Roth IRA Planning

How can clients achieve the maximum benefits from this new retirement saving vehicle?

  • WITH THE ADVENT OF THE HIGHLY PUBLICIZED Roth IRA, CPAs will need to advise their clients about rolling over existing IRAs into Roth IRAs. In addition, many clients will need guidance on what kind of IRA they should contribute to in 1998 and beyond.

  • WITH A FEW EXCEPTIONS, ROTH IRAs are treated the same as conventional IRAs. Nondeductible Roth IRA contributions, plus earnings, are distributed tax-free after age 59½ if the account is at least five years old. The maximum annual contribution of $2,000 is phased out for single taxpayers with AGIs between $95,000 and $110,000 and married taxpayers with AGIs between $150,000 and $160,000.

  • A QUALIFIED ROTH IRA DISTRIBUTION is tax-free and not subject to a 10% premature withdrawal penalty if the account has been in existence for five years, is made after age 59½ or made on account of the taxpayers death or disability. First-time homebuyers also can take tax-free distributions of up to $10,000 under certain circumstances.

  • TAXPAYERS CAN CONVERT EXISTING IRAs to Roth IRAs under certain circumstances. If the rollover is made before January 1, 1999, the distribution can be included in income ratably over a four-year period, allowing the taxpayer to spread out the tax consequences. If money from the IRA is used to pay the resulting tax, a 10% premature distribution penalty applies to the money so used.

  • THERE ARE ADVANTAGES AND DISADVANTAGES to converting to a Roth IRA. Important factors include the taxpayers marginal bracket now and in retirement and how many years of contributions remain. CPAs should analyze each clients situation carefully.

  • A TAXPAYER SHOULD MAKE MAXIMUM contributions to a Roth IRA before contributing to a nondeductible IRA. Taxpayers who are short on cash should also consider cutting back on their 401(k) contributions in order to fund a Roth IRA but not contributing less to the 401(k) than their employer will match.
Gary R. Stout, CPA, DBA, is professor of accounting and MIS, California State University, Northridge. His e-mail address is
Robert L. Barker, CPA, PhD, chairs the Department of Accounting and MIS at California State University, Northridge. His e-mail address is

T he highly publicized Roth IRA, created by the Taxpayer Relief Act of 1997, is familiar to most CPAs. The new retirement saving vehicle became available after December 31, 1997, under new IRC section 408A. Roth IRAs offer clients a third option in addition to deductible and nondeductible IRAs. Many clients with IRAs must decide whether they should convert those accounts to Roth IRAs and pay tax on them now. Others must decide what type of IRA to contribute to in 1998. This article explains the available options and provides a worksheet CPAs can use to help clients make the right choice.

Under prior law, taxpayers could deduct contributions to IRAs in computing their adjusted gross incomes if they were not active participants in employer-sponsored retirement plans or if their incomes were below specified levels. Contributions were partly deductible for active participants whose incomes fell within a specified phase-out range. Taxpayers ineligible to make deductible contributions could make nondeductible contributions. Total contributions (deductible and nondeductible) for a tax year could not exceed the greater of $2,000 or earned income. Earnings on IRA contributions (deductible or nondeductible) were includable in gross income only when distributed. A taxpayer was required to begin IRA distributions by April 1 of the year after he or she attained age 70½, subject to a minimum distribution excise tax. Distributions to beneficiaries generally were required to begin within five years of the IRA owners death. Taxpayers could not make IRA contributions after age 70½.

Except as described below, a Roth IRA (a section 408A IRA) is treated the same as a conventional IRA (a section 219 IRA). While contributions to a Roth IRA are non-deductible, distributions are tax-free after age 59½ if the account is at least five years old.

Contributions and AGI limitations. A Roth IRA must be designated as such by the taxpayer at the time it is established. After 1997, an individual can make an annual nondeductible contribution to a Roth IRA equal to the lesser of $2,000 or 100% of his or her compensation, minus any contributions for the tax year to all other non-Roth IRAs. This means the total annual contributions to all three types of IRAs cannot exceed $2,000. For higher income individuals, the allowable contribution is phased-out pro rata for single taxpayers with AGIs of $95,000 to $110,000 and for married taxpayers filing jointly with AGIs ranging from $150,000 to $160,000. Under section 408A (c)(3)(C)(ii), the AGI limit for married taxpayers filing separately is zero. This means they cannot make contributions. These AGI limitations apply without regard to whether a taxpayer actively participates in an employer-sponsored retirement plan.

It is important for CPAs to note that active participants in qualified plans can still contribute to nondeductible IRAs without regard to AGI and taxpayers who are not active participants in qualified plans can contribute to deductible regular IRAs with no AGI limits. However, in 1998, with the introduction of the Roth IRA, there is no reason why any taxpayer would contribute to a nondeductible regular IRA if he or she is eligible for a deductible contribution to a regular IRA or a nondeductible contribution to a Roth IRA. A taxpayer can contribute to a Roth IRA even after he or she reaches age 70½. Roth IRA contributions (similar to regular IRAs) may be treated as funded for year one if the taxpayer makes a contribution by April 15 of year two.

Example. Ronald is single. His 1998 AGI is $75,000. Because he is covered under his employers defined-benefit pension plan, Ronald is not eligible to make a deductible contribution to a regular IRA. He can, however, contribute $2,000 to a Roth IRA and has until April 15, 1999, to make the contribution.

Excess contributions. IRC section 4973 imposes a 6% tax on excess contributions to several types of accounts, including Roth IRAs. Contributions returned (for the preceding tax year) to a taxpayer before April 15 are not considered excess contributions.

A taxpayer does not have to include in his or her gross income qualified distributions from a Roth IRA; distributions also are not subject to the 10% premature distribution penalty. This means interest earned in a Roth IRA that is distributed in a qualified distribution is tax-free. A qualified distribution must satisfy the five-year holding period and be

  • Made after age 59½
  • Made to a beneficiary after the taxpayers death.
  • Attributable to the taxpayer being disabled.

First-time homebuyers also can take tax-free qualified distributions. A qualified first-time homebuyer distribution is one a first-time home buyer uses within 120 days to pay qualified acquisition costs on a principal residence. Qualified acquisition costs include those to acquire, construct or reconstruct a residence. They also include usual and reasonable settlement, financing and closing costs. A first-time homebuyer generally is an individual (and spouse, if married) who had no ownership interest in a principal residence during the two-year period ending on the date the new residence is to be acquired. There is a lifetime limit of $10,000 on qualified first-time homebuyer distributions.

Example. Cindy and Steve are buying their first home. After paying the $10,000 downpayment from their savings, they find they need an additional $3,000 to cover legal fees, points and appraisal costs. Cindy can take a qualified distribution from her Roth IRA tax-free to pay these expenses, provided the account has existed for at least five years.

Definitions and restrictions. Some other restrictions apply to qualified Roth IRA distributions.

  • Distributions a taxpayer takes to pay education expenses are not qualified distributions.
  • To satisfy the five-year holding period, a taxpayer cannot take a distribution within the five tax years beginning with the first tax year for which a contribution was made to a Roth IRA.

A taxpayer must include nonqualified distributions in income to the extent they exceed his or her basis in the account. The amount includable in income is subject to a 10% premature distribution penalty. However, distributions from Roth IRAs are made on a Fifo basis. Roth IRAs and regular IRAs are treated separately under IRC section 72. Therefore, the initial nondeductible contribution comes out before any earnings. Note that an amount equal to total contributions made to a Roth IRA can be withdrawn tax-free at any time. Then, when the taxpayer is eligible for a qualified distribution, earnings can be withdrawn tax-free.

As enacted, the law creates a loophole by permitting an individual to avoid paying the 10% premature distribution penalty by rolling over his or her regular IRA to a Roth IRA and then taking a distribution of the entire amount before earning any income. This error will be corrected by the IRS Restructuring and Reform Act of 1998 (Title VI of HR 2676), which will impose a 10% penalty (at the time the taxpayer takes a withdrawal from the Roth IRA), on the includable income as of the time of the rollover. Any withdrawal the taxpayer takes of converted funds within the five-year period would be deemed to come first from amounts that were includable in income as a result of the conversion.

Example. Scott will be 47 in 2009. He will have made Roth IRA contributions totaling $24,000 since 1998; the current account balance on July 1, 2009, will be $36,000. While Scott will not be old enough to take a qualified distribution, he can, however, withdraw up to $24,000 (his contributions) without penalty. Alternatively, Scott can withdraw up to $10,000 to purchase a first home. If Scott takes a $30,000 withdrawal in 2009 to buy a boat, $24,000 will be tax-free as a return of his contributions and $6,000 will be taxable in his regular bracket and subject to a 10% penalty as a nonqualified distribution.

Roth IRAs are not subject to minimum distribution rules. Therefore, a taxpayer does not need to begin distributions at age 70½ his is a significant advantage, as tax-free compounding can continue until the taxpayers death. Depending on the IRA beneficiarys age, the tax-free compounding can continue long after the taxpayers death.

To understand whether a client will come out ahead by investing in a Roth IRA, the CPA needs to determine whether a clients marginal tax rate in retirement will be higher or lower than it is during his or her working years. If the CPA expects that retirement rate to be higher than the current rate, it makes sense for the client to make an aftertax contribution to a Roth IRA now and receive the proceeds tax-free in retirement. The client is effectively locking in a lower rate by paying the tax now. Conversely, if the clients marginal tax rate is higher than it will be in retirement, he or she would do better by taking the deduction now and paying taxes on the IRA distribution in retirement. However, this alternative is better for the client only if he or she invests the tax savings each year.

Exhibit 1, page 63, shows these principles at work. An investor contributing to a Roth IRA typically comes out ahead of an investor in a deductible IRA regardless of the marginal tax rate or the time frame if he or she does not invest the tax savings. The deductible IRA is a better alternative only if the taxpayer invests the tax savings each year and his or her marginal tax rate declines in retirement.

The truly exciting benefit of a Roth IRA is a taxpayers ability to convert an existing IRA into a Roth IRA. Distributions from a Roth IRA may be rolled over to another Roth IRA tax-free. Regular IRAs (deductible or nondeductible) may be converted to Roth IRAs under certain circumstances. Taxpayers may not convert their regular IRAs to Roth IRAs during any year in which (1) their AGIs exceed $100,000 (section 408A[c][3][B][i]) or (2) they are married and file separately (section 408A[c][3][B][ii]). The $100,000 AGI limitation does not include the amount of the taxable rollover according to the House/Senate conference report explanation.

A taxpayer can roll a SEP-IRA into a regular IRA and later roll it over into a Roth IRA, although a taxpayer cannot roll a SEP-IRA into a Roth IRA. The same would be true for a distribution from a qualified plan, such as a profit-sharing or a 401(k) plan.

Under section 408A(d)(3)(A)(i), a taxpayer who makes a permissible rollover from a regular IRA to a Roth IRA must include the distribution in gross income in the year it is made. This rule has one exception: For a distribution taken before January 1, 1999, any amount the taxpayer normally might take into gross income because of the distribution is included ratably over a four-year period beginning with the year of the conversion (section 408A[d][3][A][iii]). The premature distribution penalties will not apply (section 408A[d][3][A][ii]). This allows taxpayers a one-year window to convert their regular IRAs to Roth IRAs with slightly more favorable tax treatmentthe ability to spread the tax liability over four years.

Example. Jordans regular IRA has a current balance of $52,000. In 1998, she decides to convert it to a Roth IRA. If she wishes, Jordan has the option of including 25% of the account balance, $13,000, in her income in 1998, 1999, 2000 and 2001.

The law is silent on what happens if the taxpayer should die during the four-year inclusion period. The 1998 IRS Restructuring and Reform Act will require any amounts remaining as a result of a 1998 conversion to be included on the taxpayers final return. If the surviving spouse is the beneficiary of the Roth IRA, he or she could continue the deferral by including the remaining amounts in income over the rest of the four-year period.

Clients considering converting a traditional IRA, whether it is deductible or not, to a Roth IRA must consider one critical issue: Does he or she want to pay taxes nowduring his or her working yearsor in retirement?

To be eligible to convert an existing IRA to a Roth IRA, a taxpayers AGI can be no more than $100,000, whether he or she files a single or a joint return. After conversion, the client has 60 days to decide where to invest the converted IRA funds. The 10% IRA withdrawal penalty does not apply to converted funds, but any withdrawal the taxpayer takes to pay the taxes due at conversion will be subject to the penalty. All money in a deductible IRA is subject to tax at conversion. In a nondeductible IRA, only the earnings are taxed. As discussed above, if the conversion occurs in 1998, the taxpayer may divide the taxable portion of the IRA by four and add it to his or her income over the next four years.

Example. If Jordan is able to pay the $3,640 of federal tax in each of the four years (assuming a 28% marginal bracket) that results from converting her regular IRA to a Roth IRA in 1998 out of other funds, the conversion will not result in a penalty. However, any money she withdraws to pay the tax is subject to a 10% penalty.

We developed a worksheet CPAs can use to determine whether it is advisable for a client to convert his or her regular nondeductible IRA to a Roth IRA in 1998. The data needed to complete the analysis includes

  • The current fair market value of the clients IRA.
  • The average annual growth rate of the IRA until it is distributed.
  • The number of years until distributions begin.
  • The number of years of additional $2,000 contributions.
  • The current basis of the IRA (cumulative nondeductible contributions), if any.
  • The clients current marginal tax rate.
  • The clients marginal tax rate at the time of future distributions.

The worksheet theory and logic are presented in exhibit 2, page 64. CPAs can download the worksheet from our Web site at California State University, The worksheet is in Microsoft Office 97 Excel workbook format.

Exhibit 3, below, summarizes the computation results for 10 different client situations as examples. Several general conclusions can be made with regard to these examples:

  • The current fair market value (high or low) does not matterthis will not change the taxpayers choice of a regular IRA vs. a Roth IRA.
  • If the number of years before the taxpayer begins distributions is small (five or fewer), the relative advantage of a regular IRA or a Roth IRA will be small. Some situations favor the Roth and others favor a regular IRA, but the difference is small.
  • The regular IRA appears to be better much of the time (examples 5, 7, 8 and 10, but not example 3) when the taxpayers marginal tax rate is expected to be much lower during the distribution years than during the contribution years (31% current; 15% future).

The limited number of solutions demonstrates that it is very difficult for CPAs to draw general conclusions based on specific fact situations due to the number of different factors involved. This makes it all the more imperative for CPAs to run the numbers for each of their clients before making recommendations.

Advantages. Overall, there are a number of advantages to taxpayers from converting an existing IRA to a Roth IRA.

  • No minimum distribution requirements at age 70½.
  • The ability to generate greater tax-free returns in a Roth IRA, assuming the taxpayer can pay the income tax on conversion from non-IRA funds.
  • The ability to name a new beneficiary after age 70½.
  • No mandatory contribution cut-off age as with regular IRAs.
  • Paying income taxes upon conversion will reduce the taxpayers eventual gross estate.

Disadvantages. There also are some disadvantages of converting to a Roth IRA.

  • The taxpayer may be in a higher marginal tax rate today when the conversion is taxed than he or she will be at retirement.
  • The extra income upon conversion (even with a four-year spread) could push the taxpayer into a higher bracket. Higher income in the rollover year(s) also may have an impact on the new child credit, education credits, interest expense deduction for student loans, the $25,000 active rental real estate deduction, the medical expense deduction and the 2% of AGI miscellaneous itemized deductions.
  • Earnings in a Roth IRA cannot be withdrawn until five years from the first year of contribution or conversion.
  • Congress could repeal Roth IRAs in the future.

For a taxpayer who does not need to take the minimum distributions required by a regular IRA to cover living expenses, the Roth advantage can be even greater than shown above. However, if a taxpayer is close to retirement and expects to be in a lower tax bracket, the conversion probably is not appropriate. Or, if the only way a taxpayer can convert is to pay the tax from the distribution and also pay the 10% penalty, then he or she probably is better off not converting to a Roth IRA. Tax-free distributions from a Roth IRA also benefit Social Security recipients, when compared with income recognized from regular IRA distributions. Roth IRA distributions are not included in the computation to determine whether retirees have to pay tax on a portion of their Social Security benefits.

The Roth IRA allows taxpayers more tax-free growth while they are aliveand beyond. If you leave your Roth IRA to your spouse, it can be left intact until he or she passes on, allowing even greater tax-free growth since no minimum distributions are required. If you leave your Roth IRA to a young beneficiary and the withdrawals are taken over his or her life expectancy, the compounding effect is unbelievable. This could make the Roth IRA the ultimate tax shelter and wealth accumulation device, perhaps even better than an annuity investment of similar size due to the tax-free nature of withdrawals. Unfortunately, the only way to get a significant amount of money into a Roth IRA quickly is by rolling over an existing IRA.

If cash for retirement savings is limited, taxpayers should fund their Roth IRAs before they choose to make maximum contributions to their 401(k) plans. This is true except when an employer matches the contribution.

Example. Terry currently contributes 10% of his salary$6,000to his companys 401(k) plan. His employer matches 50% of the first 6%, or $1,800. If Terry cannot afford to make a Roth IRA contribution, he should consider reducing his 401(k) contribution level, but not below the 6% eligible for matching. For example, if Terry reduced his 401(k) contributions to 7% of his salary, he could contribute the difference to a more advantageous Roth IRA without losing out on the employer match.

In general, a Roth IRA beats a nondeductible IRA hands down. Obviously, a tax-free return is better than a tax-deferred return. We see no practical reason for anyone to continue contributing to a regular nondeductible IRA, except perhaps for high AGI taxpayers. CPAs with eligible clients making nondeductible IRA contributions should recommend the client redirect future contributions to a Roth IRA.

The Roth IRA is a tremendous planning tool, almost too good to be true. CPAs should discuss a possible rollover with their clients as soon as possible to see if it makes sense. By running the numbers for each client using our worksheet, CPAs can ensure they are recommending the best solution. Because of the tax break, 1998 is the year to take action on any rollovers.

Exhibit 1: How Attractive Are Roth IRAs?
  • Investors A, B and C were in the 28% tax bracket when they made their IRA contributions.
  • Each investor withdrew all retirement savings as a lump sum upon retirement. (Note: The same relative performance applies even if the funds are withdrawn over an extended period.)
  • Investor A makes annual $2,000 contributions with aftertax dollars but pays no tax upon withdrawal.
  • Investors B and C make annual contributions with pretax dollars but pay tax on withdrawals at the rate in column 1.
  • Investor C also invests an amount equal to her $560 annual tax savings (28% of $2,000) in a taxable account and pays tax at 28% on the accounts annual earnings.
  • A compound annual return of 8% applies to all sums invested.
    Investor A Investor B Investor C
Tax Bracket in Retirement Years Roth IRA Deductible IRA Deductible IRA + Tax Break
15% 5 $12,672 $10,771 $13,849
15 10   31,291   26,597   35,162
15 15   58,649   49,851   63,242
15 20   98,846   84,01   105,182
28% 5   12,672   9,124   12,446
28 10   31,291   22,530   30,249
28 15   58,649   42,227   55,763
28 20   98,846   71,169   92,401
31% 5   12,672   8,744   12,122
31 10   31,291   21,   30,391
31 15   58,649   40,468   54,036
31 20   98,846   68,204   89,451
Source: Chart adapted from American Century Investor Perspective , 4th quarter 1997.


Exhibit 2: Should a Taxpayer Roll Over a Regular IRA to a Roth IRA?
The following is a comparison of the net present value at the date distributions would begin from a regular IRA.
Sheet 1
Enter data on this sheet. The results appear at the bottom of this sheet. Computation details appear on sheets 2 and 3.
Current fair market value of IRA account $ 40,000
Expected average earnings rate until distributions begin 7%
Number of years before distribution begins 30
Number of years of additional $2,000 contributions 25
Number of noncontribution years (assumed to be at end) 5
Current tax basis of IRA account $ 20,000
Marginal tax rate expected after distributions begin 28%
Current marginal tax rate 28%
Regular IRA result $ 375,517
Roth IRA result $ 458,231
Difference (Positive number means regular IRA is better.) $ (82,714)

Sheet 2
Expected net aftertax value of regular IRA at the beginning of the distribution period
**** Expected value at beginning of distribution period of current IRA amount $ 304,490
Plus Expected value at beginning of distribution period of additional contributions 202,146
Minus Adjustment for noncontribution years (12,307)
Equals Total expected value at beginning of distribution period $ 494,329
Minus Accumulated tax basis (assuming non-deductible additional contributions) (70,000)
Equals Taxable amount at beginning of distribution period $ 424,329
**** Tax at expected rate at beginning of distribution period (118,812)
**** Total expected value at beginning of distribution period $ 494,329
Minus Tax at expected rate at beginning of distribution period (118,812)
Equals Net aftertax value at beginning of distribution period $ 375,517

Sheet 3
Expected net aftertax value of Roth IRA at the beginning of the regular IRA distribution period
**** Current fair market value of IRA account $ 40,000
Minus Current tax basis of IRA account (20,000)
Equals Taxable income recognized due to rollover $ 20,000
**** Tax on rollover at current marginal rate $ 5,600
**** One-fourth of tax on rollover $ 1,400
**** Present value of 4 annual installments of tax on rollover $ 4,742
**** Expected value of tax paid on rollover at beginning of distribution period $ 36,098
**** Expected value at beginning of distribution period of current IRA amount $ 494,329
Minus Tax at marginal rate expected at beginning of distribution period 0
Minus Expected value of tax paid on rollover at beginning of distribution period $ (36,098)
Equals Net aftertax value at beginning of distribution period $ 458,231


Exhibit 3: Comparison of Regular and Roth IRAs
Description/Client 1 2 3 4 5 6 7 8 9 10
Current fair market value $40,000 $40,000 $40,000 $40,000 $40,000 $40,000 $40,000 $40,000 $40,000 $40,000
Earnings rate 7% 12% 12% 12% 12% 12% 7% 12% 7% 7%
Years to accumulate 30 30 30 30 5 5 30 30 5 5
Years of additional contribution 25 25 25 25 0 0 0 0 5 5
Current basis $20,000 $20,000 $20,000 $20,000 0 0 0 0 0 0
Future tax rate 28% 28% 15% 28% 15% 28% 15% 15% 28% 15%
Current tax rate 28% 28% 28% 31% 28% 31% 28% 28% 31% 31%
Regular IRA greater by         $4,000   $27,000 $75,000   $6,000
Roth IRA greater by $83,000 $336,000 $121,000 $322,000   $3,000     $2,000  


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