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01/15/98 -- The New Roth IRA - Part I
01/22/98 -- The New Roth IRA - Part II
01/29/98 -- The New Roth IRA - Part III
02/05/98 -- The New Roth IRA - Part IV
Calculate! Regular IRA vs. Roth
Calculate! Should I convert my IRA?

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Thursday, January 22, 1998

Tax Q&A
by Roy Lewis

The second in a running series of special tax articles.

The New Roth IRA - Part II
by Roy Lewis

Last week we started discussing the new Roth IRA (Roth - Part I). This week we'll look a little closer at aspects of rolling over from a regular IRA to a Roth IRA.

Must be "qualified"

As most of you know, a rollover from a regular IRA to a Roth IRA is possible if certain provisions are met. First, the rollover must be qualified. The term "qualified rollover" can be tough to completely understand, but it is basically a rollover that meets the 60-day rollover time period and is not in violation of the "one-year" rollover rules. For additional information regarding qualified rollovers, check out IRS Publication 590 at the IRS website.

Does it meet AGI limitations?

Assuming you meet the "qualified" distribution rules, you still have one other hurdle to overcome -- Adjusted Gross Income (AGI) limitations. The law states that if your AGI is greater than $100,000, you may NOT make a rollover from a regular IRA to a Roth IRA. This $100,000 limitation applies not only to single filers, but also to married people filing jointly and head of household filers. Also, don't think that you can beat the AGI limitations by filing a married-separate tax return because you can't. The law specifically states that if you are a married taxpayer filing a separate tax return, you may NOT rollover your regular IRA to a Roth IRA… regardless of your AGI.

As we'll see below, when you rollover your regular IRA into a Roth IRA, you must claim a portion of the rollover on this year's taxes, which would increase your AGI for this year. However, for the sake of the AGI limitations mentioned above, you do NOT include the rollover that you are liable for in the calculation. Let's look an an example:

Jack, a single person, has 1998 AGI of $75,000. Jack also has a regular IRA in the amount of $40,000 that he wants to rollover to a Roth IRA. For AGI limitation purposes, Jack's threshold is $75,000 (the amount of his "normal" AGI, without regard to the rollover amount), and NOT the combination of his "normal" income and his "rollover" amount. Jack's income tax AGI and taxable income WILL change if he decides to make this rollover, but that's an issue that we'll discuss in detail a little later.

Rollover taxation issues

OK… you've determined that you CAN make a rollover. Whew! You now need to know more about the tax issues involved in making the rollover. In effect, the funds rolled over from the regular IRA to the Roth IRA that would have been taxable had the distribution not been part of a qualified rollover will be subject to income tax at your normal tax rate… plain and simple. (Note: The difference here is that because the rollover is "qualified," the 10% penalty for an early withdrawal from an IRA account will NOT be imposed).

If your IRA consists only of prior tax deductible contributions and the earnings thereon, the total amount of the rollover will be subject to taxation. If part of your IRA consists of prior non-deductible contributions, they will not be taxed again at the time of the rollover to a Roth IRA. And if your IRA consists of funds from a prior rollover from another qualified pension plan (such as a pension/profit sharing plan, 401(k) plan, 403(b) plan, Keogh plan, SEP plan, etc.), all of the funds will be taxable to you at the time of the rollover.

But wait, you mumble. Didn't I read something about spreading the tax over a period of years? Well… kinda. Let's look closer.

Spreading it out

The law says that if all or any part of a regular IRA is rolled over to a Roth IRA in a qualified rollover contribution BEFORE January 1, 1999, the amount required to be included in gross income as a result of that rollover contribution MUST be included in gross income ratably over the four tax-year period beginning with the tax year in which the rollover is made.

That sentence is quite a mouthful, but gives you a lot of information. It says that:

1. A qualified rollover contribution that takes place in 1998 will receive a special tax break. And that special tax break is ONLY available for rollovers that take place in 1998. And this means that the rollover MUST occur in 1998 -- no later than December 31, 1998 -- and not a day later. Any rollover from a regular IRA to a Roth IRA that takes place after December 31, 1998 will NOT be allowed this special tax break.

2. The special tax break is that the income that must be reported based on the IRA rollover MUST be spread evenly over a four-year period. Note that it is the INCOME that must be spread over the four tax year period… and NOT the tax itself. Please also note that this spread of income MUST take place… it is NOT an election.

3. This "spread out" income will impact any and all tax issues that are based upon AGI… except for any current or future Roth contribution and/or rollover 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 impacted. In some cases, severely impacted.

4. Because the rollover is "qualified," the 10% penalty for an early withdrawal from an IRA account will NOT be imposed. But, should you decide to remove your funds "early" from the Roth IRA, you may be subject to an even greater penalty -- up to 20% in some cases. We'll discuss this penalty issue in detail next week.

Confused? Well, let's continue with the example of Jack and his rollover. Jack's 1998 AGI is $75,000, and he wants to make a $40,000 rollover from his regular IRA to a Roth IRA. For 1998, Jack's AGI for income tax purposes will be $85,000 (his regular AGI of $75,000 plus one-fourth of his $40,000 rollover amount). In 1999, 2000, and 2001 Jack will add an additional $10,000 (representing his "spread out" of his 1998 IRA rollover) to his normal AGI for that year, and will pay tax on that "spread out" income at his normal tax rate for those years. If Jack delayed his rollover until 1999, this additional $40,000 rollover income would NOT be spread out, but the entire amount would be added to his normal 1999 AGI and would be taxed in total in 1999. In either case, Jack would NOT be hit with a 10% early withdrawal penalty on the amount of the IRA rolled over to the Roth IRA (assuming Jack keeps his nose clean and doesn't take the funds out of his Roth IRA "early").

As mentioned above, all of the tax issues that use AGI for a benchmark (except Roth contributions and rollovers) will now be based upon Jack's new 1998 AGI of $85,000.

So Jack can look forward to paying more tax dollars to Uncle Sammy over the next four tax years. In effect, Jack is trading tax dollars now for the tax-free status of the Roth IRA earnings in the future. Is that appropriate? Perhaps for Jack, based upon his personal situation, the answer is yes. But it is certainly NOT appropriate for everybody. In fact, for many people, the rollover of a regular IRA to a Roth IRA may actu