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By Sue Stevens, CFA, CFP, CPA | 02-08-07 | 06:00 AM | Email Article

In last week's column, we discussed the ins and outs of traditional IRAs. Roth IRAs differ from traditional IRAs in that you put away aftertax money, you are not required to take Required Minimum Distributions (RMDs), and when you take out the money in the future you won't owe any tax at all. Because you use aftertax money to make your contributions, you don't get a tax deduction like you would with a traditional IRA.

Sue Stevens, CPA, CFP, MBA, and CFA Charterholder, runs her own financial planning firm, Stevens Portfolio Design, and manages over $100 million in assets.

Eligibility to Make Contributions
The contribution maximum is the same for Roth IRAs as it is for traditional IRAs ($4,000--or $5,000 for investors over age 50). The income thresholds, however, are higher than they are for traditional IRAs. Thus more people will be eligible to make Roth contributions than deductible traditional IRA contributions.

Singles may contribute to a Roth IRA if modified adjusted gross income (AGI) is less than $110,000 (in 2007 that increases to $114,000). Married couples filing jointly may contribute as long as their modified AGI is below $160,000 (in 2007 that increases to $166,000). Married filing separate may only contribute if modified AGI is under $10,000.

You can contribute past age 70� as long as you have earned income and are otherwise eligible. You do not have to take Required Minimum Distributions at age 70�.

Contributions can be made in the year the income is earned or up to the filing deadline of your tax return, not including extensions (April 15 in most cases).

Tax Penalties on Roth IRAs
There are fewer potential penalties for Roth IRAs than there are with traditional IRAs. Because you are not required to take RMDs, you won't run into that nasty 50% penalty that you'll face if you don't take distributions from a traditional IRA on time.

You may, however, bump into the 10% early distribution penalty if you tap your Roth IRA before you're age 59 1/2. Here are the exceptions to that penalty:

  • You're disabled
  • You're an IRA beneficiary
  • You're a first-time homeowner and need to cover certain expenses
  • You have significant unreimbursed medical expenses
  • You're paying for medical premiums after losing a job
  • You have qualified higher education expenses
  • IRS levy of a qualified plan
  • You're taking substantially equal periodic payments (same rules as under traditional IRA)

Claiming a Loss on Your Roth IRA
It is possible to take a deduction for a loss on your Roth IRA, but it may not make sense in every situation. The loss you can take revolves around your "basis," or the amount you've invested with aftertax money. You must withdraw the entire amount in your Roth to be eligible to claim a loss. Because the money you withdraw is a qualified distribution (a return of your own contributions) you would not owe a 10% penalty.

This type of loss is not like a capital loss on a taxable investment. With taxable capital losses you can deduct up to $3,000 against ordinary income and carry the rest of your loss forward indefinitely. With a Roth loss, you must use it in the year you generate it. So if you sell your Roth in 2007 and realize a loss, you would claim it on your 2007 tax return. It goes on Schedule A and is subject to the 2% miscellaneous itemized-deduction threshold.

Think carefully before you liquidate your Roth IRA, however. For example, if your Roth is worth $20,000 and you pull it all out to recognize a loss, you'll only be able to put back $4,000 this year--the Roth contribution limit for 2007 ($5,000 for people over age 50). You would lose the advantage of having accumulated a greater balance in your account.

The same principle of taking a loss applies to nondeductible traditional IRA contributions, but not tax-deductible contributions. For more information, see IRA Publication 590.

Roth Distributions
You can always take out your contributions without paying income tax. After all, you paid the tax on that money before it was contributed to the Roth IRA.

For the earnings to be distributed tax-free (i.e., qualified), you must hold for at least five years plus one of the following:

  • Attain age 59�
  • Be a beneficiary of the IRA
  • Be disabled
  • Be eligible for a qualified first-time homebuyer withdrawal of up to $10,000

There are ordering rules for taking nonqualified distributions out of a Roth IRA. To figure out how much tax you owe, you first subtract your regular contributions. If your distribution is more than your original contributions, then you look to any conversions you did, and finally to earnings on contributions.

Should You Convert Your Traditional IRA to a Roth IRA?
If you think income tax rates may go up in the future, you may want to consider taking part (or all) of your traditional IRA, paying tax now, and converting it to a Roth IRA.

To convert a traditional IRA to a Roth IRA, you pay the tax on the traditional IRA up front with money from a separate account. If you have to use money in your traditional IRA to pay the tax on the conversion, it will be considered an early withdrawal (assuming you are under age 59�), and you will owe a 10% penalty on it.

Converting to a Roth doesn't have to be an all-or-nothing proposition. You can convert part of your traditional IRA. You should consider a conversion: 1) to take advantage of lower stock prices, 2) to minimize future taxes if you expect tax rates to go up, 3) to avoid taking Required Minimum Distributions at age 70�, or 4) to be able to contribute longer.

There can be several advantages to converting your traditional IRA to a Roth, but what has stopped many people is the fact that if your AGI is more than $100,000, you can't convert.

Last year, however, a new law was passed that will allow anyone regardless of income level to convert in the year 2010 and beyond. To take advantage of that opportunity, more people are now making nondeductible traditional IRA contributions so that they can build up the amount they will be able to convert in the future (in this scenario, you would only pay tax on the earnings of the nondeductible contributions because the contributions are made with after-tax dollars).

Keep in mind there are always potential disadvantages of converting a traditional IRA to a Roth IRA--like the possibility of a totally new tax system that would change the rules. If we have a flat tax or a consumption tax in the future, it may turn out to be a mistake to pay more income tax now.

Roth 401(k) Accounts
In 2006, companies started offering Roth 401(k) options. A Roth 401(k) is a variation on a traditional 401(k) retirement plan with some of the characteristics of a Roth IRA. More and more firms are now offering this type of plan.

Just like the traditional 401(k) plan, Roth 401(k) contributions are limited to $15,500 in 2007  ($20,500 if over age 50). Your contributions can be split between the traditional and Roth plans.

You'll get an income-tax savings through traditional 401(k) contributions, but not with Roth 401(k) contributions. But unlike a Roth IRA, there are no income limitations on contributions to a Roth 401(k). So for those of you with higher incomes, this may be an alternative to making nondeductible traditional IRA contributions. A Roth 401(k) does require that you take required minimum distributions at age 70 1/2, but you can avoid that if you roll your Roth 401(k) over to a Roth IRA.

More on IRAs
If you want to know more about traditional IRAs, read "How to Save Taxes Using a Traditional IRA." Next week we'll complete our in-depth series on IRAs with a discussion of rollover IRAs and inherited IRAs.

A version of this article appeared in the July 2005 issue ofMorningstar Practical Finance

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Sue Stevens, CFA, CFP, CPA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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