To IRA or Roth IRA, That is the Question!

1. Introduction

The Taxpayer Relief Act of 1997 created a new type of individual retirement account (i.e. an IRA) called the Roth IRA. Individuals can only start making contributions to a Roth IRA in 1998.

The key benefits of a Roth IRA, as compared to a regular IRA, are that: any future distributions (including, most importantly, distributions of earnings) are tax free; the IRA owner doesn't have to start taking distributions when he or he reaches age 70-1/2; and an individual can continue to make contributions to a Roth IRA after age 70-1/2.

The key drawbacks are that contributions to a Roth IRA are always nondeductible; conversions from a regular IRA are currently taxable and that qualified distributions cannot be made until 5 tax years have elapsed.

We will review whether you will benefit more from making contributions to a Roth IRA or to a regular IRA and the steps you can take to lower your AGI so as to be eligible to contribute to a Roth IRA or to roll over or convert a regular IRA to a Roth IRA.

2. Roth IRA or Non-Roth IRA Contributions

If you are trying to decide whether to make a contribution to a regular IRA or to a Roth IRA then you must weigh many of the same factors that are relevant to the decision of whether or not you make a non-Roth IRA to Roth IRA rollover or conversion.

You see, with a regular IRA, contributions of up to $2,000 (or your compensation, if less) are deductible in the year made by anyone who is not an active participant in an employer's qualified plan. If you are an active plan participant, the otherwise deductible amount is reduced by a fraction of that amount.

An individual who is not an active plan participant, but whose spouse is, and who has an AGI of no more than $150,000 for 1998, may claim a deduction of up to $2,000 for a contribution to a regular IRA for that year.

Those who are not permitted to deduct IRA contributions may make nondeductible contributions of up to $2,000 to a regular IRA. Those who are allowed only partial deductions may make the balance of their contribution as a nondeductible contribution.

If you are considering whether to make a regular or Roth IRA contribution, then you need to keep in mind that the tax rules for each are different. Following is a summary:

a. Contributions to a regular IRA (whether deductible or not) grow tax-deferred within the account, and are taxable on withdrawal to the extent attributable to deductible contributions and to earnings on both deductible and nondeductible contributions.

Where both deductible and nondeductible IRA contributions have been made, the excludible portion of a payout is that portion of the amount withdrawn which bears the same ratio as the individual's aggregate nondeductible IRA contributions bear to the aggregate balance on the last day of the taxable year of all IRAs of the individual including all IRA accounts and annuity contracts, SEPs and rollover IRAs.

Taxable distributions before age 59-1/2 are also subject to the 10% premature distribution penalty unless one of several exceptions applies. Regular IRAs are subject to minimum distribution rules that generally require distributions to be paid out beginning after age 70-1/2 over the account owner's (and designated beneficiary's) life or life expectancy.

b. Contributions to a Roth IRA are nondeductible, grow tax-free within the account, and distributions (even distributions of earnings) are tax-free if the distribution is a qualified distribution. In addition, Roth IRAs are not subject to the minimum distribution rules.

Because the rollover or conversion is generally made in one year, with the full tax impact taken in one year (or over 4 years if made in 1998), and regular contributions are made on an annual basis, however, the tax effects of making annual contributions are more gradual, making the advantages and disadvantages more difficult to discern at first glance.

3. Issues to Consider

The following issues should be analyzed to help you decide whether to make regular IRA contributions or Roth IRA contributions.

a. Roth-IRA's advantages over nondeductible regular IRA contributions

If you are unable to make deductible IRA contributions because of active plan participation and income level and your income does not exceed the Roth IRA contribution levels, then you have an easy decision. The Roth IRA has the key advantage of a nondeductible IRA, namely tax-free buildup within the account, and also allows:

Tax-free and penalty-free qualified withdrawals
Tax-free and penalty-free recovery of contributions if the withdrawal is nonqualified
Amounts in the account continue to build up tax-free after age 70-1/2 without any required distributions

If you can make no more than a $2,000 annual contribution, the regular deductible IRA contribution has a relative advantage over the Roth IRA contribution if:

Your tax bracket during the payout years will be lower than your tax bracket during the contribution years
You will need to tap your IRA funds to supplement other retirement income

Example #1

John's marginal tax rate is 28% and he can contribute no more than $2,000 a year to an IRA. If he contributes $2,000 to a deductible IRA, leaves the funds untouched for five years, and the IRA earns 10% compounded annually, the IRA's value would grow to $3,221.

If John then withdraws the full amount in the IRA, and his marginal tax rate at that time is 15%, and he does not owe a penalty tax (e.g., he is over age 59-1/2), he will pay a tax of $483 (15% of $3,221) on the amount withdrawn, leaving him with $2,739.

If John chose instead to use a Roth IRA, he would be able to contribute only $1,440, i.e., he would first pay $560 tax on the $2,000. After five years the value of the Roth IRA would be $2,320 (again assuming the IRA earns 10% compounded annually). Net result: The deductible IRA would yield John $419 more than the amount he would have if he invested in a Roth IRA ($2,739 less $2,320).

Note: The deductible IRA produces better results in this situation because it allows you to deduct contributions from income taxed at higher rates, and defer paying tax until tax rates are lower.

If your tax bracket stays the same, the deductible IRA produces the same overall tax result as the Roth IRA.

Example #2

Assume the same facts as in the above example except that John's marginal tax rate when he withdraws the IRA money is 28%. If John then withdraws the full amount in the IRA and owes no penalty tax (e.g., he is over age 59-1/2), a total tax of $902 would be due (28% of $3,221), then he would be left with $2,320, exactly the same amount he would have if he invested in a deductible IRA.

If you are able to make a full $2,000 contribution to either a deductible IRA or a Roth IRA, the deductible IRA still has the advantage, if your tax bracket when your distributions are made will be lower than it is when contributions are made.

Example #3

Assume the same facts as in the first example, except that John can contribute a full $2,000 to a deductible IRA or a Roth IRA. He invests the tax dollars saved by taking the deductible IRA route ($560) and these funds earn 7.2% compounded annually after tax (the equivalent of a pre-tax return of 10% for someone in the 28% tax bracket).

If John withdraws the full amount in the regular IRA and in the account funded by the tax savings after five years, at a time when he is in the 15% tax bracket and isn't subject to the 10% penalty tax, he will have a total of $3,532 ($2,739 after-tax net from the IRA, plus $793 from the account funded by the tax savings). That's $311 more than the $3,221 that the Roth IRA would yield after five years.

Another factor to consider when deciding between a deductible IRA contribution and a Roth IRA contribution is the favorable effect that a deductible IRA contribution has on tax breaks that are subject to an adjusted gross income (AGI) based “floor.”

For example, foregoing a deductible IRA contribution in favor of a nondeductible Roth IRA contribution could result in a bigger reduction in itemized deductions, and smaller benefits from the new education credits and child credit.

A Roth IRA contribution will outpace a regular deductible IRA contribution when your tax bracket during the payout years will be higher than your tax bracket during the contribution years. This will hold true even if you can afford to contribute the same amount to either type of IRA.

Example #4

John is in the 15% tax bracket when he makes a deductible IRA contribution of $2,000, and the IRA earns 10% compounded annually. He also has the discipline to save the $300 in tax savings created by his contribution (15% of $2,000), and invests these tax dollars saved at an after-tax rate of 8.5% (the equivalent of a 10% pre-tax return for someone in the 15% tax bracket).

After five years, when his deductible IRA has grown to $3,221, he withdraws the entire amount at a time when his marginal tax rate is 28%. His net after-tax amount from the IRA (assuming no penalty tax is due) will be $2,319 ($3,221 less $902 tax). He also will have accumulated $451 in the taxable account created by his initial tax savings, for a total of $2,770 ($2,319 plus $451).

If John had instead invested $2,000 in a Roth IRA, which also grew at 10% compounded annually, he would be left with $3,221 after five years, $451 more than he would net with the deductible IRA.

The Roth IRA will also be a more powerful family wealth builder than a deductible IRA for those of you who will not have to tap your IRA account during your retirement years.

The deductible IRA will be depleted by minimum distributions which must begin by April 1 of the year following the year in which you attain age 70-1/2, whether or not you want to withdraw cash. What is left in the account will be taxed when it is withdrawn by your beneficiaries.

By contrast, because the Roth IRA is not subject to the lifetime required minimum distribution rules, those of you who use this savings vehicle can leave a bigger nest egg to your beneficiaries, who can withdraw money from the account without paying any tax.

4. Planning to Reduce AGI

Starting in 1998, you will be allowed to make nondeductible contributions of up to $2,000 (less any amount contributed to a regular IRA) to a Roth IRA. The otherwise allowable contribution amount is reduced ratably for modified AGI between $150,000 and $160,000 for joint filers, and between $95,000 and $110,000 for single filers.

An individual also will be able to roll over all or part of the amount in a regular IRA to a Roth IRA starting in 1998 but only if his modified AGI for the year is not more than $100,000. Some of you may be able to take steps to ensure that your modified AGI does not exceed the allowable thresholds.

You can take a number of steps to reduce AGI to avoid exceeding the Roth IRA income limits. Not all steps will be available or desirable for you, but for many of you whose income without any planning would be in the range of a threshold may be able to use one or more of the following strategies to keep your AGI below the $100,000 rollover/conversion limit, or the $95,000 to $110,000 or $150,000 to $160,000 phaseout levels:

Convert taxable interest to tax-exempt interest.
Convert taxable interest to tax-deferred interest or income.
Defer W-2, Schedule C, Schedule E and/or Schedule F income into 1999.
Increase contributions to 401(k) plans, SIMPLE pension plans, SEPs, Keoghs, etc.
Increase contributions to pre-tax flexible spending plans.
Take capital losses in 1998.
Shift income to your kids by hiring them to work in your Schedule C, E or F.
Accelerate Schedule C, Schedule E and/or Schedule F expenses into 1998.

In closing wewould like to wish all of you good luck in figuring out the answer to the big question: “To Roth or not to Roth, that is the question.”

RealTax professionals have the knowledge and expertise to help you evaluate if a regular IRA or Roth IRA is better for you. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.