Roth IRAs and Taxes: Contributions, Rollovers, Distributions

As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

Q: How much may an individual contribute to a Roth IRA?

An eligible individual may contribute cash to a Roth IRA on his own behalf up to the lesser of the maximum annual contribution limit (equal to the “deductible amount” under IRC Section 219(b)(5)(A)) or 100% of compensation includable in his gross income for the taxable year reduced by any contributions made to traditional IRAs for the taxable year on his own behalf.

The maximum annual contribution limit is $5,000 for taxable years beginning in 2011 and 2012 and $5,500 in 2013 and 2014.  The $5,000 amount is indexed for inflation. The maximum annual contribution limit is increased by $1,000 for individuals who have attained age 50 before the close of the tax year.  SEPs and SIMPLE IRAs may not be designated as Roth IRAs, and contributions to a SEP or SIMPLE IRA will not affect the amount that an individual can contribute to a Roth IRA. Qualified rollover contributions do not count towards this limit.  Roth IRA contributions are not deductible and can be made even after the individual turns age 70½.

An individual may contribute cash to a Roth IRA for a non-working spouse for a taxable year up to the maximum deductible limit (disregarding active participant restrictions) permitted with respect to traditional IRAs for such non-working spouse, reduced by any such contributions made to traditional IRAs for the taxable year on behalf of the non-working spouse. Thus, a married couple (both spouses under age 50) may be permitted a maximum contribution of up to $11,000 in 2013 and 2014.

The maximum contribution permitted to an individual Roth IRA or a spousal Roth IRA is reduced or eliminated for certain high-income taxpayers. The amount of the reduction is the amount that bears the same ratio to the overall limit as the taxpayer’s adjusted gross income (AGI) in excess of an “applicable dollar amount” bears to $15,000 ($10,000 in the case of a joint return). Thus, the amount of the reduction is calculated as follows:

maximum contribution

x

 AGI - "applicable dollar amount"  
$15,000 ($10,000 if a joint return)

     

 

The “applicable dollar amount” in 2014 is (1) $114,,000 in the case of an individual for 2014, (2) $181,000 in 2014 in the case of a married couple filing a joint return, and (3) $0 in the case of a married person filing separately.

Thus, the Roth IRA contribution limit is $0 for (1) individuals with AGI of $129,000 and above in 2014, (2) married couples filing a joint return with AGI of $191,000 and above in 2014), and (3) a married individual filing separately with AGI of $10,000 and above. Except for married individuals filing separately, the “applicable dollar amount” is indexed for inflation. The amount of the reduction is rounded to the next lowest multiple of $10. Unless the individual’s contribution limit is reduced to zero, the IRC permits a minimum contribution of $200.

For this purpose, AGI is calculated without regard to the exclusions for foreign earned income, qualified adoption expenses paid by the employer, and interest on qualified United States savings bonds used to pay higher education expenses. Social Security benefits includable in gross income under IRC Section 86 and losses or gains on passive investments under IRC Section 469 are taken into account. Also for this purpose, deductible contributions to a traditional IRA plan are not taken into account in determining AGI; amounts included in gross income as a result of a rollover or conversion from a traditional IRA to a Roth IRA are not taken into account for purposes of determining the maximum contribution limit for a Roth IRA.

Q: Can an individual roll over or convert a traditional IRA or other eligible retirement plan into a Roth IRA?

Yes.

A “qualified rollover contribution” can be made from a traditional IRA or any eligible retirement plan to a Roth IRA. A rollover was not permitted prior to 2010 if a taxpayer had adjusted gross income (“AGI”) of more than $100,000 for the taxable year of the distribution to which the rollover related or if the taxpayer was a married individual filing a separate return.

Amounts that are held in a SEP or a SIMPLE IRA that have been held in the account for two or more years also may be converted to a Roth IRA.

The taxpayer must include in income the amount of the distribution from the traditional IRA or other eligible retirement plan that would be includable if the distribution were not rolled over. Thus, if only deductible contributions were made to an eligible retirement plan, the entire amount of the distribution would be includable in income in the year rolled over or converted. (Special rules apply for conversions made in 2010). While the 10 percent early distribution penalty does not apply at the time of the conversion to a Roth IRA, it does apply to any converted amounts distributed during the five year period beginning with the year of the conversion.

When an individual retirement annuity is converted to a Roth IRA, or when an individual retirement account that holds an annuity contract as an asset is converted to a Roth IRA, the amount that is deemed distributed is the fair market value of the annuity contract on the date of the (deemed) distribution. If, in converting to a Roth IRA, an IRA annuity contract is completely surrendered for its cash value, regulations provide that the cash received will be the conversion amount.

Non-rollover contributions made to a traditional IRA for a taxable year (and any earnings allocable thereto) may be transferred to a Roth IRA on or before the due date (excluding extensions of time) for filing the federal income tax return of the contributing individual and no such amount will be includable in income, providing no deduction was allowed with respect to such contributions. Such contributions would be subject to the maximum annual contribution limits.

A “qualified rollover contribution” is any rollover contribution to a Roth IRA from a traditional IRA or other eligible retirement plan that meets the requirements of IRC Section 408(d)(3).  A rollover or conversion of a traditional IRA to a Roth IRA does not count in applying the one IRA-to-IRA rollover in any twelve month period limit.

For years prior to 2010, the taxpayer’s AGI was calculated without regard to the exclusions for foreign earned income, qualified adoption expenses paid by the employer, and interest on qualified United States savings bonds used to pay higher education expenses. Deductible contributions to a traditional IRA also were not taken into account in determining AGI. Amounts included in gross income as a result of a rollover or conversion from a traditional IRA or other eligible retirement plan to a Roth IRA were not taken into account. Social Security benefits includable in gross income under IRC Section 86 and losses or gains on passive investments under IRC Section 469 were taken into account. The definition of AGI excludes minimum required distributions to IRA owners aged 70½ or older, solely for purposes of determining eligibility to convert a regular IRA to a Roth IRA.

An eligible retirement plan, for this purpose, includes a qualified retirement plan, an IRC Section 403(b) tax sheltered annuity, or an eligible IRC Section 457 governmental plan. Taxpayers, including plan beneficiaries, can directly transfer (and thereby convert) money from these plans into a Roth IRA without the need for a conduit traditional IRA. (Other than by direct conversion from an eligible non-IRA retirement plan, a beneficiary may not convert to a Roth IRA.)

Planning Point: Major reasons for converting to a Roth IRA often include obtaining tax-free qualified distributions from the Roth IRA and greater stretch from the Roth IRA because distributions from a Roth IRA are not required until after the death of the owner (or the death of the IRA owner’s spouse if the spouse is the sole designated beneficiary and elects to treat the IRA as the spouse’s own), rather than starting at age 70½. A conversion also may make sense if it is expected that tax rates will increase (from the time of conversion to the time of distribution), but not if tax rates will decrease. Consider whether any special tax benefits, such as net unrealized appreciation, would be lost if a qualified plan is converted to a Roth IRA. Also, a qualified plan may offer better asset protection than a Roth IRA. State laws vary on this issue. If a taxpayer cannot qualify under the Roth AGI limitations, perhaps he or she can establish a traditional IRA, and then convert that into a Roth IRA. Note that this, however, has not yet been addressed by the IRS.

Q: How are amounts distributed from a Roth IRA taxed?

Where a Roth IRA contains both contributions and conversion amounts, there are ordering rules that apply in determining which amounts are withdrawn. In applying the ordering rules, traditional IRAs are not aggregated with Roth IRAs. All Roth IRAs are aggregated with each other. Regular Roth IRA contributions are deemed to be withdrawn first, then converted amounts second (in order if there has been more than one conversion). Withdrawals of converted amounts are treated first as coming from converted amounts that were includable in income. The ordering rules continue to treat earnings as being withdrawn after contributions.

“Qualified distributions” from a Roth IRA are not includable in gross income. Thus, earnings are tax-free, not tax deferred as with traditional IRAs. A “qualified distribution” is any distribution made after the five-taxable year period beginning with the first taxable year for which the individual made a contribution to a Roth IRA (or such individual’s spouse made a contribution to a Roth IRA) established for such individual and such distribution meets one of the following requirements.

(1) It is made on or after the date on which the individual attains age 59½;

(2) It is made to a beneficiary (or to the estate of the individual) on or after the death of the individual;

(3) It is attributable to the individual’s being disabled (within the meaning of IRC Section 72(m)(7));

(4) It is a “qualified first-time homebuyer distribution” (see below).

A “qualified first-time homebuyer distribution” is any payment or distribution that is used within 120 days after the day it was received by the individual to pay the qualified acquisition costs of a principal residence of a first-time homebuyer. The aggregate amount of payments or distributions received by an individual from all Roth and traditional IRAs that may be treated as qualified first-time homebuyer distributions is limited to a lifetime maximum of $10,000. The first-time homebuyer may be the individual, his or her spouse, any child, grandchild, or ancestor of the individual or his or her spouse. A first-time homebuyer is further defined as an individual (and, if married, such individual’s spouse) who has had no present ownership interest in a principal residence during the two year period ending on the date of acquisition of the residence for which the distribution is being made. The date of acquisition is the date on which a binding contract to acquire the residence is entered into or the date construction or reconstruction of the residence begins. Qualified acquisition costs are defined as the costs of acquiring, constructing, or reconstructing a residence, including reasonable settlement, financing, or other closing costs.

In calculating the five-taxable-year period, it is important to remember that contributions to Roth IRAs, as with traditional IRAs, may be made as late as the due date for filing the individual’s tax return for the year (without extensions). Thus, if a contribution is made to a Roth IRA between January 1, 2013 and April 15, 2014 for the 2013 taxable year, the five-taxable-year holding period begins to run in 2013.

For purposes of determining whether a distribution from a Roth IRA that is allocable to a “qualified rollover contribution” from a traditional IRA is a “qualified distribution,” the five-taxable-year period begins with the taxable year for which the conversion applies. A subsequent conversion will not start the running of a new five-taxable-year period.

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For more tax stories and Tax Facts Q&A’s, check out our Special Report: 21 Days of Tax Planning Advice for 2014.

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