the taxes message board. Thanks!

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