By Elizabeth R. Salasko
The Taxpayer Relief Act of 1997 (TRA 97) overhauled the rules for traditional deductible and nondeductible individual retirement accounts (IRAs) and created two new types of IRAs, the "Roth IRA" and the "Education IRA." Most of the new provisions went into effect on January 1, 1998.
An IRA is a savings vehicle that allows an individual to make contributions to an account that he or she manages. Earnings on the contributions are not subject to income tax until the individual withdraws amounts from the account. The contributions may be deductible, subject to certain income and other limitations. Individuals generally have until April 15 to make a contribution to an IRA for the previous calendar year. The Code generally limits an individual's contribution to $2,000 per year and imposes an excise tax of 6% on excess contributions. Withdrawals before age 59 1/2 generally trigger an excise tax of 10% of the withdrawn amount, which is in addition to the income tax payable on the withdrawn amount. Mandatory distributions generally begin after the individual reaches age 70 1/2.
The changes made by TRA 97 present a myriad of choices to tax-payers seeking to save for important life events in addition to retirement, including college education and home ownership. This article summarizes the rules for traditional and nondeductible IRAs and describes the rules for the new Roth and Education IRAs.
* Contributions. Before TRA 97, a taxpayer could contribute an amount equal to his or her earned income, up to $2,000 per year, to a traditional IRA. Code § 408(a)(1). If neither the taxpayer nor his or her spouse participated in a qualified retirement plan, the taxpayer could deduct the full $2,000. If the taxpayer or his or her spouse participated in a qualified plan, the taxpayer could deduct the contribution only if the taxpayer's adjusted gross income (AGI) did not exceed certain limits.
* Limits on Deductibility. Before TRA 97, Congress phased out the deductibility of IRA contributions at relatively low AGI levels. For married taxpayers filing jointly, if one or both spouses participated in a qualified plan, the couple could deduct an IRA contribution only if the couple's AGI was less than $40,000. Congress ratably reduced the deduction if the
couple's AGI was $40,000-50,000 and eliminated the deduction for couples with AGIs above $50,000. A single taxpayer who participated in a qualified plan could deduct an IRA contribution only if the taxpayer's AGI was below $25,000. Congress phased out the deduction for such single taxpayers with AGI between $25,000 and $35,000 and eliminated the deduction if the taxpayer had an AGI above $35,000. Code § 219(g).
TRA 97 changed the rules regarding participation by a spouse in a qualified plan and the phaseout limits for deductibility of IRA contributions. Both changes will make deductible IRAs more widely available to tax-payers. Under TRA 97, a spouse's participation in a qualified plan does not count against a nonparticipating spouse, for whom an IRA contribution is now fully deductible, as long as the couple's AGI does not exceed $150,000. Congress phased out the deduction for couples with AGIs between $150,000 and $160,000 and eliminated the deduction for couples with AGIs above $160,000.
For married or single taxpayers who participate in a qualified plan, the phaseout range for single taxpayers is now $30,000-40,000 and is $50,000-60,000 for married taxpayers. The phaseout range for single taxpayers will increase each year until 2005, when it will be $50,000-60,000. For married taxpayers, the phaseout range will increase each year until 2007, when the range will be $80,000-100,000.
The following example illustrates the foregoing rules. Abigail is a participant in a qualified plan. Benjamin, her husband, does not participate in a qualified plan. Their AGI for 1997 was $140,000. Before TRA 97, neither Abigail nor Benjamin could make a deductible IRA contribution because their combined AGI exceeded the 1997 phaseout limit of $50,000. Assume that Abigail and Benjamin again have an AGI of $140,000 for 1998. Abigail may not make a deductible IRA contribution because she is a participant in a qualified plan and their joint AGI exceeds the 1998 phaseout limit of $60,000. Benjamin, however, may make a $2,000 deductible IRA contribution because he is not a participant in a qualified plan and their joint AGI is below the $150,000 limit. If Abigail and Benjamin's AGI increases to $250,000 in 1999, neither of them may make a deductible IRA contribution because their joint AGI will exceed $160,000.
* Withdrawals. Withdrawals from a traditional IRA before the IRA owner attains age 59 1/2 generally result in a 10% penalty. Code § 72(t)(1). Before TRA 97 the penalty did not apply to certain withdrawals, such as withdrawals following the death or disability of the IRA owner or for the payment of medical expenses or health insurance premiums for unemployed individuals. Code § 72(t)(2). TRA 97 added two more exceptions to the penalty rules for withdrawals for certain higher education expenses and first-time homebuyer expenses.
* Withdrawals to fund higher education. No penalties will apply to withdrawals if the taxpayer uses the withdrawn amounts to pay for certain higher education expenses for the taxpayer, the taxpayer's spouse or the taxpayer's or spouse's children or grandchildren. Code § 72(t)(2)(E)(7). Qualified expenses include tuition, room and board, fees, books, supplies and equipment required for enrollment or attendance at qualified post-secondary eligible educational institutions (including graduate courses). The Code does not limit the amount of the withdrawals a taxpayer may make for qualified higher education expenses, although a taxpayer cannot use withdrawals to pay expenses for which the taxpayer takes a Hope Scholarship credit.
The Hope Scholarship credit is available only to students who cannot be claimed as a dependent by another taxpayer. Congress limited the Hope credit to $1,500 per year (100% of the first $1,000 plus 50% of the next $1,000 of qualified tuition paid) during a taxpayer's first and second year of post-secondary education. Code § 25A(b). Congress phased out the Hope credit for single taxpayers with AGIs between $40,000 and $50,000 and for married taxpayers filing jointly with AGIs between $80,000 and $90,000. Code § 25A(d).
Although penalties will not apply, withdrawals from an IRA to fund higher education will be taxable. Accordingly, relying on withdrawals from a traditional IRA to fund higher education may be less appealing than a loan from a 401(k) or other qualified plan that permits plan loans. A loan generally results in no income tax or penalty tax consequences, although the participant must usually repay a loan from a qualified plan over five years. By contrast, the taxpayer need not repay an IRA withdrawal.
* Withdrawals to fund first-time homebuyer expenses. A taxpayer may now make penalty-free withdrawals from a traditional IRA to finance up to $10,000 of "qualified first-time homebuyer expenses." Code § 72(t)(2)(F). The first-time homebuyer may be the taxpayer, his or her spouse or a child, grandchild or ancestor of the taxpayer or spouse. The taxpayer must use the withdrawn funds within 120 days to pay "qualified acquisition expenses" for his or her principal residence, including a downpayment, construction costs, mortgage financing expenses (e.g., points) and other closing costs. Code § 72(t)(8). The "first-time" requirement is not what it seems. TRA 97 defines a first-time homebuyer as any taxpayer who has not had an ownership interest (severally or jointly with his or her current spouse) in a principal residence for the two year period before signing a purchase agreement or beginning construction of a new home. As under prior law, amounts withdrawn are taxable as ordinary income.
Taxpayers who cannot take full advantage of deductible contributions to traditional IRAs because of participation in qualified retirement plans or AGI limitations may nevertheless make nondeductible contributions to IRAs. These contributions may not exceed earned income up to $2,000 per year less any contributions made to traditional or Roth IRAs (described below). Code § 408(o). Distributions of earnings are taxable and subject to a 10% penalty under the same rules that govern traditional IRAs. Distributions of previously taxed contributions are tax free. Code §§ 72, 408(d). TRA 97 changed none of these provisions.
The Roth IRA
A new type of IRA, the "Roth IRA," named for Senate Finance Committee Chairman William V. Roth Jr., is now available as an alternative to the traditional and nondeductible IRAs.
* Contributions. A taxpayer whose AGI does not exceed certain limits can make a nondeductible contribution to a Roth IRA of up to $2,000 per year. Contributions to nondeductible and traditional IRAs will count against the combined annual contribution limit of $2,000. Code § 408A(c)(2). Generally, a taxpayer must contribute to a Roth IRA during the tax year. The taxpayer, however, may designate a contribution made in the next succeeding year to apply to the previous year by April 15 of the succeeding year. Code §§ 408A(c)(7); 219(g)(3). The taxpayer must properly identify the tax year for which he or she makes a contribution to start a five year waiting period for withdrawals (described below). For married taxpayers, TRA 97 allows the full contribution as long as the couple's AGIs does not exceed $150,000. The Code phases out the maximum contribution for couples with AGIs between $150,000 and $160,000 and makes the Roth IRA unavailable for couples with AGIs above $160,000. The Code allows single taxpayers with AGIs below $95,000 to use Roth IRAs, phases out Roth IRAs for single taxpayers with AGIs between $95,000 and $110,000 and eliminates Roth IRAs for single taxpayers with AGIs above $110,000. Code § 408A(c)(3). The Code does not limit contributions to a Roth IRA based on a taxpayer's active participation in a qualified plan.
* Distributions and withdrawals. In a dramatic departure from prior law, TRA 97 provides that a taxpayer need not start taking distributions from a Roth IRA at age 70 1/2. Code § 408A(c)(5). This difference makes the Roth IRA particularly attractive. A taxpayer who lives beyond age 70 1/2 and who does not currently need the funds can continue to make contributions to a Roth IRA to the extent he or she qualifies and to defer income tax on the Roth IRA assets until death. Code § 408A(c)(4). Tax on the assets of a Roth IRA would continue to be deferred until distributed to beneficiaries.
A taxpayer may generally withdraw contributed amounts from a Roth IRA free of income tax and penalties. This is an advantage over a nondeductible IRA, from which withdrawals consist in part of previously taxed contributions and in part of taxable earnings. A taxpayer can withdraw earnings from a Roth IRA free of income tax and penalties if the withdrawal is at least five years after the tax year for which the taxpayer made the first contribution or five years after the tax year in which a rollover was made and is taken on account of death, disability, after age 59 1/2 or for first-time homebuyer expenses in the manner described above. Code § 408A(d)(2).
The five year period may in fact be less than five full years. For example, if a taxpayer makes a contribution on April 15, 1999 on account of tax year 1998, the five year period would be from 1998 to 2002, and distributions after 2002 would satisfy the five year waiting period. The earnings on amounts withdrawn before that time will be taxable, although no penalty will apply before age 59 1/2 if the withdrawals are used to fund first-time homebuyer expenses or higher education expenses. Code § 72(t)(2).
* Death of owner. Amounts remaining in a Roth IRA on the owner's death are not taxable as income in respect of a decedent. If the Roth IRA owner's spouse is the sole beneficiary of the Roth IRA, he or she will be treated as the account owner. The surviving spouse need not take distributions at age 70 1/2, as with a traditional IRA, but may leave the full Roth IRA to a nonspouse beneficiary. Code § 72(t)(2). On the surviving spouse's death, distributions can be made over the life expectancy of the named beneficiary, if payments start by December 31 of the calendar year following the account owner's death; otherwise, distributions must be made by the end of the calendar year in which the fifth anniversary of the account owner's death occurs. In either event, a Roth IRA can accrue tax free earnings for many years before distributions will be required. Code § 408A(d)(1)(B) deems partial distributions from any of a taxpayer's Roth IRAs to come first from nontaxable contributions to the IRA.
* Rollover from traditional IRA to Roth IRA. Certain taxpayers can roll over assets from their traditional or nondeductible IRAs to a Roth IRA or convert a traditional IRA to a Roth IRA by notifying an existing IRA trustee or by making a direct trustee-to-trustee transfer. To qualify for either opportunity, a taxpayer who is single or married filing jointly must have AGI of less than $100,000, excluding the income from the rollover. Code § 408A(c)(3)(B)(i). Taxpayers who are married filing separately may not make rollovers to a Roth IRA. Code § 408A(c)(3)(B)(ii). Earnings from the traditional or nondeductible IRA and contributions to the extent previously deducted will be taxed at the time of the rollover. Code § 408A(d)(3)(A). For calendar year 1998 only, taxes on the amount rolled over will be spread ratably over a four year period. Code § 408A(d)(3)(A)(iii). The full amount of the taxes will be due in the year of any rollover that takes place after 1998. The 10% penalty will not apply to amounts rolled over. Code § 408A(d)(3)(A)(ii).
Rollovers to a Roth IRA make sense if an IRA holds mostly nondeductible contributions and has accumulated little in taxable earnings, or when a traditional IRA (with deductible contributions) has been open for only a short period of time. A rollover would also be appropriate if a taxpayer does not expect to need to make withdrawals from the IRA upon retirement. In this situation, a Roth IRA will allow for a significantly longer deferral period.
A rollover may also be beneficial to a younger taxpayer who expects to keep assets in the IRA for a long time. The value of the deferral of income tax on the earnings of the Roth IRA assets may be greater than the value of current deductions for contributions, especially if the taxpayer expects his or her marginal tax bracket on retirement to be as high as or higher than at the time the contributions are made.
A taxpayer may transfer nondeductible IRA contributions for any given year to a Roth IRA at any time during that year, or by April 15 of the following year, if designated as on account of the previous year, without incurring any taxable income. Code § 408A(d)(3)(D).
The New Education IRA
TRA 97 created a new tax deferred savings vehicle for funding higher education for individuals under age 18, the "Education IRA." Though called an IRA, an Education IRA is not technically an individual retirement account within the meaning of Code § 7701(a)(37).
* Contributions. Married tax- payers with "modified" AGIs below $150,000 and single taxpayers with modified AGIs below $95,000 may contribute up to $500 per beneficiary to an Education IRA. Modified AGI is adjusted gross income increased by certain excludable non-U.S. income. Code § 530(c) phases out contributions in the same manner as for the Roth IRA. An individual may be a beneficiary of multiple Education IRAs, and beneficiaries need not be dependents of or related to the contributors. The IRS is taking the position, however, that the total contribution per beneficiary per year cannot exceed $500. Contributions, which are not tax deductible, are in addition to the $2,000 combined limit for traditional, nondeductible and Roth IRAs. Contributions will qualify for the $10,000 per donee annual gift tax exclusion under Code § 2503(b), though not for the educational expense exclusion of Code § 2503(e). See Code §§ 530(d)(3), 529(c)(2). A taxpayer may not make contributions to an Education IRA in any amount in the same year that the taxpayer contributes to a Code § 529 qualified state tuition program. Contributions in excess of the allowable limit are subject to a 6% excise tax unless returned, with earnings, before filing of the contributor's tax return. Code § 4973(a).
* Withdrawals. A beneficiary of an Education IRA may withdraw contributions from the IRA tax free. A withdrawal of earnings from the Education IRA will be tax free to the extent that the beneficiary uses the withdrawn amounts to pay for post-secondary education expenses. Qualified expenses include tuition, books, supplies for students enrolled at least half-time and the minimum room and board allowance applicable for a full-time student as determined by the institution under guidelines for determining financial aid. Code § 530(b)(2)(A) reduces
qualified education expenses by nontaxable scholarships, fellowship grants and educational Assistance allowances.
A taxpayer cannot take either a Hope Scholarship credit (discussed above) or a Lifetime Learning credit in a year in which the taxpayer makes withdrawals from an Education IRA. Code § 25A(e). The Lifetime Learning credit is available to students who are not claimed as dependents by another taxpayer and is equal to 20% of up to $5,000 in qualifying post-secondary education, including graduate courses, after June 30, 1998. The $5,000 limit increases to $10,000 in 2003. Code § 25A(c). The Lifetime Learning credit phases out for single taxpayers with AGIs between $40,000 and $50,000 and $80,000 and $90,000 for married taxpayers filing jointly. Code § 25A(d).
To the extent the amounts withdrawn from an Education IRA exceed qualified education expenses, a pro rata share of the earnings will be taxable to the beneficiary and a 10% penalty will apply to the taxable amount (unless made on account of death or disability). Code § 530(d)(2),(4).
When the beneficiary of an Education IRA reaches age 30, he or she may roll over unused assets within 60 days to an Education IRA for another member of the beneficiary's family. Code §§ 530(d)(5), 529(e)(2), 2032A(e)(2). "Member of the family" includes the following persons and their spouses:
* a son or daughter of the taxpayer or a descendent of either;
* a stepson or stepdaughter of the taxpayer;
* a brother, sister, stepbrother or stepsister of the taxpayer;
* a father or mother of the taxpayer or an ancestor of either;
* a stepfather or stepmother of the taxpayer;
* a son or daughter of a brother or sister of the taxpayer;
* a brother or sister of the father or mother of the taxpayer; or
* a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law or sister-in-law of the taxpayer.
Code §§ 529(e)(2), 152(a)(1)-(8).
To the extent that the new beneficiary is in the same generation as the prior designated beneficiary, the rollover will have no gift tax consequences. If the new beneficiary is a generation below the first beneficiary, the transfer will be a taxable gift, although the annual exclusion will apply. Code §§ 530(d)(3), 529(c). Funds may also be rolled over before age 30 to another member of the beneficiary's family, but no more than once in a 12 month period. A named beneficiary may be redesignated at any time to a different member of the named beneficiary's family without tax consequences. Code § 530(d)(5), (6). Funds remaining in an Education IRA when the beneficiary reaches age 30 must be distributed to the beneficiary as taxable income subject to a 10% penalty.
If a beneficiary dies before age 30 with assets still in an Education IRA, his or her gross estate will include the remaining assets. Code § 530(b)(1)(E). Earnings accumulated in an Education IRA at death are not subject to the 10% penalty. A disabled beneficiary may withdraw assets from an Education IRA without a penalty tax. Code § 530(d)(4). An Education IRA may be transferred to a spouse or former spouse under the terms of a divorce decree without tax consequences. Like traditional IRAs, if a taxpayer uses an Education IRA as security for a loan, Code § 408(e)(4) treats the amount used as security as a taxable distribution. Code § 408(e)(4).
Taxpayers must consider many factors when evaluating which IRA will be most beneficial to them. If a taxpayer is eligible to make a contribution to either a Roth IRA or a nondeductible IRA, a Roth IRA will generally be a better choice because earnings in a nondeductible IRA will be taxed on withdrawal, while earnings in a Roth IRA will not be taxed under most circumstances. Nevertheless, because there are AGI limitations on contributions to a Roth IRA, but no AGI limitations on contributions to a nondeductible IRA, a taxpayer may be able to make a greater contribution to a nondeductible IRA. A combination of the two in these cases may be appropriate.
Likewise, the AGI limitations of a Roth IRA may preclude a full contribution by a taxpayer who is not an active participant in a qualified plan, while a traditional IRA has no such limitation. If a taxpayer could make full contributions to either a Roth or a traditional IRA, the choice involves predicting how the taxpayer's income will change over time, what the taxpayer's life expectancy may be and when he or she may need to make withdrawals. In all cases, taxpayers can make contributions to an Education IRA in addition to contributions to other types of IRAs, and families should consider Education IRAs as part of their planning for college tuition.
With the new array of choices for IRA planning provided by TRA 97, taxpayers no longer need accept plain vanilla in their selection of IRAs. As new flavors have been added to the menu in the form of Roth IRAs and Education IRAs, lawyers should be prepared to advise their clients about these new choices of IRAs
Elizabeth R. Salasko is a partner in Smith, Stratton, Wise, Heher & Brennan in Princeton, New Jersey.
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