Article: Roth IRAs Take on Greater Appeal

September 2005

Roth IRAs take on greater appeal

Several new developments will allow more taxpayers to access Roth accounts, either by direct investment or by converting traditional IRAs to Roth status

Contrary to the traditional IRA, an investment in a Roth IRA is, as you may know, non-deductible. But the appeal of a Roth IRA is that, unlike its traditional counterpart, when you retire you can make Roth withdrawals entirely tax-free, assuming you have had the Roth for at least five years and have reached age 59½. Even better, at age 70½ there are no minimum distribution rules. You can access your Roth IRA at any time without mandatory annual withdrawal requirements. Any undrawn amounts are passed to your heirs, who also extract the funds tax-free.

Studies tell us that when an IRA investment can be maintained for a duration of at least 10 to 15 years, a Roth generally outperforms the traditional IRA. However, the biggest problem with the Roth IRA is that so few taxpayers have access, due to income limitations. Further, even when the Roth is available, the annual investment has been limited to $3,000, although that amount increases to $4,000 for 2005. But several new developments will allow more taxpayers to access Roth accounts, either by direct investment or by converting traditional IRAs to Roth status.

Roth conversions. In general, you can convert a traditional IRA to a Roth if your adjusted gross income for the year of the conversion does not exceed $100,000. (This $100,000 threshold applies for both single and joint filers.) The conversion of a traditional IRA to Roth triggers taxation on the current value of the IRA account, but that can be efficient if the Roth will be maintained for a significant number of years before extraction. A new law change will give some retirees the ability to convert a qualified retirement plan or IRA into Roth status, as the $100,000 income threshold will no longer include their minimum required distribution from those retirement plans or IRAs.

Example: Tom and Sue have an annual income of $120,000. This includes a $40,000 minimum required distribution from Tom’s IRA (he is over age 70½). Prior to 2005, Tom and Sue had not been able to consider a Roth conversion, because their income for purposes of the eligibility rule had consistently been in excess of $100,000. However, starting in 2005 they are able to consider a Roth conversion because their income for this purpose is only $80,000 ($120,000 total income less $40,000 MRD).

This strategy might fit particularly well for higher income retirees who do not utilize the forced distribution from their IRA or other qualified plans. Once converted to Roth status, the funds can be maintained without any further withdrawals during the retiree’s lifetime. The Roth balances can then be paid out tax-free to heirs over an extended life-expectancy distribution table that refers to the age of the heir, with all withdrawals in tax-free Roth status.

New 401(k) opportunity. Beginning in 2006, employer 401(k) salary reduction retirement plans will have a new twist. Assuming the employer chooses to adopt this new privilege, employees will have the flexibility of designating their salary reduction amount as going into Roth status rather than traditional deductible 401(k) status. The employee’s investment, of course, will not be tax deductible, because of the Roth status of the account; however, there are two significant advantages that go with this 401(k) approach to funding a Roth IRA.

A 401(k) plan allows significantly greater annual investment than the traditional Roth IRA limit. For 2005, a 401(k) investment of up to $14,000 is allowable per employee, with an additional $4,000 catch-up contribution for those who have attained age 50. For 2006, the base limitation moves to $15,000, and the age 50 catch-up contribution potentially adds another $5,000.

Under the 401(k) approach to investing in a Roth, there is no income eligibility threshold. The traditional Roth IRA requires that a joint filer have income under $150,000 or a single filer have income under $95,000, in order to do the full $4,000 IRA amount. But with the 401(k) plan, there will be no income testing to invest in a Roth.

A condition to attaining these advantages will hinge on whether the employer chooses to modify the company 401(k) plan to accept Roth investments. From the employer’s standpoint, this will require more paperwork and administration, but one would expect that many employers will recognize the advantage of offering to their employees this new retirement saving tool.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.