Roth IRA planning.

• Author: Lott, Amanda
• Position: Individual retirement accounts

EXECUTIVE SUMMARY

* Advantages of Roth IRAs include nontaxable qualified distributions, lack of required minimum distributions, and that contributions can be made at any age.

* Partial rollovers of qualified retirement plan assets into a Roth IRA, a recently approved option, can accommodate tax-free transfers if, after rolling after-tax proceeds into the Roth account, individuals then roll pretax monies into another plan or traditional IRA. Similarly, they can roll pretax monies in a traditional IRA into a qualified plan and convert the remaining after-tax funds into a Roth IRA.

* Roth IRA contribution limits are similar to those for traditional IRAs, but designated Roth account contributions are subject to higher limits for qualified plans. While the latter are subject to required minimum distributions after age 701/2, these may be avoided with an in-service distribution or rollover to a Roth IRA.

* Converting assets from a traditional IRA or qualified plan to a Roth IRA is no longer limited by modified adjusted gross income, opening this option to more individuals. Pretax retirement accounts can be converted to designated Roth accounts within a qualified plan, with many former restrictions removed in recent years. Income recognition on conversion should be assessed for its effects on taxes and other income-based criteria.

* Bankruptcy protection limits, beneficiaries, investment allocations, and risk from adverse law changes should also help guide planning decisions regarding IRAs.

PREVIEW

* By making strategic Roth contributions, rollovers, and conversions, individuals can maximize tax-free asset appreciation.

* The right Roth strategy depends on the individual's age, cash needs, and goals.

* A Roth conversion should take into account its effects on taxes and other financial obligations.

In 1997, Congress created the Roth IRA. (1) While a taxpayer cannot take an upfront deduction for contributions, qualified distributions are not taxable.

In addition to Roth contributions, individuals may make qualified rollovers of traditional IRA and qualified plan assets into Roth IRAs, commonly referred to as conversions. Converted assets are included in gross income, subject to a few exceptions. (2) The opportunity to get more assets into Roth vehicles via various means has evolved over the last several years, most recently with the promulgation of Notice 2014-54. This was a huge taxpayer win, allowing rollovers of after-tax dollars in retirement plans directly to Roth IRAs to potentially be completely tax-free.

Benefits of Roth Assets

Roth IRA assets can have many advantages:

* Similarly to an IRA or qualified plan, the earnings within the account are tax-sheltered.

* Unlike those from a regular IRA or a qualified plan, distributions from a Roth IRA are not included in gross income if certain conditions are met. (3)

* Roth IRA assets are not subject to required minimum distributions (RMDs). However, assets in a designated Roth account under a qualified cash or deferred arrangement are subject to RMDs. (4)

* Once the original owner of a Roth IRA dies, if the assets transfer to nonspouse beneficiaries, lifetime distributions must begin, but these distributions are tax-free. (5)

* Owners who will be in a higher tax bracket in the future could benefit from tax rate arbitrage by paying taxes on contributed monies at their current, lower rate.

* Contributions to Roth IRAs can be made at any age, even after age 70 1/2, (6) assuming that the taxpayer meets the contribution requirements. (7)

Strategies to Maximize Roth Assets

Roll Over After-Tax Monies in a Qualified Retirement Plan Directly to a Roth IRA

An important recent development in Roth planning is the promulgation of Notice 2014-54 in September 2014. Previously, opinions had differed regarding the treatment of after-tax portions that a taxpayer rolled from a qualified retirement plan to a Roth IRA.

Example 1: An individual has a $1 million Sec. 401 (k) plan balance, of which $100,000 is attributable to after-tax contributions (not designated Roth account contributions).

If the individual moved $100,000 directly to a Roth, would it cause an inclusion of $90,000 of taxable income (based on the pro rata rule) or zero taxable income? Until it issued Notice 2014-54, the IRS had argued that the distribution should be considered a pro rata distribution of all pretax and after-tax balances in the plan. (8)

Under Notice 2009-68, the IRS stated that if an individual made a partial rollover to another plan or IRA and a distribution to himself or herself, this is treated as two separate distributions, to each of which the "cream-in-the-coffee" rule (9) would apply. If it is deemed to be one distribution, then an exception could apply, (10) which would make any after-tax amounts kept by the individual not subject to the cream-in-the-coffee rule. This exception states that in a partial rollover from a qualified retirement plan, the pretax monies are deemed to be rolled over first. Therefore, in Example 1 above, if the individual had $1 million distributed to him and, within 60 days, he deposited $900,000 to an IRA, 100% of the dollars in the IRA would be considered pretax. The dollars remaining outside would be considered 100% after-tax. This would bypass the cream-in-the-coffee rule and effectively distribute $100,000 to the individual with no income tax ramifications.

In Notice 2014-54, the IRS declared that pretax and after-tax amounts distributed to multiple destinations at the same time should be treated as a single distribution, which allows the exception to apply. Therefore, an individual can effectively move after-tax proceeds directly to a Roth IRA without causing an income tax liability if all of the pretax monies are simultaneously rolled to another plan or a traditional IRA. This was a huge win for taxpayers and presents an opportunity to accumulate more in Roth assets if coordinated correctly.

Roll Pretax Monies of an IRA Into a Qualified Retirement Plan and Convert Remaining IRA Balance

If an individual has an IRA that contains both pretax and after-tax amounts and does a conversion, the pro rata rule would apply. If the taxpayer has a $100,000 IRA with $60,000 of after-tax contributions and $40,000 of earnings (i.e., pretax), any dollar converted would result in 40 cents of taxable income.

An opportunity exists for individuals who have an IRA with after-tax contributions and who also participate in a qualified retirement plan that accepts rollovers. If the individual rolls dollars into the qualified plan, they are deemed to come from the pretax dollars first, (11) and a qualified plan can accept only pretax dollars. Therefore, if the individual rolls in all pretax amounts, the dollars remaining in the IRA would be 100% after-tax. The individual could then do a conversion of the IRA and nothing would be included in his or her income, given that 100% of the dollars that are converted to a Roth IRA are after-tax. (12)

Example 2: Following Example 1, if the taxpayer rolled $40,000 of his IRA into his qualified retirement plan, it would leave $60,000 in his IRA. The pretax dollars are considered to be rolled into the plan, deeming the $60,000 remaining in his IRA as 100% after-tax dollars, since he had $60,000 of after-tax contributions. When he then converts the IRA to a Roth IRA, the amount included in income is calculated as follows: $60,000 - ($60,000 x [$60,000/$60,000]) = $0 included as taxable income

This assumes that the $60,000 in the IRA was the only IRA account that the individual had. If he had others (whether SIMPLE, SEP, or traditional), they would be factored into the calculation to determine the taxability of converting the $60,000. When a taxpayer can do a Roth conversion with no tax liability, it makes deciding whether to convert much easier.

Contributions

The most direct way to build Roth assets is through contributions, either to a Roth IRA or to a designated Roth account.

Roth IRA Contributions

Taxpayers whose modified adjusted gross income (MAGI) is below certain thresholds and who have earned income of at least $5,500 (or $6,500 if age 50 or above) can contribute the maximum amount directly to a Roth IRA, and the same holds true for a spouse, if there is at least $11,000 of earned income between them ($13,000 if both are age 50 or above). (13) A Roth IRA may be more appropriate than a traditional IRA in the following circumstances:

* Individuals who are young, with many years of compounding power in front of them.

* Individuals who are likely in a lower tax bracket today than they will be when they withdraw the assets.

* Individuals who have more assets than they will need for...