Perhaps the most interesting provision of the Taxpayer Relief Act of 1997 is the one allowing the rollover of an ordinary IRA to a new Roth IRA. Taxes are due on the amount rolled over, but the 10% penalty on early withdrawal from an IRA is waived. You can transfer money into a Roth IRA if your adjusted gross income (AGI) is no more than $100,000 in the year you make the transfer. (Note: You do not include your IRA rollover amount in determining if your AGI is $100,000 or less.) If you do a rollover between January 1, 1998 and December 31, 1998 you can average your rollover amount over the next four years for income tax purposes. This should reduce the tax owed on the rollover. Once the money is in a Roth IRA, no further Federal income taxes are due on any investment gains or withdrawals, as long as the money remains in the Roth IRA for five years or until age 59 1/2, whichever is longer. The Roth IRA is also not subject to "required minimum distributions" at age 70 1/2.
There is no limit on how much you can transfer. However, with the top tax bracket beginning at $271,050 adjusted gross income (AGI), investors taking advantage of the four-year averaging probably won't want to transfer over $1,000,000 to a Roth IRA.
Many folk's initial reaction is that this is too good to be true and they should rollover their entire IRA to take advantage of this "tax break" immediately. First, you have to wait until January 1, 1998 to do a Roth IRA rollover. Second, it only makes sense to do a Roth rollover if you think there is a good chance you will be in a higher tax bracket when you withdraw the money from your Roth IRA. (That's why it may not make sense to roll over more than $1,000,000.) Many people are in a lower tax bracket when they retire, so you need to look at this calculation very carefully. Finally, you need to have funds available outside of your IRA to pay the income taxes on the rollover. There is good news and bad news on this last point. The good news is that the tax payment is in effect an additional contribution to your Roth IRA. It will compound tax free until you withdraw funds from the Roth IRA. The bad news is that not everyone has the liquid assets available to fund a large tax payment
Who should do a Roth IRA rollover?
It depends on your current tax bracket and your expected tax bracket when you withdraw the money from your IRA.
(1) If your tax bracket is higher when you retire and start withdrawing money from your IRA, a Roth IRA is probably an advantage.
(2) If your tax bracket is lower when you retire and start withdrawing money from your IRA, you'd be better off paying your taxes then, not now. A Roth IRA does not make sense for you.
(3) If your tax bracket remains the same when you retire and start withdrawing money from your IRA, a Roth IRA and an ordinary IRA will have the identicle effect on your finances. In that case it probably makes sense to keep the ordinary IRA since it usually isn't wise to pay your taxes early without some incentive to do so.
What would put me in a higher tax bracket when I retire?
There are several events that could put you in a higher tax bracket. Some folks may even have a high probability of experiencing more than one.
Are there any risks to doing a Roth rollover?
There's risk in everything. The biggest risk is that tax policy could change before you withdraw funds from your Roth IRA. For example, what if Congress passes a consumption tax to replace the income tax as some Republicans advocate? Anyone who prepaid his or her income tax years ahead of time would look and feel pretty foolish.
How do I determine if a Roth rollover is for me?
Retire Early has developed a Microsoft Excel spreadsheet that can help you determine if a Roth rollover makes sense for you. The Retire Early IRA Withdrawal Calculator and Roth Analyzer allows you to input varying inflation and investment return assumptions along with several different IRA early withdrawal scenarios. To download a free copy and instructions for use, click here.
Other sites with information on Roth IRAs.
The Roth IRA Home Page Web Site - Your first stop for the latest thinking on Roth IRAs. From the good folks at Brentmark Software.
Roth IRA could hold future pitfalls - Houston Chronicle columnist Eric Tyson with some cautionary comments on the Roth IRA.
Evaluating the Roth IRA: How much deferral can you handle? - Excellent description of the estate planning advantages of a Roth IRA.
Deal of the Century - Roth IRA - An excellent article by Richard Franklin, a Naples, FL tax attorney.
Strong Funds - 1998 Roth IRA - Includes a calculator for determining the future value of a Roth IRA vs. an ordinary IRA.
Gabelli Funds - Robin's Roth IRA Review - Straight talk on Roth IRAs from the Gabelli Funds web site.
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Copyright © 1998 John P. Greaney, All rights reserved.