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By: H. Quincy Long & Carol Cantrell
By H. Quincy Long and Carol A. Cantrell
The Taxpayer Relief Act of 1997 enacted the original Roth IRA to stimulate national savings, which was at an all time low. Congress felt more people would be inclined to save if they could look forward to tax free income coming out the other end. The Joint Conference Report added the income limits for annual Roth contributions and the $100,000 income limit for conversions. IRC § 408A(c)(3)(B). The Act allowed a 4-year spread on conversion from a regular to a Roth IRA if the conversion occurred in 1998. Very few taxpayers took advantage of this generous offer. According to the latest IRS statistics, only about 3 percent of the current $2.5 trillion invested in IRAs is in Roth IRA plans.
Under the Senate's budget rules, The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) had to reduce federal tax revenues by no more than $70 billion for it to be protected from a point of order or filibuster that would require 60 votes to override. To meet that revenue target while still including all of the tax cuts that Congressional leaders wanted, TIPRA contained several tax increase provisions. One of the largest of these is Section 512 of the Act, which removes the $100,000 income limits for taxpayers to convert IRA balances into Roth IRAs.
1. Revenue Effect
The Roth conversion would increase federal tax receipts by $6.5 billion in the budget window (2006-2015), However, it loses revenue in the first five years of that window because some high-income taxpayers will transfer savings into nondeductible IRAs getting ready for the conversion in 2010. The IRS looses the tax that would otherwise have been paid on the taxable accounts. In calendar years 2011 and 2012, the Treasury gains the tax due on all of the rollovers.
But the Treasury starts losing revenue again in fiscal year 2014, stemming from several sources. First, the taxable withdrawals from the traditional accounts that would have occurred disappear. Second, to the extent that taxpayers cashed in taxable investments to pay the rollover tax in 2011 and 2012, the tax base is reduced for a very long time. The Tax Policy Center estimates that the revenue loss grows in nominal terms until 2046. The bottom line in present value is that the government loses over $ 4 billion due to the conversions from existing IRAs, even though the provision appears to raise $6.5 billion in the budget window.
The losses from contributions through nondeductible IRAs are even more substantial. Effectively eliminating the income limits for Roth IRA contributions results in a present value revenue loss of over $ 10 billion through 2049 (and more thereafter). The revenue losses would be significantly greater if the high IRA contribution limits, enacted as part of the 2001 tax cut package, are made permanent as the President has proposed.
On balance, this "revenue raiser" actually reduces tax revenues by over $14 billion over the long term. The revenue losses, which grow until 2046, reduce federal revenues at the same time that the baby boomers are aging, placing greater and greater demands on the federal government.
2. Criticism of the Roth Conversion Legislation
"The Roth IRA is the antithesis of sensible tax and budget policy. Congress talked of simplification and a balanced budget but gave us both numbing complexity for ordinary citizens and budget busting, without any policy justification." Daniel Halperin, Professor of Law at Harvard Law School, "I Want a Roth IRA for Xmas" (Tax Notes, Dec. 21, 1998, p. 1567).
"I think Congress is on to something. When you overspend, say on a vacation, what you need to do is buy a very expensive automobile, . . . with a large dealer 'cash back' and a deferral of loan payments. The cash back pays for the vacation, enabling you to ignore what the vacation cost. While you do have to pay for the car eventually, that is outside the 'budget window.'" Id."...this specific gimmick (TIPRA Roth Conversion) is particularly insidious. It would have large and damaging effects on the federal budget for decades to come." Leonard E. Burman, Tax Policy Center Director, "Smoke and Mirrors" (Tax Notes, May 11, 2006).
Section 824 of the Pension Protection Act permits rollovers of amounts in retirement plans directly to Roth IRAs. This means that an individual will no longer need to do to rollovers in order to get money from a retirement plan into a Roth IRA. Instead, the rollover to a Roth IRA will be able to be accomplished in one step. This provision is effective for distributions after December 31, 2007.
A Roth IRA is an individual retirement plan that, except as explained below, is subject to the same rules that apply to a traditional IRA.[2] To be a Roth IRA, the account must be designated as a Roth IRA when it is set up. Neither a SEP IRA nor a SIMPLE IRA can be designated as a Roth IRA.
1. Deductibility of Contributions. Unlike a traditional IRA, you cannot deduct contributions to a Roth IRA. But, if you satisfy the requirements, qualified distributions are tax free.
2. Income Limits. Generally, you can contribute to a Roth IRA if you have taxable compensation[3] and your modified AGI is less than:
3. Age Limits. Contributions can be made to your Roth IRA regardless of your age. With a traditional IRA, you cannot make contributions after age 70 1/2.
4. Contribution Limits. If contributions are made only to Roth IRAs, your contribution limit generally is the lesser of:
However, if your modified AGI is above a certain amount, your contribution limit may be reduced, as shown on the following chart: [4]
This table shows whether your contribution to a Roth IRA is affected by the amount of your modified adjusted gross income (modified AGI).
| IF you have taxable compensation and your filing status is ... | AND your modified AGI is ... | THEN ... |
| married filing jointly or qualifying widow(er) | less than $150,000 | For 2006, you can contribute up to $4,000 ($5,000 if you are age 50 or older). |
| at least $150,000 but less than $160,000 | the amount you can contribute is reduced. | |
| $160,000 or more | you cannot contribute to a Roth IRA. | |
| married filing separately and you lived with your spouse at any time during the year | zero (-0-) | For 2006, you can contribute up to $4,000 ($5,000 if you are age 50 or older). |
| | more than zero (-0-) but less than $10,000 | the amount you can contribute is reduced. |
| $10,000 or more | you cannot contribute to a Roth IRA. | |
| Single, head of household, or married filing separately and you did not live with your spouse at any time during the year | less than $95,000 | For 2006, you can contribute up to $4,000 ($5,000 if you are age 50 or older). |
| at least $95,000 but less than $110,000 | the amount you can contribute is reduced. | |
| $110,000 or more | you cannot contribute to a Roth IRA. |
5. Spousal Roth IRA. You can contribute to a Roth IRA for your spouse provided the contributions satisfy the spousal IRA limit, you file jointly, and your modified AGI is less than $160,000.
6. Modified AGI for Roth IRA Purposes. Your modified Adjusted Gross Income (AGI) for Roth IRA purposes is the same as your modified AGI for traditional IRA purposes with the following modifications: subtract conversion income (this is any income resulting from the conversion of an IRA other than a Roth IRA to a Roth IRA) and subtract any required minimum distributions (for conversion purposes only).[5]
7. Time Limit for Contributions. Contributions to a Roth IRA may be made for a year at any time during the year or by the due date of your return for that year (not including extensions). For most people this means that 2006 Roth IRA contributions may be made until April 16, 2007.
8. Excise Tax on Excess Contributions. A 6% excise tax applies to any excess contribution to a Roth IRA for each year the excess remains in the IRA. If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year. The excise tax may be avoided if the excess contribution and all attributable earnings are withdrawn on or before the due date (including extensions) for filing the tax return for the year in which the excess contribuiton was made. However, taxes and possible early distribution penalties must be paid on any attributable earnings.
1. Taxability of Distributions. Qualified distributions (see below) and distributions which represent a return of contributions (no matter what your age) are not included in gross income. Other parts of the distribution may have to be included in gross income.
2. Qualified Distributions. A qualified distribution is any payment or distribution from a Roth IRA that meets the following requirements:
a. It is made after the five year period beginning with the first taxable year for which a contribution was made to a Roth IRA, and
b. The payment or distribution is:
i) Made on or after the date you reach age 59½,
ii) Made because you are disabled,
iii) Made to a beneficiary or to your estate after your death, or
iv) One that meets the requirements listed under the first home exception (up to a $10,000 lifetime limit).
3. Additional Tax on Early Distributions. Unless one of the exceptions listed below applies, there may be a 10% additional tax imposed on the taxable part of any distributions that are not qualified distributions.
Exceptions. The 10% additional tax may not have to be paid in the following situations.
4. Required Minimum Distributions. There are no requirements to take distributions from a Roth IRA at any age for the original owner. The minimum distribution rules that apply to traditional IRAs do not apply to Roth IRAs while the owner is alive. However, after the death of a Roth IRA owner, certain of the minimum distribution rules that apply to traditional IRA's also apply to Roth IRA.
5. Basis of distributed property. The basis of property distributed from a Roth IRA is its fair market value (FMV) on the date of distribution, whether or not the distribution is a qualified distribution.
Amounts from a Traditional IRA can be converted into a Roth IRA if, for the tax year during which the conversion is made, both of the following requirements are met.
To figure modified AGI for Roth IRA conversion purposes, take the Adjusted Gross Income from IRS Form 1040 or 1040A and add back in any amounts for:
a) traditional IRA deduction,
b) student loan interest deduction,
c) tuition and fees deduction,
d) domestic activities production deduction,
e) foreign earned income exclusion,
f) foreign housing exclusion or deduction,
g) exclusion of qualified savings bond interest shown on Form 8815, and
h) exclusion of employer-provided adoption benefits shown on Form 8839.
Then subtract the following amounts:
a) conversion income (this is any income resulting from the conversion of an IRA other than a Roth IRA to a Roth IRA) and
b) any required minimum distributions (this is only for conversion purposes).
Amounts from a Traditional IRA can be converted to a Roth IRA in any of the following three ways:
If a non-qualified distribution is taken from a Roth IRA within the 5-year period starting with the first day of the tax year in which an amount from a Traditional IRA is converted to a Roth IRA, the 10% additional tax on early distributions may still have to be paid. The 10% additional tax generally must be paid on any amount attributable to the part of the amount converted that had to be included in income. A separate 5-year period applies to each conversion. The 10% additional tax must be paid in the year of the distribution, even if the conversion income had been included in an earlier year.
For conversions done in 2010 only, the tax on conversion income can be paid ratably over two years and included in income for 2011 and 2012. This means no tax is paid on the income in the year of conversion. For conversions done in 2011 and after, the conversion income is included in the year of conversion as is the case currently.
It can be advantageous to convert to a Roth IRA on January 1 of the conversion year. This allows the Roth owner to obtain at least one year of tax-free growth on the tax money inside the Roth before paying them in April the following year. In Case Study # 1, a 40 year-old individual converts 100 percent of an IRA worth $1,360,489 to a Roth on January 1, 2010. Taxes on this will be $476,171 figured at the 35 percent bracket due next year. Assuming he leaves the $476,171 in the Roth for the full 5 year period earning 8 percent before he has to pay it, he earns $38,094. [8% X $476,171] From that point on, he has an extra $38,094 working for him tax-free inside the Roth.
Another advantage of the Roth conversion is the ability to increase tax-free savings by paying the conversion tax from outside funds. In effect, some portion of the traditional IRA, including the opportunity for a tax-free buildup, belongs to Treasury, which will get its share of any distribution. By using outside funds to pay the tax in order to maintain the account at the same level, conversion effectively buys out the Treasury's interest in the advantage of the tax-free buildup. The taxpayer now owns the whole IRA, not just 65 percent of it (assuming a 35 percent marginal rate). See Case Study #2.
The required minimum distribution rules do not apply to a Roth IRA before the death of the IRA participant IRC Section 408A(c)(5). However, the beneficiary of an inherited Roth IRA must take required minimum distributions. This rule allows a Roth participant to keep his money in the IRA longer during his lifetime and produces a significant advantage over the regular IRA or qualified plans. See Case Study #3.
The advantages of the Roth over the regular IRA are even more dramatic of the beneficiaries of the Roth will take advantage of the long-term payout rather than cash in the Roth immediately upon the owner's death. The beneficiary of an inherited IRA must take minimum required distributions over their life expectancy beginning with the year following the IRA owner's death. See Case Study 4. However, if they take only the required minimum distribution each year, they can leave the rest to grow tax-free for many years. See Case Study #4.
If an individual converts when the highest tax rate is 35 percent and rates go up afterward, the effect is to lock in the rate on the taxable portion of the IRA. In addition, many people expect to be in a higher tax bracket upon retirement due to generous pensions, stock options, and deferred compensation plans. These people can also benefit by timing the conversion so that it occurs in a year when the highest rate is less than the rate they expect to be in during their retirement.
Conversion may also benefit those who expect to be in a very low tax bracket during retirement. If they convert all at once causing 85 percent of their Social Security to be taxed in the conversion year, they may avoid having the annual required minimum distributions cause their Social Security to be heavily taxed for many years to come.
Those expecting to experience significantly higher rates of investment return in an alternate form of investment (particularly with self-directed IRAs) may want to convert to a Roth before the jump in growth rate.
The rollover provision is tantamount to eliminating the income limits on contributions to Roth IRAs. Contributions to a Roth may not be made if income exceeds $ 160,000 (married filing jointly) or $ 110,000 (single or head of household). However, individuals can circumvent these income limits by making nondeductible contributions to a Traditional IRAand then converting that IRA into a Roth IRA. Moreover, they can start making the maximum allowable contributions in 2006, expecting to convert the account balance in 2010. They would have to pay tax on any earnings in the account, but the converted balance would be a tax-free Roth account from that point hence. A high-income married couple could expect to shelter more than $ 36,000 in savings this way ($ 44,000 if they are over age 50).
After 2010, they can make the maximum contribution to a nondeductible IRA every year and then immediately convert it into a Roth IRA, effectively circumventing the income limits via this convoluted process. Presumably financial institutions that offer IRAs will try to streamline this process. Another likely outcome is that Congress would decide to eliminate the income limits for Roth IRAs altogether on the grounds that it would be a low-cost simplification measure.
It can be very advantageous for the Roth beneficiary to be a trust. Even though the Roth IRA must still pay the trust the required minimum distribution (RMD) each year, the trust can accumulate the excess of the RMD over the income the trust is required to pay the beneficiary each year without fear of the high trust tax brackets. Even a simple or QTIP trust that is required to distribute all of its income can accumulate income from a Roth IRA. The Texas Property Code defines "income" from an IRA as all of a required payment from the IRA up to 4 percent of the fair market value of the IRA. Texas Property Code § 116.171(c)(1).
Thus, for a trust that has a $1,000,000 Roth IRA and a 70 year old income beneficiary, the Roth IRA must pay the trust a required minimum distribution of $58,823 ($1,000,000/17). However, the trust only needs to pay the beneficiary $40,000 (4% of $1,000,000). The trust can pocket the difference each year and pay no tax.
IRC Section 408A(d)(6)(A) (added by the Technical Corrections Act of 1998) allows a taxpayer to "unwind" a conversion to a Roth by transferring the amount plus earnings back to a traditional IRA.[7] The "recharacterization" must occur on or before the tax filing deadline for the IRA conversion year. Treasury generously relied on a provision in the Preamble to the 1998 proposed regulations that said:
[Congress] intended to permit a taxpayer who had converted an amount heldin a non-Roth IRA to a Roth IRA and later discovered that this is or her modified adjusted gross income for the year of the conversion exceeded $ 100,000 to correct the conversion by re-transferring the converted amount to a non-Roth IRA. The proposed regulations interpret section 408A(d)(6) liberally to provide broad relief to taxpayers who wish to change the nature of an IRA contribution (and not only to allow taxpayers to correct Roth IRA conversions for which they were ineligible).
The purpose of that generous rule was apparently to provide relief to taxpayers when the market dropped between the time of the Roth conversion and the time that tax was due. Through providing the opportunity to "recharacterize and reconvert" (a fancy term for changing the date of the Roth conversion), Treasury provided taxpayers with an opportunity to game the system by delaying the tax payment as long as possible. By doing so, the taxpayer creates a situation whereby taxes stay the same when the market rises but decline when the market drops.
Thus, Treasury bears the downside risk. If the market declines, the taxpayer can simply unwind the conversion. If the market goes up, the taxpayer wins by pocketing the tax-free increase. Similarly, a conservative investor who puts the tax money in a CD breaks even when the market rises and benefits when the market declines.
That relief is not only generous but not necessary. First, without the income limits on conversion, the original reason for the ability to reconvert to a traditional IRA is no longer present. Second, a wise taxpayer can always avoid hardship by simultaneously paying tax or converting to cash as of the date of conversion. Alternatively, the investor could make an estimated tax payment at the time of the conversion. "In the absence of any real hardship, do-overs at the election of one participant have no more place in the tax field then they do on the golf course." Daniel Halperin, "Fun and Games with the Roth IRA (Tax Notes, July 11, 2006).
Internal Revenue Code Section 408, which created IRA's, contains almost no investment restrictions. The following is from the Internal Revenue Service website in the Frequently Asked Questions regarding IRA's.
"Are there any restrictions on the things I can invest my IRA in?"
"The law does not permit IRA funds to be invested in collectibles such as:
"The law also does not permit IRA funds to be invested in life insurance contracts. See Code section 408(m) for additional investment restrictions."
"Finally, IRA trustees are permitted to impose additional restrictions on investments. For example, because of administrative burdens, many IRA trustees do not permit IRA owners to invest IRA funds in real estate. IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option."
Since the "recovery time" of the taxes for Roth conversions is a significant factor to be considered when deciding whether or not to convert, what the IRA owner intends to invest in is important to understand. The following are actual examples of non-traditional investments in self-directed Roth IRA's.
Joyful Judy transferred $104,000.00 into her Roth IRA at Entrust, and immediately invested the money in HUGS, Inc., a non-publicly traded company. Judy is over 59 1/2, so her distributions are qualified distributions, provided she has had a Roth IRA account open for at least 5 tax years. In slightly less than 2 years, HUGS, Inc. has paid $67,705.08 in dividends on Judy's $104,000.00 investment. Judy takes a distribution each month of $3,000.00, which is tax free.
Assume Judy had to do a Roth conversion in 2004 to have $104,000.00 in her Roth IRA. Since the conversion rules require MAGI of under $100,000.00 in order to convert, her marginal tax rate was most likely 25%. Therefore, she would have owed an additional $26,000.00 in federal income tax for 2004 for her $104,000.00 conversion. Judy's dividends in the first 11 months were $28,531.92.
Dapper Don has a traditional IRA and a Roth IRA at Entrust. In February, 2005 he came across a piece of real estate which was going to be foreclosed on soon unless the owner sold it. A deal was negotiated to purchase the property for $10,000.00 plus closing costs (a total of $11,613.22). Don believed he would make a significant amount of money on the resale of this property, but he only had $208.35 in cash in his Roth IRA. Don decided to do a Roth conversion of $12,000.00 to get the money for the investment into his Roth IRA. Approximately 7 weeks later, Don's IRA sells the property for $24,734.00 in cash and a $5,000.00 note (which is paid off in another 3 months) for a total profit on his investment of $18,120.78, or approximately 156% in less than 5 months.
Don was 62 years old and single at the time of this investment, but he had not had the Roth IRA for 5 tax years. Distributions will not be qualified distributions until January 1, 2008. Since Don was single in 2005 when he did the conversion, his most likely marginal tax rate was 28%. If so, the tax on his $12,000.00 conversion would have been $3,360.00, which he recovered in less than 7 weeks. This tax is less than his 2003 Roth IRA contribution of $3,500.00, so if he needed to pull out the money from his Roth IRA to pay the tax he could have done so with no penalty, even though it was not a qualified distribution, since it would represent a return of contributions.
Speedy Eddie had some significant investment losses in 2003, resulting in an unusually low income year. Therefore, he decides to convert $39,629.35 to his Roth IRA. Eddie is very familiar with purchasing existing real estate notes at a discount, and planned to invest his Roth IRA in this way. Some examples of notes he has purchased in his Roth IRA include:
A note purchase of $10,575.00 on 3-28-2005 which was paid off on 8-7-2006 for a total profit in a little over 2 years of $16,677.69, all tax free.
A partial note purchase on 3-10-2006 for $13,800.00 which paid off on 5-11-2006 for a tax free profit of $5,035.51.
A note purchased on 8-10-2004 for $11,334.00, on which his IRA has collected $7,611.84 in monthly payments and on which there still is owed a principal balance of $12,483.03.
Fantastic Florence finds a property which is subject to nearly $100,000.00 in delinquent property taxes and is about to be foreclosed on by the taxing authorities. She contacts the owner and buys the property in her Roth IRA at Entrust for around $3,000.00 (including closing costs). The owner just wants to be rid of the headache. Florence's IRA sells the property to an investor 3 1/2 months later and her IRA nets approximately $46,500.00 from the sale. Florence's IRA will have to pay Unrelated Business Income Tax (UBIT) of about $13,500.00, but even after payment of taxes her IRA will be worth around $33,000.00 in only 3 1/2 months!
Although this is not a Roth conversion story, it demonstrates how powerful even a small Roth IRA can be. Also, if an IRA makes an investment which will subject to unrelated business income tax (UBIT) (generally when the IRA either owns debt financed property or owns a business, either directly or indirectly), it is better to do so in a Roth IRA since the tax will only be paid once (by the Roth IRA. This avoids the double taxation issue, and can be a great way to build up a Roth IRA.
Appendix A
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