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ROTH IRAs

What is a Roth IRA?

A Roth IRA is for workers (including self-employed) with earned income. The maximum yearly deposit is $2,000 ($4,000 for a married couple). An individual qualifies for the full contribution if: (1) single, with an adjusted gross income up to $95,000, or (2) a married couple, with an adjusted gross income up to $150,000. With adjusted gross income above these income levels, the contributions are rapidly phased out.

There is no tax deduction for the money that is put in a Roth IRA. However, the contribution and earnings can be taken out tax free, as long as you wait at least five years and are: (1) at least 59-1/2, (2) disabled, or (3) taking up to $10,000 in earnings to buy a first home. A person is never required to take the money out of a Roth IRA. It can be left to heirs income tax-free, as long as it is held at least five years. However, it is still part of the taxable estate upon death.

Examples of money accumulated with a $2,000 annual contribution, invested at an average rate of return of 10%, and a combined federal and state income tax rate of 31.6%.

1. For a 20-year old with an accumulation period of 40 years and a distribution period of 20 years, there would be $80,000 invested over these 40 years. The total distributions would be: (1) $714,400 in a taxable (non-IRA account), (2) $1,447,638 in a non-deductible IRA account, (3) $1,648,109 in a deductible IRA account, and (4) $2,079,471 in a Roth IRA. (Whew, that sure beats Social Security!)

2. For a 30-year old with an accumulation period of 30 years and a distribution period of 20 years, there would be $60,000 invested over these 30 years. The total distributions would be: (1) $342,256 in a taxable (non-IRA account), (2) $547,594 in a non-deductible IRA account, (3) $636,787 in a deductible IRA account, and (4) $772,857 in a Roth IRA.


Converting a current IRA to a Roth IRA

An individual, married or single, will qualify to convert a portion or all of a current IRA to a Roth IRA if their adjusted gross income is under $100,000. However, the money that is converted must be reported as taxable income in the year of conversion. This additional taxable income is not included in the adjusted gross income computation. If the conversion is in 1998, the taxable income, and thus the tax, can be spread over the next four years (1998 ­ 2001). If the conversion is in 1999 or after, the entire taxable income must be reported in the year of conversion. You can not convert just the nondeductible IRA. Conversions are treated as coming proportionately from every IRA you own.


General rules for not converting a regular IRA to a Roth IRA:

1. Don¹t convert if you will have to pay income tax out of your IRA funds, or borrow money to pay the taxes due. It is unlikely that a person will ever recover that loss.

2. Don¹t convert if you will drop to a much lower tax bracket in retirement. This general rule applies to the person who is currently in the 28% tax bracket and expects to retire in the 15% bracket or lower.

3. Don¹t convert if the IRA income you have to report will push you into a higher tax bracket, make you ineligible for any tax credits, or make your Social Security income taxable.

General rules for converting a regular IRA to a Roth IRA:

1. Do consider converting if you can pay the income taxes out of your earnings or other savings. The tax-free growth will probably yield a larger amount.

2. Do consider converting if your tax bracket will rise in retirement, remain the same, or possibly fall a small amount
(i.e. 31% to 28%).

Computer software and other sources to help in the conversion decision

Most, if not all, custodians of IRAs have computer software to help a person determine whether it is advantageous to convert a present IRA to a Roth IRA. Each individual case is unique and a complete analysis of the pros and cons of conversion should be determined. An accountant or tax preparer should also have software to aid in a proper decision. They should be able to test a tax return to determine the feasibility of converting a current IRA to a Roth IRA.


The following IRA conversion software is available to accountants and tax practitioners:

1. Tax Tools 98, version 8.010, has a module entitled "Roth IRA - Why convert an existing IRA?". This is manufactured by CFS Income Tax, P. O. Box 979, Simi Valley, CA 93062-0879. They may also be contacted at 1-800-343-1157 or on the Internet at www.taxtools.com. A first time user of Tax Tools will be charged $179 for the 1998 package (well worth it!) and then $89.50 for renewals. I find this software to be user friendly, simple, and
produces professional answers.

2. T. Rowe Price, P. O. Box 89000, Baltimore, MD 21202 has a product called "T. Rowe Price IRA Analyzer" that can be purchased for $9.95. It may be ordered by calling 1-800-IRA-5000. They may also be contacted at 1-800-541-8803. They have a great Internet site at www.troweprice.com where you can put in your own figures and obtain information immediately on individual computations.

For a wealth of information on Roth IRAs look on the Internet at www.rothira.com. This site is maintained by Brentmark Software, Inc. and has links to articles, tax forms, calculators, books, and software all relating to the Roth IRA. It also has the latest information on the Technical Corrections Bill and its applications to the Roth IRAs. If you want to learn all the ins and outs of Roth IRAs, this is a "must" site to check on the Internet.


Examples of gains projected by converting present IRA funds to a Roth IRA:
The assumptions made in these projected gains are: (1) $100,000 of current IRA funds being converted to a Roth IRA in 1998 with no nondeductible contributions included in the $100,000. (2) There is an annual investment rate return of 10% in both the accumulation and the distribution periods. (3) The federal income tax rate is 28% and the state income tax rate is 5% in both the accumulation and the distribution periods. (4) This will make the federal and state income tax due of $31,600 and it is payable equally in 1998, 1999, 2000, and 2001.

1. For a 40-year old individual projecting a 20-year accumulation period and a 20-year distribution period, a regular IRA will produce $1,170,782 after taxes. A Roth IRA for the same periods will produce $1,436,745 or a net gain of $265,963.

2. For a 40-year old individual projecting a 20-year accumulation period and a 10-year distribution period, a regular IRA will produce $823,352 after taxes. A Roth IRA for the same periods will produce $995,336 or a net gain of $171,984.

3. For a 50-year old individual projecting a 10-year accumulation period and a 10-year distribution period, a regular IRA will produce $336,035 after taxes. A Roth IRA for the same periods will produce $383,745 or a net gain of $47,710.

4. For a 60-year old individual projecting a 10-year accumulation period and a 10-year distribution period, a regular IRA will produce $336,035 after taxes. A Roth IRA for the same periods will produce $383,745 or a net gain of $47,710.

5. For a 70-year old individual projecting a 5-year accumulation period and a 10-year distribution period, a regular IRA will produce $215,816 after taxes. A Roth IRA for the same periods will produce $238,276 or a net gain of $22,460.


Summary:
In analyzing the above examples there are two things that should be apparent. (1) The sooner that an individual
commences funding an IRA the larger the nest egg will be upon retirement. (2) If the distribution period tax rate is the same (or only slightly lower) than the accumulation period, there will always be a net gain in converting to a Roth IRA.

Of course, the advantages of the Roth IRA are dependent upon having the same income taxing system in the years of distribution that we have now. IF our present income tax system is scrapped and in its place is enacted a national sales or consumption tax, the tax advantages of the Roth IRA would turn into disadvantages. The author does not believe that this will happen but each individual should make his or her own individual judgment of our federal income tax system and its future.

There are many software packages available to accountants and tax practitioners to analyze the decision to convert an IRA to a Roth IRA. Some of it is available for purchase and many packages are available, for free, over the Internet. Your clients will have many questions this tax filing season about the Roth IRA. Obtain the knowledge and the software to truly serve your client¹s needs.


   
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