Death & Taxes

Top Roth IRA Questions

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By Roy Lewis and Dave Braze
August 9, 2002

Although the Roth IRA has been with us for more than a few years now, we still get plenty of questions about how it works, who qualifies, contributions, distributions, and the like. It can get confusing. We thought we'd lend a helping hand by answering the most commonly asked questions regarding the Roth IRA.

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

Age is not a determining factor. As long as your daughter has earned income with which to open the Roth IRA account, and as long as she is under the adjusted gross income (AGI) limitations, she can make an IRA contribution regardless of her age.

Q. How do I open a Roth IRA?

It's actually pretty easy. In fact, we broke the process down in our 60-second guide to opening an IRA.

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

Nope -- sorry. To make a Roth IRA contribution, you must have earned income. Earned income is generally income 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 report it on Schedule C (Business Income) or Schedule F (Farm Income) with your normal tax return. Earned income generally does not include Social Security benefits, pensions, interest, dividends, rental income, or capital gains. Remember also that earned income also doesn't include foreign earned income that is not taxed by Uncle Sam by virtue of the foreign earned income exclusion.

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've waited at least five tax years, you're able to withdraw your original converted 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.

Even if you do determine that you'll have to break into the earnings prior to age 59-1/2, 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 avoid a penalty.

Q. I've heard from a friend that the Roth IRA AGI limitation is $100,000. I've heard from other friends that the actual AGI limitation is much higher. Which is it?

It depends on whether you're talking about a "conversion" or a "contribution."

If you're talking about converting your traditional IRA to a Roth IRA, then the AGI limitation is $100,000 for all filing categories. (Except for married filing separately folks, who are effectively prohibited from making a conversion regardless of their AGI, unless the couple is separated and has lived apart for the entire tax year.)

But if you're talking about making a contribution to a Roth IRA, then the rules are a bit different. The AGI limitations depend on your filing status. If you file as a single taxpayer, the amount you can contribute to a Roth begins to be reduced once your AGI exceeds $95,000, reaching $0 by $110,000. For married filers, the phase-out range is between $150,000 and $160,000.

Q. If I convert my IRA to a Roth IRA, will that income increase my adjusted gross income for the current year?

Absolutely. The income you have to report for an IRA conversion to a Roth IRA will have an impact on any and all tax issues that are based on AGI -- except for any Roth contribution and/or conversion issues. (In other words, if you meet the AGI limitation rules to convert or contribute to a Roth before taking the conversion income into consideration, this income won't make you ineligible based on an increased AGI.) But any tax provisions that use AGI as a guidepost will be affected -- including medical expenses (7.5% AGI floor), miscellaneous deductions (2% AGI floor), taxability of Social Security (based on AGI), passive loss limitations (based on AGI), and many others.

In some cases, your AGI may be severely affected. This must be taken into consideration when you decide to make a Roth IRA conversion.

Q. When I convert my traditional IRA to a Roth IRA, do I have to pay the taxes all at once?

'Fraid so. You're required to report the entire conversion income in the year of conversion. For conversions occurring in 1998, the income could have been spread out over several years, but that option is no longer available.

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 related to estimated taxes?

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 may allow you to dodge the penalty, but there is no "safe harbor" simply because the underpayment was caused by a Roth IRA conversion.

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

As noted above, age is not a determining factor. If your dad's AGI is less than the $100,000 limitation, he's eligible to make the conversion. Beware, though, that your father is in the period of minimum required distributions (MRD) from his traditional IRA. Therefore, before he converts that traditional IRA to a Roth, he must receive his MRD for that year. Whatever that amount is, it cannot be transferred to the Roth.

Q. I want to contribute to my Roth IRA, but my custodian says I can't put annual contributions into a Roth account that contains converted contributions. Is this true? And, if so, what should I do?

There's no legal reason for you to separate your contribution and conversion funds into separate accounts. Under the old Roth IRA rules, contributions and conversions had different five-tax-year start times, depending on conversion and/or contribution dates. Because of these staggered start times, the IRS suggested that contributions and conversions be maintained in separate Roth IRA accounts. That suggestion was made to the various financial institutions, and the institutions passed that information on to their clients.

But with the changes made to the Roth IRA rules by the Tax Reform Act of 1998, the need for these separate accounts has been negated. It's now acceptable to commingle your Roth IRA conversions and contributions. While there are still staggered start times for contributions vs. conversions, the rules surrounding those start times are much clearer. So, having conversions and contributions in the same account, while still tricky, isn't impossible to deal with. If your broker still insists you separate your conversion funds and contribution funds, make sure to tell him about the new law that removed the segregation restrictions. And, if that doesn't work, consider finding a new broker.

Q. I converted my traditional IRA to a Roth IRA back in January. I've just discovered that my adjusted gross income will exceed the $100,000 conversion limitation this year. What should I do?

You can "recharacterize" your converted Roth IRA back to a traditional IRA without any penalty or tax. You've just got to do it prior to Oct. 15 of the following year. Please note we said the following year. In the example above, if the conversion was made in January of Year 1, the recharacterization wouldn't have to take place until Oct. 15 of Year 2, more than 20 months downstream! You're 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 traditional IRA account.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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