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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 15, 1998

Tax Q&A
by Roy Lewis

Fools, this is the first in a series of special tax articles that we'll be running through the end of April. A new article will appear each Thursday and will talk about some of the most relevant tax issues today. We'll also end each article by answering some "viewer mail" from our message boards.

The New Roth IRA - Part I

It seemed like such an easy concept when it was introduced: Put some money away for a while and then take those funds and earnings out tax-free at some time in the future. But, like most issues involving government rules and regulations, the Roth IRA has turned into a monster. And while the concept may still remain an easy one to understand, the actual rules and regulations have become very complex. In the next few weeks, we'll discuss the new Roth IRA in greater detail and hopefully make things more clear. Let's get started.

Beginning January 1, 1998, an individual can make an annual nondeductible contribution to a Roth IRA up to the excess of:

(1) the lesser of $2,000 or 100% of the individual's earned income, minus

(2) the aggregate amount of contributions for the tax year to all other individual retirement plans (other than Roth IRAs) maintained for the benefit of that individual.

What this means is that your total contributions for the tax year to a regular IRA and a Roth IRA can't exceed $2,000 in total. So, in effect, you'll want to determine which savings vehicle is best for you (Roth or Regular IRA), and place that $2,000 contribution in the selected IRA. While the law certainly doesn't prohibit you from placing, for example, $500 in a Roth IRA and $1,500 in a Regular IRA, the administrative hassles and fees of this type of arrangement may be more than you are willing to bear.

A few distinctions to pay attention to:

1. It's important to understand that you can fund a Roth IRA and a SEP IRA at the same time. The $2,000 restriction is only applicable to the combination of Regular and Roth IRAs. So if you are in a situation where you are able to fund both a Roth IRA and a SEP IRA, the law allows you to do so. (For those who have no idea what a SEP IRA is, this won't matter to you).

2. Finally, remember that you can fund a Roth IRA even if you are covered by a company retirement (pension/profit sharing/401k) plan.

Example: John is a single taxpayer. In 1998 he will make $50,000 on his W-2 from his employer. John is also a participant in his company's pension plan. Additionally, John will contribute the maximum amount to his employer's 401(k) plan. In his spare time, John has a consulting job and will earn additional business (Schedule C) income in the amount of $15,000. John will make a maximum SEP IRA contribution based upon his net business income. Even with all of these tax deferred savings and investment vehicles, John can still make a $2,000 Roth IRA contribution for 1998.

It should also be noted that any amounts rolled over to a Roth IRA (which we'll discuss next week) in a "qualified rollover contribution" are NOT counted towards the $2,000 annual contribution limit. So, in the example above, even with everything John had going on, he could make a "qualified rollover contribution" and still have the choice of making a $2,000 Roth IRA contribution for 1998.

Income Limitations

And now for the bad news -- some individuals may not be eligible for the Roth IRA. Limitations based tax filing status and Adjusted Gross Income (AGI) are listed below:

Single and Head of Household

Income: AGI = $95,000 or less

Rule: $2,000 contribution to a Roth IRA is fully allowable.

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.

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.

What the Heck is Phase Out?

If you fall into the "phase out" ranges listed above, you can click here to learn exactly how to calculate what is or isn't allowed.

Finally, in closing, you should be aware that there are no age limits on contributions to a Roth IRA. A young child with earned income can make a Roth IRA contribution if deemed appropriate. Not only that, unlike a Regular IRA, persons OVER the age of 70 1/2 can still make Roth IRA contributions as long as they have earned income and are not otherwise restricted by the AGI limitations.

And remember that Roth IRA contributions for a tax year must be made no later than the time for filing your tax return, not including extensions. So if you are qualified to make a 1998 Roth IRA contribution, that contribution must be made no later than April 15, 1999… the due date of your tax return.

Next week we'll discuss Regular IRA rollovers into a Roth IRA and Roth IRA withdrawals and distributions.

And for your general tax knowledge, here are a few questions and answers that you may find of interest. These questions were pulled from the popular "Tax Strategies" message folders on both AOL and Motley Fool website:

1. Mikeraz, a new Fool, wondered about tax filing documents…

Q: 1997 was my first year as an investor. What type of tax documents should I expect from my broker?

A: Expect to receive a combined statement from your broker that will report interest earned by you on your free cash balance (1099 INT), dividends that you received on your stock (1099 DIV), and sales that you made during the calendar year (1099-B). In addition, while not required to do so, they will also provide you with a report of the margin interest that you paid to the broker during the year (if any).

Q: Will they have the same mailing deadline as my 1099s and W2s?

A: The official date for the brokerage company to get this information to you is Jan. 31... but don't be surprised if you don't see anything until about the first week in February. But do NOT file your return without it.

Q: What do I need to do to prove that my sale of stock on December 5 was a loss sale and that I didn't repurchase the same security within 30 days?

A: Just report it according to the instructions on Schedule D. There is nothing special you have to do if you did NOT make a wash sale. All loss sales are assumed to be deductible. It is only if your loss sale WAS a wash sale that you need to report differently on Schedule D.

2. On the Fool website, tc001 wondered about filing amended tax returns to maximize his Roth IRA contributions…

Q: While I was in grad school ('94 & '95) my income was low so I was in the 15% tax bracket. I made the maximum contribution to my IRA each year. Now, if I convert to a Roth IRA, it will be in the 28% bracket. My idea is to file amended returns for those years to reverse the deduction on the $4000 and pay the tax at the 15% rate for those years rather than my '98 rate of 28%. Is this possible, and reasonable? Is there any downside to doing this? Any facts or opinions are appreciated.

A: Not only is it possible, it is a great idea.

In order to designate an otherwise deductible IRA contribution as non-deductible, you must make an election (by filing IRS Form 8606) with your original tax return. The law does not state that the election must be made only on a timely filed tax return, nor is the law very specific regarding making this election at a later date. If you look at the actual tax code and regulations, you might be left scratching your head about filing an amended return.

But, if you review IRS notice 87-16, you will read the following (under the question and answer section):

"C3: May a taxpayer change a deductible or nondeductible designation of a contribution to an IRA on a prior year's return?

"A: Yes. The designation may be changed by amending the tax return prior to expiration of the statute of limitations on assessments, pursuant to section 6501 of the Code. Of course, since contributions must be made by April 15 of the year following the year for which the contribution are made, no additional contributions may be made after that date."

Therefore, using IRS Notice 87-16 as authority, it appears that you MAY amended the returns in question (but remember that your statute date for your 1994 tax return is April 15, 1998... so don't waste too much time in filing the amended return for that year). Designate your prior deductible contribution as non-deductible (by filing Form 8606 with the amended return), pay the tax (and interest) on the amended return, and convert your prior deductible contribution to a non-deductible contribution and you'll be well set for your Roth IRA rollover.

Remember that you would still have to pay tax on the EARNINGS of the IRA accounts since inception when you make your Roth IRA rollover, but you would avoid the tax on the original contributions.

Good thinking... and nice trick. I had not even thought of this, but it will certainly come in handy in the future.

3. Finally, SherrylK98 had a question about capital gains and IRA accounts:

Q: How will the new rates on capital gains affect stocks held in an IRA? In particular, using the F4 stocks, how will holding them 18 months versus 12 months affect me? Or, since I don't have to pay taxes on the profits until I start to withdraw them, doesn't it matter?

A: One of the nice things about trading shares in an IRA (or other tax-deferred retirement account) is that the character of the gains is immaterial. And therefore the record keeping is really easy: You almost don't need to keep any. The funds will be taxed when they are withdrawn by you from the IRA account, and the income will be treated as ordinary income to you when you withdraw it, regardless of how the income was generated. Long-term gain… short-term gain… interest… dividends… no matter.

So your first impression was right -- it doesn't matter.

Next week we'll continue to look at the Roth IRA and answer a few more questions from the message boards.

-Roy Lewis
(Please understand that Roy cannot answer individual questions in e-mail. Please ask any questions in the Tax message folder.)

Calculate! Regular IRA vs. Roth
Calculate! Should I convert my IRA?


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