Similar in concept to the traditional IRA, the Roth IRA differs in that contributions are never deductible and, if certain requirements are met, distributions from the account may be received free of federal income tax.

Establishing a Roth IRA

Annual contributions: A Roth IRA may be established and funded at any time between January 1 of the current year, up to and including the date an individual’s federal income tax return is due, (generally April 15 of the following year), not including extensions. The account must be designed as a Roth IRA at the time it is established.

Conversion of existing IRA account: IRA Sec. 408A, which provides for Roth IRAs, allows an existing, traditional IRA (either an annual contribution IRA or a rollover IRA) to be converted to a Roth IRA. The conversion from the old traditional IRA to the Roth IRA results in a taxable event. Previously deducted IRA contributions and all earnings in the account are added to the taxpayer’s gross income for the year of conversion.

Any 10% excise tax (penalty for withdrawals before age 59 _), which might apply to converted amounts, is waived. However, if a taxpayer withdraws amounts from the converted Roth IRA within five years of the year of conversion, the 10% excise tax will apply to those amounts deemed to be part of the conversion.

The taxpayer making the conversion must have an adjusted gross income (AGI) of $100,000 or less in the year of conversion or no conversion is permitted. The law also prohibits conversion if a taxpayer is using the married filing separate status. A taxpayer who converts amounts from a traditional IRA to a Roth IRA may reverse the transaction and recharacterize the converted funds. Only one such conversion and recharacterization is permitted during a tax year. For example assume that a taxpayer converts and then unconverts a Roth IRA in 2002. In general, the taxpayer must wait until tax year 2003 before again converting amounts from a traditional IRA to a Roth IRA. The recharacterization of converted amounts must generally be made by the due date for the taxpayer’s return, plus any extensions.

There are currently two types of Roth IRAs.

• Individual retirement accounts: These are trusts with a corporate trustee.
• Individual retirement annuities: These are special annuities issued by a life insurance company.

Contribution Limits

• After a five-year waiting period;
• After the taxpayer reaches age 59 1/2;
• Due to the taxpayer’s death;
• Because the taxpayer becomes disabled; or
• To pay for qualified first-time-home-buyer expenses.

Distributions which are not qualified are subject to tax. Amounts withdrawn are first considered to come from nondeductible contributions and conversion amounts (all Roth IRAs are aggregated for this calculation) and are not subject to tax. After all original contributions have been withdrawn, remaining amounts are considered to be income earned within the IRA and, if withdrawn, are taxable. If taxable distributions are received prior to age 59 _, a 10% penalty tax may be added.

A taxpayer who converted a traditional IRA to a Roth IRA in 1998 could have elected to recognize any taxable income from the conversion ratably, over a four-year period. If such a taxpayer withdraws amounts from the Roth IRA prior to the year 2001, however, the benefits of any remaining deferral will be lost and recognition of any remaining, unrecognized income will be accelerated, up to the amount of the distribution allocable to the 1998 conversion.

Other Differences

There are several other significant differences between the traditional IRA and the Roth IRA.

• Contributions after age 70 1/2: Unlike the traditional IRA, contributions to a Roth IRA may be made even after the taxpayer has reached age 70 1/2, as long as the taxpayer has compensation.
• Distribution requirements: Roth IRAs are not subject to the mandatory distribution requirements during the life of the owner (triggered at age 70 1/2), which apply to traditional IRAs.

Factors Favoring Conversion to a Roth IRA

Factors which would favor converting an existing traditional IRA to a Roth IRA include the following:

• The dollar amount in an existing IRA is relatively small.
• The majority of contributions in an existing IRA consist of nondeductible contributions.
• A taxpayer has at least five years before withdrawals are planned.
• A taxpayer anticipates that the funds in an IRA will not be needed at retirement and would like to continue tax-free growth for as long as possible.
• Sufficient non-IRA funds are available to pay the additional income tax due as a result of the conversion from a traditional IRA to a Roth IRA.
• It is anticipated that a taxpayer’s marginal tax bracket during retirement will be the same as, or higher than, the current marginal bracket.

Investment Alternatives

• Banks and savings and loans: Certificates of deposit are generally insured by the FDIC. Fixed and variable rates are available. There may be stiff penalties for early withdrawal.
• Annuities: Traditional, fixed individual retirement annuities issued by life insurance companies can guarantee fixed monthly income at retirement and may include a disability-waiver-of-premium provision. Variable annuities do not guarantee a fixed monthly income at retirement.
• Money market: Yield fluctuates with the economy. Investor cannot lock in higher interest rates. It is easy to switch to other investments.
• Mutual funds: A wide variety of mutual funds with many investment objectives are available.
• Zero coupon bonds: Bonds are issued at a deep discount from face value. There are no worries about reinvesting interest payments. Zero coupon bonds are subject to inflation risk and interest rate risk.
• Stocks: A wide variety of investments (and risk) are possible. Losses are not qualified plans, specifically in the areas of real estate and mortgage pools.
• Limited partnerships: Some limited partnerships are especially designed for qualified plans, specifically in the areas of real estate and mortgage pools.

Prohibited Investments or Transactions

• Life insurance: Roth IRAs cannot include life insurance contracts.
• Loans to IRA taxpayer: Self-borrowing triggers a constructive distribution of the entire amount in an IRA.
• Collectibles: Purchase of art works, antiques, metlas, gems, stamps, etc., will be treated as a taxable distribution. Coins issued under state law and certain U.S. gold, silver and platinum coins are exceptions. Certain kinds of bullions may be purchased.

Other Factors to Consider

• Is the interest rate fixed or variable? If the interest rates drop, a fixed rate is better, especially if you can make future contributions at the same fixed rate. If interest rates go up, you may be able to roll the account to another Roth IRA.
• What is the yield? More frequent compounding will produce a higher return.
• How often can you change investments? Is there a charge?