Monthly Newsletter - OCTOBER 1997

Many of the provisions of the Taxpayer Relief Act of 1997 expanded the applications of Individual Retirement Accounts (IRA's). The new law made regular IRA's more attractive to middle income taxpayers and introduced two new types of IRA's: Education IRA's and Roth IRA's. Most of the planning opportunities, however, apply to the new Roth IRA.

• Each year, effective January 1, 1998, an individual can contribute $2,000 into a Roth IRA and a married couple can contribute $2,000 into each of their Roth IRA's. No deduction is allowed for amounts contributed to the Roth IRA.
  
• Amounts contributed to the Roth IRA will grow TAX FREE if certain conditions are met.
  
• Amounts withdrawn from a Roth IRA will not be subject to income taxes (or the 10% penalty for premature distributions) if the distribution is (1) taken at least 5 years after contributions were first made to the Roth IRA and (2) amounts withdrawn were taken after the taxpayer reached the age of 59 1/2 or were used for the first $10,000 of first time home buyer expenses.
  
• Distributions that do not meet the two criteria listed above will be subject to regular income taxes plus the 10% penalty for premature distributions on the portion of the distribution which represents investment earnings. All individuals, EXCEPT those who have converted their existing IRA's to a Roth IRA during 1998, are allowed to withdraw the total of their non-deductible contributions tax free from their Roth IRA's. Individuals who convert their existing IRA's to a Roth IRA, then withdraw money from the Roth IRA before five years have elapsed, will be subject to a 10% premature distribution penalty.
  
  An example of how a premature distribution will be taxed: An individual has $10,000 in a Roth IRA which consists of $6,000 in contributions and $4,000 of earnings. This individual decides to withdraw $6,050 from the Roth IRA. In this case, taxes and the 10% penalty will be owed on only $50 of the distribution. However, next year, if the taxpayers withdraws another $1,000, the total amount withdrawn will be subject to taxes and the penalty.
  
• High income taxpayers will not be allowed to make contributions to a Roth IRA. No contribution is allowed in any year that an individual taxpayer's income exceeds $110,000 or a married couple's combined income exceeds $160,000. A reduced contribution will be allowed for individuals whose income falls between $95,000 and $110,000 and for married couples whose income falls between $150,000 and $160,000.
  
• Each year, individuals can contribute a COMBINED TOTAL of $2,000 to a regular IRA and a Roth IRA. Taxpayers who contribute $2,000 to a regular IRA and $2,000 to a Roth IRA in the same tax year will find themselves subject to an IRS penalty for over-contributing to an IRA. Married couples generally can each contribute a combined total of $2,000 to each of their IRA's and Roth IRA's.
  

1. Amounts withdrawn from a Roth IRA will not be subject to income taxes if the two criteria listed above are met. A portion (or all) of amounts withdrawn from a regular IRA will always be taxed.
   
2. Up to $10,000 can be withdrawn tax-free from a Roth IRA to pay for first time homebuyer expenses (as long as the Roth IRA was opened for at least 5 years). If money is withdrawn from an IRA to pay for first time homebuyer expenses, most (or all) of the distribution will be taxable, but, effective January 1, 1998, will not be subject to the 10% penalty for premature distributions.
   
3. Contributions made to a Roth IRA can be withdrawn tax-free at any time. If amounts are withdrawn from a regular IRA, a portion (or all) of the distribution will always be taxed; even if the taxpayer previously made non-deductible contributions to the IRA.
   
4. Upon reaching the age of 70 1/2, individuals are required to withdraw a minimum amount from their IRA accounts; and will be subject to income taxes on that distribution. Roth IRA's have no minimum distribution requirements.
   
5. Upon the death of the owner of the IRA, the beneficiaries of the IRA will eventually pay income taxes on the balance of the IRA inherited. Beneficiaries of Roth IRA's will not be subject to income taxes on the balance of the Roth IRA inherited.
   

1. Contributions to a Roth IRA are never tax deductible. In many instances, taxpayers and/or their spouses can make deductible contributions to a regular IRA which will reduce their current tax liabilities.
   
2. Since money withdrawn from a regular IRA will always be subject to income taxes, there is more incentive not to make withdrawals from an IRA and, therefore, more money might be available to help fund a taxpayer's retirement. The Roth IRA makes it too easy for taxpayers to invade their retirement savings. Many people who take advantage of Roth IRA's may have depleted their IRA accounts prior to retiring. These individuals might find themselves more dependent on social security and their families for support upon retiring.
   

The Taxpayer Relief Act of 1997 included a provision which allows individuals to convert their existing IRA's to a Roth IRA. If the conversion takes place during 1998, the taxable amount of the conversion will be included in the taxpayer's income ratably over 4 years and the 10% penalty for premature distributions will not apply.

If the conversion takes place subsequent to December 31, 1998, the taxable portion of the conversion will be subject to income taxes and the 10% penalty for premature distributions that year.

Example: If a taxpayer in the 28% tax bracket elects to convert his $10,000 IRA to a Roth IRA during 1998, he will be required to include $2,500 (1/4 of the distribution) in his income for each of the years 1998 - 2001. As long as he remains in the 28% tax bracket, this individual will pay an additional $700 in federal income taxes each year. This taxpayer, therefore, will have $10,000 invested in his Roth IRA, but had to come up with $2,800 out of his non-retirement savings to pay the federal income taxes due on the conversion.

Caution: This provision is not available to many middle income and high income taxpayers. If a taxpayer's adjusted gross income exceeds $100,000 in 1998, that taxpayer would not be entitled to the favorable tax treatment. Instead, the amount rolled over would probably be subject to income taxes and the 10% penalty for premature distributions as well. This $100,000 threshold applies to single taxpayers and to married couples.

The question is...should you take advantage of this strategy during 1998 and convert part or all of your IRA into a Roth IRA???

When trying to make your decision, you should factor in the following:

• How long before you will retire. The longer the period until you retire, the more attractive this strategy appears. Remember, if you convert $10,000 from an IRA to a Roth IRA, you will have taken $2,800 out of your non-retirement savings to pay the federal taxes. It takes a number of years before the fact that money can be withdrawn tax-free from the Roth IRA outweighs the lost investment earnings on the $2,800.
  
• Your current tax rate and your anticipated future tax rate. If you feel that you will be taxed at a higher tax rate in the future, you should consider taking advantage of this strategy. Remember, as long as the tax rules do not change, you will not be taxed on amounts withdrawn from the Roth IRA once you reach the age 59 1/2 and have maintained the account for more than 5 years.
  
• Whether you trust the government not to change the rules. Many people are skeptical about undertaking any strategy that requires income taxes to be paid in advance. These people would rather hold onto their regular IRA's and allow the amount invested to continue to grow tax deferred than pay 28% or 31% of the amount converted to the government in anticipation of favorable tax treatment in the future .
  
  The government has a lousy track record when it comes to tax-free income. One example of this is Social Security benefits. At first, these benefits were not taxed. Then, up to 50% of the benefits received were subject to income taxes. Recently, the rules were changed again and as much as 85% of the benefits received are now taxed. A second example pertains to municipal bond interest. Originally, municipal bond interest was not taxed. At some point, the rules were changed. Now, the amount of municipal bond interest received during the year is included in the calculation determining the extent of social security benefits that are taxable; essentially making the tax exempt interest taxable to many retirees. In addition, interest on certain types of municipal bonds is included in calculating the alternative minimum tax.
  
  Before converting your existing IRA's to a Roth IRA, you need to determine the likelihood that amounts withdrawn from a Roth IRA will not be subject to income taxes when the time comes for you to retire. Based of what I've seen regarding social security benefits and municipal bond interest, I'd be surprised if distributions from Roth IRA's remain completely tax free.
  
• Whether you will be a first time homebuyer 5 or more years down the road. You are allowed to make a tax-free withdrawal from a Roth IRA to cover up to $10,000 of first time homebuyer costs. The only condition is that the Roth IRA had been established more than 5 years before the distribution to cover the homebuyer costs were made. If possible, you should try not to invade your IRA account to finance the down payment of your home. Amounts contributed to your IRA's should be set aside to fund your retirement.
• Your anticipated income in 1998. Remember, this strategy is not available to single taxpayers whose income exceeds $100,000 or to married couples whose combined income exceeds $100,000 or who will prepare their 1998 income tax returns using the filing status 'Married - Separate'. If the adjusted gross income on your tax return exceeds $100,000, then the amount withdrawn and rolled over will be fully taxable in 1998. The amount withdrawn will also be subject to the 10% penalty for premature distributions if the taxpayer is under the age of 59 1/2.
  

The Roth IRA appears to be a great investment vehicle. All eligible individuals should consider contributing to a Roth IRA each year. The easiest way to get more information pertaining to these new IRA's is to contact any of the large financial institutions. They are very interested in getting their hands on as much retirement money as possible and have put together fancy, easy-to-read brochures about these Roth IRA's that they will gladly mail out to you.

Feel free to contact our office at (800) 471-0045 if you would like to discuss Roth IRA's in greater detail.

An index of our previous months' newsletters can be found at oldnews.html

1997 Tax Facts

• For 1997, the standard deduction for a single individual is $4,150 and for a married couple is $6,900. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes, real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses.
• For 1997, the personal exemption has been increased to $2,650 from $2,550. Individuals will claim a personal deduction for themselves, their spouse, and their dependents.
• The maximum earnings subject to social security taxes has been increased to $65,400 in 1997 from $62,700 in 1996.
• The standard mileage rate has been increased to $.315 per mile in 1997 from $.31 per mile in 1996.

Return to home page

The MDTAXES Network, 1-800-471-0045, fax-1-800-547-3366
E-mail us @ cpa@mdtaxes.com