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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
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Thursday, January 29, 1998

Tax Q&A
by Roy Lewis

The third in a running series of special tax articles.

The New Roth IRA - Part III
by Roy Lewis

In the last two weeks we have reviewed the provisions in the law regarding the Roth IRA contribution (putting your cash in) and eligibility rules (the stick). This week we'll review the tax treatment of qualified distributions (getting your cash out) from the Roth IRA (the carrot).

Qualified Distributions

A qualified distribution from a Roth IRA is NOT included in gross income for individual tax purposes. Simple as that. In effect, a qualified distribution from a Roth IRA is tax free... no taxes due on the principal... no taxes due on the earnings… no taxes due period. This is very different from a "normal" IRA. With regular old IRA accounts, you don't pay the taxes at first, but you pay tax at your prevailing tax rate on ALL of the qualified distributions when you take them at retirement.

The Roth has you paying taxes up front on the money, and not at the back end. Now, you may say, well what's the difference? Does it matter whether I pay now or later? Well of course it does! Let's look at an example:

Scenario 1: Regular IRA for 30 years

If Sarah starts putting away $2000 in a regular self-directed non-deductible IRA (not a Roth) at age 30, and does this each year for 30 years, she'll have invested principal of $60,000 (30 years x $2000 dollars each year). Assuming Sarah has the money in a stock market index fund and she earns 10% a year, at the end of 30 years her nest egg will be worth $361,886. Now, because Sarah has never paid any tax on this money, she is now liable to pay taxes on ALL of this money when she takes it out for retirement. Let's assume Sarah takes it all out at age 60. Let's also assume that Sarah is not working and in a 15% tax bracket. Her tax due on this money will be $54,283.

Scenario 2: Roth IRA for 30 years

Now, using the same assumptions as above, what will Sarah pay in taxes using the Roth IRA instead of the regular IRA? Let's assume that over the course of her working life, Sarah pays tax at a 28% tax bracket. So, over the course of 30 years, Sarah will pay 28% on her $60,000, which amounts to $16,800. Best of all with the Roth IRA, Sarah will not have to pay any tax on her qualified distributions from the Roth IRA in the future! So, using these assumptions, Sarah's total tax liability with a Roth IRA is substantially less than that with a regular non-deductible IRA, and it probably makes sense for her to use the Roth, all other things being equal.

In addition, if Sarah has the opportunity to make a regular deductible IRA contribution, the computations necessary to determine if a Roth IRA or regular deductible IRA would be in her best interest would be a little more complicated, and the answer would not be NEARLY as clear cut. This is why it is important for each of you to run your own numbers in order to see if the Roth IRA is beneficial to your personally.

Please remember that all of this requires that distributions from the Roth IRA be "qualified." To be qualified, the distribution MUST be:

1. Made on or after the date you become age 59 1/2; OR
2. Made to your beneficiary or to your estate after you die; OR
3. Made to you after you become disabled within the definition of the IRS code; OR
4. Used to pay for Qualified First-Time Homebuyer expenses

But -- and this is a very big but -- even if one of the qualifications above is met, the distribution is STILL not qualified if:

1. It is made within the five-tax year period beginning with the first tax year for which the individual made a contribution to a Roth IRA; OR

2. It is made within the five-tax year period beginning with the first tax year for which a qualified rollover contribution from a regular IRA was made.

So, in effect, there are two sets of rules that must be met before a Roth IRA distribution becomes qualified, and therefore tax-free: the distribution rules and the five-tax year rules. Unless both sets of rules are met, the distribution will NOT be qualified, and the earnings will be subject to tax and possibly penalties. We'll discuss penalties in detail next week.

Many people are under the mistaken impression that as long as the Roth IRA funds are maintained in the Roth IRA account for more than five years, ANY distribution after that time will be treated as tax free. Nothing could be further from the truth.

Example: Bill, who is 25, makes a Roth IRA contribution of $2,000 in 1998. In 2005 (well beyond the five-tax year period), Bill closes his Roth IRA and takes a distribution in the total amount of $4,500 (representing the original $2,000 contribution and $2,500 in earnings). Bill is not disabled, nor does he use these funds to pay first-time homebuyer expenses. Since Bill is NOT over age 59 1/2 when he takes the distribution, the distribution is NOT qualified. Bill will owe income taxes on the $2,500 of earnings. Additionally, Bill may be assessed an additional 10% penalty on this $2,500 of earnings. Ouch!

But, under the rules, and unlike the rules for a regular IRA, Bill CAN remove his principal contributions without tax or penalty. So, if Bill decided to take a withdrawal of only $2,000, this withdrawal would be treated as a distribution of original contributions, and would NOT be subject to taxes or penalties. This only makes sense, since the original contributions were not tax deductible when they were made.

This same rule applies to multiple Roth IRAs that do NOT contain rollover contributions. Roth IRAs that contain both rollover contributions and regular contributions fall under a completely different set of rules that may require the payment of penalties on the "early" withdrawal of contributions. We'll discuss those rules in detail next week.

The Five-Tax Year Rule

Let's take a moment to discuss the five-tax year rule. The waiting period for a qualified distribution may be shorter than five calendar years, especially if a contribution is made after the close of the tax year for which it is made. Remember that you have until April 15th of the following year to make a contribution for the current tax year. And, according to the law, the first year that is counted is the year for which the contribution is made, not the calendar year in which the contribution is actually made.

Example: Mike, age 57, makes a $2,000 contribution to his Roth IRA on April 15, 1999 for tax year 1998. On January 2, 2003, Mike withdraws $3,000 from his Roth IRA (when he is over age 59 1/2). Of the $3,000 withdrawn, $2,000 represents the original contribution, and $1,000 represents the earnings. This entire distribution IS qualified, and is therefore not included in Mike's income since it was NOT made within the five-tax year period, and since Mike was over age 59 1/2 when he took the distribution. For purposes of the five-tax year rule, 1998 counted as the first tax year, and the five-tax year period ended December 31, 2002. So even though Mike only had his funds in his Roth IRA for less than 4 calendar years, he has met the five-tax year rules and his distribution is qualified.

Rollover Trap?

This five-tax year rule also applies to rollovers from a regular IRA to a Roth IRA. But unlike the rules that apply to contributions (which are based on the date of the earliest contribution), the rules applicable to rollovers are based on the latest rollover when the rollovers are combined into one Roth IRA rollover account. This is a potential tax trap.

Example: Chuck, age 61, makes a qualified rollover contribution from his regular IRA to a Roth IRA in 1998. The five-tax year exclusion date for this rollover contribution is January 1, 2003… the first tax year after the five-tax year period beginning in 1998 and ending on December 31, 2002. But, let's say that Chuck makes an ADDITIONAL qualified rollover contribution from a regular IRA to the SAME Roth IRA in year 2002. Chuck has now extended his five-tax year exclusion date to January 1, 2007 for his ENTIRE Roth IRA. This means that ANY distribution before 2007 from Chuck's Roth IRA would NOT be a qualified distribution and would be subject to taxes on the earnings and potentially subject to penalties on the distribution in total.

It is for this very reason that the IRS has notified Roth IRA trustees (such as banks, brokerage firms, etc.) to encourage individuals to use separate accounts to hold qualified rollover contributions from Roth IRAs made in different tax years. And the IRA trustees are following this IRS recommendation. In fact, many brokers are demanding that separate accounts be opened not only for rollovers, but for annual contributions as well. In the example above, if Chuck would have opened TWO separate Roth IRAs to hold his two rollovers, he would have had two separate five-tax year exclusion periods: December 31, 2002 for the first rollover and December 31, 2006 for the second rollover. This would have allowed Chuck to take a qualified distribution from his first Roth IRA anytime after December 31, 2002 without tax or penalty. But by combining his Roth rollover accounts, he effectively "locked up" ALL of his funds for an additional 4 years. Double Ouch!

For more on the five-year tax period and what the IRS and your broker are doing to help you keep track of it all, click here.

Next week we'll look at the taxation and penalty issues of nonqualified Roth IRA distributions.


Message Board Q&A

Now let's look at a few questions from the Tax Strategies message boards.

1. ReneBet, a Web Fool wonders…

Q: I understand the beneficiary of a Roth IRA will pay no income taxes, but will pay an estate tax. Can anyone tell me how the remainder of a regular IRA will be taxed as an inheritance?

A: Generally, with a regular IRA, the beneficiary will pay income taxes on these funds… sooner or later. If the beneficiary is a spouse, there are some liberal options regarding rollovers. If the beneficiary is a non-spouse, the options are limited.

But, in any event, the regular IRA funds will be taxed at both the beneficiary level AND the estate tax level (although the beneficiary MAY receive a deduction for this double tax).

2. COHEN1, thinking about kids in his future asks…

Q: With the $500 per year limit setup for Education IRA for children, can one set up a trust for an unborn child and still have it qualify for the no-tax benefit on capital gains (assuming you hold account for 5 years)?

A: Nope. An Education IRA can only be established for a person who has already been born.

3. Finally, KMSchaffer, who recently changed addresses, is looking for information on moving expenses…

Q: I moved this year from Illinois to Nevada to accept a new job. How much, if any, of my moving expenses can I deduct?

A: In general, you can deduct your direct travel -- the transportation of yourself and your personal effects to your new location. But beware -- remember that in order for your moving expenses to be deductible, you must be a full-time employee at the new location for at least 39 weeks in the 12-month period following your arrival.

Q: Also, a friend told me that for the first 6 months, my housing is viewed as "temporary" and I can deduct my rent from my taxes. Is this true?

A: Nope. Not any longer. The deduction for temporary living expenses was repealed in 1993. For additional information on moving expenses, check out IRS Publication 521 at the IRS website (http://www.irs.ustreas.gov)

-Roy Lewis (TMF Taxes)
(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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