IRAs after the TRA '97 - what hath Congress Roth?

• Author: Lange, James
• Position: Roth IRA

The new Roth IRA allows nondeductible contributions and tax-free withdrawals, if the rules are met. Further, for taxpayers who qualify, regular (i.e., deductible) IRAs can be converted to Roth IRAs. Should tax advisers tell eligible clients to convert? Through detailed examples, this article examines a multitude of considerations in determining the answer to this question.

The enactment of the Taxpayer Relief Act of 1997 (TRA '97) significantly increased the ability of retirement plan participants to accumulate wealth and reduce taxes. It created a new type of IRA--the Roth IRA--and expanded retirement planning opportunities for current, regular (i.e., deductible) IRA owners.

All of the new IRA provisions became effective on Jan. 1, 1998. This article explains how tax advisers can use the new IRA laws to provide maximum tax benefits for their clients.

Regular IRAs

For regular IRAs, much of the pre-TRA '97 law still applies, but there are enhancements. Under Sec. 219(b)(1)(A), a taxpayer may still contribute up to $2,000 per year, provided earned income is at least that high. If the taxpayer is not an active participant in an employer-sponsored retirement plan (active participant), the contribution is fully deductible. If the taxpayer is an active participant, the maximum $2,000 deduction is reduced proportionately over a new adjusted gross income (AGI) phaseout range, under Sec. 219(g)(3), as follows:

AGI limits Other than Tax Year married filing jointly Married filing jointly 1997 (pre- TRA'97) $25,000-$35,000 $40,000-$50,000 1998 $30,000-$40,000 $50,000-$60,000 1999 $31,000-$41,000 $51,000-$61,000 2000 S32,000-$42,000 $52,000-$62,000 2001 $33,000-$43,000 $53,000-$63,000 2002 $34,000-$44,000 $54,000-$64,000 2003 $40,000-$50,000 $60,000-$70,000 2004 $45,000-$55,000 $65,000-$75,000 2005 $50,000-$60,000 $70,000-$80,000 2006 $50,000-$60,000 $75,000-$85,000 2007 and thereafter $50,000-$60,000 $80,000-$100,000 Active participants

Prior to the TRA '97, the spouse of an active participant was also treated as an active participant. Under post-TRA '97 Sec. 219(g)(1) and (7), if the taxpayer is not an active participant, but his spouse is, there is no IRA deduction if their combined AGI equals or exceeds $160,000. The maximum $2,000 deduction is reduced proportionately, under Sec. 219(g)(7)(B), if combined AGI is between $150,000 and $160,000.

Example 1: H's and W's combined 1998 AGI is $140,000; H is an active participant. W can make a fully deductible IRA contribution of $2,000 for 1998. H cannot make a deductible IRA contribution, because he is an active participant and their combined AGI exceeds the applicable phaseout limit. As will be discussed, H could make a $2,000 contribution to a Roth IRA for 1998; W could make a $2,000 contribution to either a Roth IRA or a regular IRA.

Penalty-Free Withdrawals

The TRA '97 also increases an IRA owner's ability to withdraw funds before age 59 1/2 without incurring the 10% penalty. Under Sec. 72(t)(2)(E), the penalty can be avoided if the funds are used to pay for qualified higher education expenses of the taxpayer, his spouse, or a child or grandchild. Early withdrawals of up to $10,000 are also permitted under Sec. 72(t)(2)(F) if used within 120 days to pay the costs of a first-time home purchase, including, under Sec. 72(t)(8)(C), costs incurred for the acquisition, construction or reconstruction of a first-time homebuyer's principal residence, or financing, settlement or closing costs. According to Sec. 72(t)(8)(A), such withdrawals can be used by the IRA owner, his spouse, child, grandchild or ancestor, or ancestor of the IRA owners spouse.

Excise Tax Repeal

For many active participants, one of the most profound law changes was the repeal of the 15% excess distribution and excess accumulation taxes by TRA '97 Section 1073(a), for tax years after 1996. The excess distribution tax was imposed on taxpayers who received substantial retirement plan and IRA distributions. The excess accumulation tax was levied against the estates of IRA owners who had substantial retirement account balances at death. Some tax advisers had encouraged their clients with significant IRA balances to make early withdrawals to avoid these taxes; now, most clients will be best served by retaining their IRA accumulations instead of making taxable distributions before (1) the funds are desired or (2) required by the minimum distribution rules.

However, it may be wise to take taxable IRA distributions earlier than required when there will be significant estate taxes and the IRA holds the only funds available to pay them. The taxpayer would take an IRA distribution, pay the income tax and give the after-tax proceeds to the beneficiaries. Methods of leveraging gifts with second-to-die life insurance policies, grantor retained annuity trusts, grantor retained unitrusts, family limited partnerships and other techniques may be appropriate for wealthy individuals. The strategy of prematurely incurring income taxes on IRAs and gifting after-tax proceeds will, in limited circumstances, be beneficial by reducing the estate and providing beneficiaries funds to pay estate taxes. Because this strategy will maximize family wealth in only limited circumstances, tax advisers should run the numbers to determine whether the family would benefit.

Roth IRAs

Named for Senator Roth (R-Del.), the new Roth IRA does not allow a deduction when contributions are made, but allows tax-free withdrawals of both contributions and earnings. Thus, unlike regular IRAs, which only defer taxes, the Roth IRA allows the tax-free accumulation of wealth. Contributions are capped by Sec. 408A(c) at the lesser of $2,000 per year or 100% of earned income for the year; as is discussed below, AGI phaseouts apply. Generally, withdrawals can occur tax-free under Sec. 408A(d)(1) and (2) if the Roth IRA account has been established for five years and (1) the owner is at least age 59 1/2, (2) the owner is deceased or disabled or (3) the distribution will be used for first-time homebuyer expenses.

Contributions

Under Sec. 408A(c)(2)(B), the maximum contribution a taxpayer can make to all IRAs is $2,000 per year ($4,000 if married filing Jointly) or 100% of earned income, whichever is less. While a taxpayer can contribute to a Roth IRA even if he is an active participant, the following AGI phaseout ranges apply under Sec. 408A(c)(3)(C): $95,000 to $110,000 for single taxpayers and $150,000 to $160,000 for joint filers.

Example 2: N is single and an active participant. His 1998 AGI is $100,000. The maximum contribution he can make to a Roth IRA for 1998 is $1,333, computed as follows:

Maximum contribution = $2,000 - [((AGI - $95,000)/$15,000) x $2,000] = $2,000 - [(($100,000 - $95,000)/$15,000) x $2,000] = $2,000 - [$5,000/$15,000 X $2,000] = $2,000 - [$667] = $1,333 Above the phaseout levels, taxpayers can still contribute to a regular, nondeductible IRA, even if their AGI exceeds the phaseout amounts for deductible or Roth IRAs.

Distributions

If the Roth IRA owner takes a distribution before five years has passed or before age 59 1/2, it is tax-free under Sec. 408A(d)(1)(B) only to the extent of the previously contributed amounts (i.e., only the earnings are taxable). This rule also applies to the beneficiary of a Roth IRA whose owner dies before the five-year period has ended. The beneficiary may withdraw funds tax-free as long as they do not exceed the amount contributed, but must wait until the five-year period has passed before...