General Practice, Solo & Small Firm DivisionMagazine

Senior Law Division

Understanding the Roth IRA

By David A. Bridewell and Jeffrey R. Adams

Traditional IRAs are a pretax savings vehicle. Account contributions may be deductible from the owner’s income tax and any income and capital growth that occurs within the account is not taxed until distribution. All distributions from a traditional IRA are subject to income tax and the owner must begin withdrawing a required minimum distribution after age 70 1/2. The required minimum distribution is based upon the life expectancies of the owner and any designated beneficiary.

The Roth IRA is an after-tax savings vehicle, funded with after-tax dollars, and provides three primary advantages over the traditional IRA: the growth that occurs within a Roth IRA is income tax free; it is not subject to minimum distribution rules during the life of the IRA owner; and a person may continue making contributions to a Roth IRA. Also, withdrawals from a traditional IRA generally lead to the imposition of an early withdrawal penalty excise tax unless the owner has reached age 59 1/2.

One primary disadvantage of the Roth IRA is that contributions to it are never deductible, while contributions to a traditional IRA may be deducted from the account owner’s taxable income.

Funding and Distributing Roth Contributions. An individual generally can contribute up to $2,000 per year to a Roth IRA; the limit for a married couple is $4,000.

A person’s ability to contribute to a Roth IRA is phased out if his adjusted gross income exceeds certain levels. The amount a person can contribute to a Roth IRA is decreased by any amount contributed by such person to a traditional IRA in the same year.

To determine the tax treatment of distributions, a two-step analysis is required: the character of the distribution must be determined; and the distribution must be analyzed to determine whether it is qualified and, thus, free of tax.

Special ordering rules determine the character of distributions made from a Roth IRA. These rules provide that any distributions are deemed to be made first from contributions to the extent that such contributions have not been previously distributed from the Roth account. Because contributions are made with after-tax dollars, such distributions would be received by the account owner free of income tax as a return of principal.

To the extent that distributions exceed contributions to a Roth IRA, they are tax free only if they fall within one of the following categories of "qualified distributions": one made on or after attaining age 59 1/2; one made on or after the death of the owner; one attributable to the owner’s disability; and one not exceeding $10,000 made for the purchase of a first residence for the owner or a member of his or her immediate family. In addition, a distribution must be made at least five years after a Roth IRA owner makes a first contribution or conversion transfer to the account.

The minimum distribution rules applicable to the traditional IRA do not apply to the Roth IRA during the lifetime of the account owner. Accordingly, an owner aged 70 1/2 can continue to allow his entire Roth IRA account to grow without incurring a penalty excise tax.

IRA Account Conversions Examined. A person may convert a traditional IRA to a Roth IRA only if his adjusted gross income in the year of conversion does not exceed $100,000. While there is some ambiguity in the law, the Internal Revenue Service has taken the position that this limit applies to both married and single persons. Some tax experts have disputed this position, and the matter ultimately may be litigated. Further, married persons who file separate returns may not convert a traditional IRA to a Roth IRA.

The tax deferral built up within a traditional IRA is lost upon conversion. However, the early withdrawal penalty excise tax does not apply to a conversion of a traditional IRA to a Roth IRA. Generally, all income realized upon conversion of a traditional IRA must be included as taxable income in the year of conversion.

A converted Roth IRA is subject to the distribution rules generally applicable to Roth IRAs with one important exception. A distribution of principal from a Roth IRA within five years of conversion is subject to the early withdrawal penalty excise tax that is generally applicable to the traditional IRA.

Roth IRA as an Estate Planning Tool. The Roth IRA presents a unique estate planning opportunity for young people because it permits bona fide tax avoidance without the need to invest in low-yield, tax-exempt bonds, and allows a person to retain unfettered access to the assets originally contributed to the account.

The traditional IRA is a useful retirement vehicle but has its drawbacks as a testamentary vehicle for the transmission of assets upon death. For example, the owner of a traditional tax deferred retirement vehicle must take required minimum distributions from the account upon attaining a certain age. On the other hand, with a Roth IRA all of the assets can be held in the account until the death of the account owner and paid out over the life expectancy of the designated beneficiary, rather than beginning distribution after the owner reaches age 70 1/2. By extending the time in which the assets will remain in the Roth IRA, and by taking advantage of the tax-free growth and income it provides, the value of the assets ultimately passing to a designated beneficiary may be substantially increased.

The ability to partially convert a traditional IRA allows a qualified person to take advantage of the relative strengths of both the traditional IRA and the Roth IRA. A person with a large traditional IRA should consider converting a portion of his traditional IRA account to a Roth IRA after determining the optimum portion of the traditional IRA necessary to fund retirement and the optimum portion to pass to the next generation. The portion necessary to fund retirement should be retained in the traditional IRA and the balance converted to a Roth IRA.

Whether the Roth IRA is a proper investment tool for you depends on many factors, including your age and life expectancy; your income tax bracket upon retirement; the size of your traditional IRA; your ability to pay the income tax generated upon conversion from assets other than the traditional IRA; and your likely income and expenses during retirement. The Roth IRA is one of the best of all investment options if a person does not need to draw upon a portion of invested assets during retirement.

Establishing a Roth IRA. The following is a list of some of the issues you should consider prior to establishing, and converting to, a Roth IRA account: keep the Roth and traditional IRA accounts separate; keep new Roth IRA accounts and converted traditional IRA accounts separate; carefully shop the market among financial institutions that offer Roth IRA accounts; and consult your financial advisor, accountant, and lawyer before converting a traditional IRA account to a Roth IRA account.

David A. Bridewell is a Chicago lawyer and a long-time member of the SLD. He is also a member of the ABA Sections of Real Property, Probate & Trust Law and Business Law. Jeffrey R. Adams is an associate with McGuire, Woods, Battle & Boothe LLP in the firm’s Charlottesville, Virginia, office.

- This article is an abridged and edited version of one that originally appeared on page 12 in Experience, Winter 1999 issue (9:2).

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