The year 2010 marks the first time that wealthy individuals will have easy access to a Roth IRA. Although they still won't be able to make contributions to a Roth IRA if their adjusted gross income (AGI) is too high, there will no longer be an income limitation to prevent them from converting a traditional IRA or other qualified retirement account into a Roth. A special provision defers the taxation of a 2010 Roth IRA conversion into the years 2011 and 2012.

Whereas a traditional retirement account is designed to defer the taxation of compensation income, a Roth IRA is the inverse: There is no income tax deduction for a deposit into a Roth IRA but the distribution, including the investment income earned in the account, is exempt from taxation.

The best candidate for a Roth IRA conversion is a person who'll always be in the highest income tax bracket, a person who'll likely be subject to the estate tax, or someone who is currently in a low income tax bracket but will likely be in a higher income tax bracket in retirement. For others, the decision is less clear. It will depend on whether the advantages outweigh the disadvantages. So let's examine the pros and cons of a Roth IRA conversion and analyze the steps to make, and to undo, a Roth IRA conversion in 2010.

Pros and Cons

Roth IRAs (and, in most cases, also Roth 401(k) accounts and Roth 403(b) accounts) have five advantages over traditional retirement accounts and two disadvantages. The advantages are:

  1. Distributions are tax-free if made (a) after five years and (b) after age 59 ½ or death. Whereas distributions from a conventional retirement plan account are generally fully taxable, a distribution from a Roth IRA is excluded from gross income, provided that it was made more than five years after a taxpayer made his first contribution to any Roth IRA1 and it was made after the individual attained age 59 ½, became disabled, or died.2

  2. Greater wealth can be accumulated in a tax-sheltered environment, because Roth contributions are made with after-tax dollars. Some individuals would like to contribute more than the maximum annual dollar limitation to an IRA, 401(k) or 403(b) account. In 2009 the limits were $5,000 for an IRA and $16,500 for an employee-elected contribution to a 401(k) or 403(b) account. A contribution of after-tax dollars has the net effect of contributing more pre-tax income to the account. For someone in a 33 percent tax bracket, the maximum contributions to a Roth account are the comparable equivalents of contributing about $7,500 or $25,000 of pre-tax income (oversimplified).

  3. There are no required distributions from a Roth IRA after age 70 ½. Traditional IRAs, qualified retirement plans, Roth 401(k) plans and Roth 403(b) plans must make required minimum distributions (RMDs) after the required beginning date (the RBD, which is April 1 following the year that the individual attains age 70 ½).3 The RMD ranges between 4 percent and 5 percent of the account balance between ages 71 and 80, and between 5 percent and 8 percent of the account balance between ages 81 and 90.4

    An important advantage of a Roth IRA is that account owners are not required to receive any distribution from Roth IRAs during their lifetime.5 This permits a greater accumulation of resources for major expenses that may occur in retirement. Individuals who have a Roth 401(k) or Roth 403(b) account do not have this advantage, but can easily obtain it by making a tax-free rollover of the account to a Roth IRA.6 After the account owner's death, a Roth IRA must begin making distributions under rules similar to the rules that apply to a traditional IRA (there is, however, a slight twist described under “disadvantages.”)

Continue on Page 2

  1. Roth accounts can reduce the size of a person's taxable estate, thereby reducing federal and state estate taxes. By paying the applicable income tax in the year that contributions are made to a Roth account, a person will have a smaller estate that could be subject to estate tax. By comparison, a person with a taxable estate will be paying estate tax on the deferred income taxes in a traditional retirement account.

    A Roth IRA conversion can therefore be an important pre-mortem estate tax planning strategy. For example, assume that Grandma is about to enter the hospital with a serious medical condition and that she has a taxable estate of $3.6 million, which consists of $1 million in a traditional IRA and $2.6 million of cash, stock and real estate. Grandma can avoid a federal estate tax liability by doing a Roth IRA conversion of $300,000 from her IRA, which will trigger a $100,000 income tax liability and bring her taxable estate down to the $3.5 million level that eliminates the federal estate tax. If she dies, her family will inherit a $700,000 taxable IRA,7 a $300,000 tax-exempt Roth IRA, and $2.5 million of cash, stock and real estate. Had she not done the Roth IRA conversion, the estate would have paid a 45 percent federal estate tax on the $100,000 of deferred income taxes. If Grandma overcomes the medical condition, she has the option to reverse the Roth IRA conversion anytime before her income tax return is due in the following year (a “recharacterization,” described below).

  2. Contributions to a Roth IRA are possible after age 70 ½. Whereas an employee or a self-employed individual over the age of 70 ½ can continue to make tax-deductible contributions to his account in an employer retirement plan,8 contributions cannot be made to a traditional IRA during or after the year that an individual attains age 70 ½.9 By comparison, contributions are permitted to a Roth IRA by an individual who has employment or self-employment income after age 70 ½.10

That's all very well and good but let's not ignore the disadvantages. They are:

  1. Income might be taxed at a higher rate with a Roth account. In many cases, the income contributed to and withdrawn from a Roth account will be taxed at a higher income tax rate than income contributed to and withdrawn from a traditional retirement account. If a person is in the same marginal income tax bracket during working years and retirement years, then a Roth account will produce an identical amount of after-tax wealth compared to a traditional retirement account. If, however, a person is in a lower income tax bracket in retirement years, then the income deposited into a Roth account will likely be taxed at a higher rate and the individual will have less after-tax wealth. (See “Is Income in a Roth Account Taxed at a Higher Rate?” this page.)

    Although each person's financial situation is unique, in most cases people have less income during retirement and are likely to be in a lower income tax bracket. A Roth IRA conversion exacerbates the problem because it accelerates into a single taxable year (or two years: 2011 and 2012) the taxation of income that could have been spread out among many years in retirement.

    In some cases, however, a Roth IRA conversion can produce clear income tax savings, such as when a person who works in one of the nine states that has no state income tax11 intends to retire to another state that has an income tax.

    For most people, though, the issue will be whether the five advantages provided by a Roth IRA exceed the cost of accelerating taxable income into an earlier year through a Roth IRA conversion.

  2. A Roth IRA must be liquidated faster than a traditional retirement account if an individual dies between ages 71 and 91 and if the account fails to qualify for “stretch” treatment. Generally, a Roth IRA must be liquidated after death under the same rules that govern the liquidation of a traditional IRA. A stretch arrangement is possible: A Roth IRA can be liquidated over a designated beneficiary's life expectancy (typically until the beneficiary attains age 83, 84 or 85).12 If, however, a Roth IRA fails to qualify for stretch treatment,13 then the Roth IRA must be liquidated within just five years after the owner's death.14 By comparison, a traditional IRA and a conventional retirement account can be liquidated over more than five years: between five years and 16 years for individuals who die between the ages of 71 and 91.15

Continue on Page 3: General Rules, Limitations

General Rules, Limitations

Money can be deposited into a Roth account with either a regular contribution or a Roth IRA conversion. A regular contribution is permitted only in a year that a person has earned income from employment. If an employer offers a Roth 401(k) or Roth 403(b) plan, a person can elect to contribute up to $16,500 of after-tax dollars to the account in 2009 (up to $22,000 if an employee is older than 49)16 and there is no income ceiling to prevent a contribution. By comparison, a person can contribute only up to $5,000 ($6,000 if an individual is older than 49) to a Roth IRA. But a person's ability to contribute to a Roth IRA is restricted if his 2009 AGI is more than $105,000 ($166,000 on joint returns). And it's prohibited if AGI exceeds $120,000 ($176,000 joint).17

  • The Year 2010 — Until the year 2010, a Roth IRA conversion is prohibited if a person's modified AGI exceeds $100,000.18 But starting in 2010, Roth IRA conversions are permitted regardless of any income limitation.19 A person can convert a traditional IRA or other qualified retirement plan account into a Roth IRA by making a Roth IRA conversion regardless of whether he has compensation income in that year. A conversion is treated as a taxable distribution from the traditional account followed by a contribution to a Roth IRA.20

    Typically the amount of a Roth IRA conversion is recognized as taxable income in the year of the conversion.21 A special rule applies for conversions in the year 2010: generally a taxpayer won't have to report any taxable income in the year 2010, but instead the amount of the conversion will be reported ratably in the years 2011 and 2012.22

    For example, if a person converts $100,000 into a Roth IRA in the year 2010, then generally he'll report no income in the year 2010 but instead will report $50,000 of income in 2011 and 2012, respectively. A taxpayer, instead, can elect to have the entire amount taxed in 2010.23 Doing so offers a significant tax-planning opportunity because by the time that a person files a 2010 income tax year in 2011 he might have a better idea which year would produce the lowest income tax liability.

    The year 2010 may also prove to be a particularly good year to make a Roth IRA conversion if investment values are close to the low points that were seen at the worst points of the recession in late 2008 and early 2009. That is, it might be best to use a Roth IRA conversion to lock-in taxation of retirement assets in a year when those assets' values are low. (See “Show Me the Money,” p. 34.)

    A Roth IRA conversion can be made from a traditional IRA, a qualified retirement plan (for example, 401(k), profit sharing), a 403(b) plan, a 457(b) plan and a few other plans.24 As a practical matter, though, people who are still employed generally find it easiest to convert a traditional IRA because many employer plans prohibit distributions before an employee has separated from service.25 If there is a conversion from a qualified retirement plan, it makes sense to establish a separate Roth IRA for that conversion rather than commingle those amounts with a Roth IRA that holds regular contributions. Then, the individual can have greater bankruptcy protection than the $1 million threshold available to traditional IRAs and Roth IRAs under the bankruptcy code.26 A SEP-IRA or a SIMPLE IRA can be converted into a Roth IRA — but there are some restrictions.27 The Internal Revenue Service permits a beneficiary to make a Roth IRA conversion from an inherited retirement account.28

Continue on Page 4

  • Conversion Mechanics — There are three ways to do a Roth IRA conversion:

    The easiest method is to contact the administrator of a traditional IRA and have the entire account transferred to a Roth IRA with the same administrator.29

    The second is to arrange a trustee-to-trustee transfer from a traditional retirement plan to a Roth IRA.30

    The least desirable method is the “60-day rollover,” in which an individual receives a distribution from a traditional retirement plan and has up to 60 days to deposit the amount into a Roth IRA.31 The 60-day method, unlike a trustee-to-trustee transfer, may require income tax withholding by the distributing plan.32 Also, there have been many situations in which an individual fails to complete the transaction within 60 days, creating potentially huge tax liabilities and numerous pleas to the IRS for relief.

    The conversion rules are fairly generous. A person under the age of 59 ½ can convert a traditional IRA to a Roth IRA even if he's receiving “substantially equal periodic payments” that avoid the 10 percent early distribution penalty.33 A person over the age of 70 ½ also can make a Roth IRA conversion, although the RMD for that year cannot be converted.34

  • The Five-Year Fermentation Period — There are two different sanctions on distributions that are made within five years of a regular contribution or a Roth IRA conversion. The first applies to the taxation of a Roth IRA's investment income and the second applies to a distribution of an amount that was converted with a Roth IRA conversion.

For a distribution of the investment income of a Roth IRA to be excluded from gross income, it must be made (a) after the individual attained age 59 ½, became disabled, or died,35 and (b) more than five years after a taxpayer made a contribution or conversion to a Roth IRA.36

The investment income magically ferments from taxable income into tax-exempt income after five years. A distribution of such income within the five-year period is generally taxable. The five-year requirement applies not only to distributions that the account owner might receive during his lifetime, but also to distributions made after death.37 For example, if a Roth IRA is liquidated after the account owner's death but during a year that is within the five-year period, the accumulated investment income will be taxable to the beneficiary.38

Distributions of investment income are tax-exempt if they are made more than five years after a taxpayer made his first contribution or conversion to any Roth IRA.39 Thus, if an individual made a contribution to any Roth IRA before 2006, including a Roth IRA conversion,40 that person will have satisfied the five-year fermentation requirement for a Roth IRA conversion in 2010 or any later year.

But if a Roth IRA conversion in 2010 is a person's first Roth IRA, the five-year fermentation period won't be satisfied until after 2014. The five-year period also applies to any person who establishes his first Roth IRA with a tax-free rollover from a Roth 401(k) or a Roth 403(b) — even though all of the assets from such an account are essentially after-tax dollars.41

Continue on Page 5

Even if a distribution is made from a Roth IRA during the five-year period, a taxpayer often can avoid recognizing taxable income, because distributions are characterized by a favorable arrangement that can be described as “best income in, first income out” ((BIFO), as opposed to “first in, first out” (FIFO) or “last in, first out” LIFO)). Distributions are deemed to be made first from tax-exempt non-deductible contributions, then from tax-exempt Roth IRA conversion amounts, and last from investment income accumulated during the Roth IRA years.42 This is more advantageous than the rule that applies to a distribution from a traditional IRA when an individual made a non-deductible contribution: A portion of every distribution includes some taxable income.43

The second five-year requirement applies only to a Roth IRA conversion. If a distribution of a converted amount is made (a) within five years of the year of the conversion and (b) before the account owner has attained age 59 ½, then a 10 percent early distribution penalty can apply even though the converted amount is exempt from the income tax.44 Unlike the once-in-a-lifetime five-year computation that determines the taxability of a Roth IRA's investment income, this five-year computation is made separately for every year in which a Roth IRA conversion occurs. But the penalty does not apply if the distribution of the converted amount is made under circumstances that would exempt a distribution from a traditional retirement plan from the 10 percent early distribution penalty (for example, a distribution is exempt if it is made after age 59 ½, disability or death).

Tax Tips

A Roth IRA conversion can generate the greatest amount of taxable income that a person might ever have in his lifetime. There are several planning strategies that can reduce the tax bite and maximize the benefits to the Roth IRA owner:

  • Take time to think. Because the 2010 federal income tax return isn't due until April 15, 2011 (Oct. 15, 2011, with an extension), a taxpayer has ample time to determine whether it's better to elect to have the entire conversion taxed in 2010 (perhaps when there is a maximum 35 percent tax rate) compared to reporting the income in 2011 and 2012 (perhaps when income could be taxed at a 39.6 percent rate or even higher). If investment values plummet in 2011, it's even possible to undue a 2010 Roth IRA conversion with a “recharacterization” in 2011.

  • Use money wisely. Avoid using assets in the Roth IRA to pay the income tax liability; use other resources instead.

  • Identify clients who have tax deduction carryforwards in 2010, 2011 and 2012 and urge them to consider a Roth IRA conversion. For example, a client who has a charitable deduction carryforward should consider making a Roth IRA conversion. The charitable carryforward produces an offsetting 50 percent (or 30 percent or 20 percent, depending on the type of charitable deduction)45 income tax deduction that reduces the cost of the conversion. A taxpayer who has a charitable deduction carryforward that expires in the year 2010 should consider electing to report the income from the conversion in 2010 rather than in 2011 and 2012.

  • Consider accelerating tax deductions. An income tax deduction in a high-income (and high-tax rate) year will usually produce a greater tax benefit than the same deduction in a low-income (and low-tax rate) year. Taxpayers therefore should consider accelerating tax deductions into a Roth IRA conversion year. For example, a business owner could replace equipment in 2010, 2011 and 2012 and make the Internal Revenue Code Section 179 election to deduct the entire cost. A person who regularly makes charitable gifts could donate appreciated publicly-traded stock to a grant-making private foundation or donor advised fund so that the charitable income tax deduction is obtained in the highest income year and the charitable grants are made in years when the donor is in a lower income tax bracket.

  • Consider creditor protection issues. A person's IRA generally has $1 million of protection in bankruptcy court and IRAs that hold nothing but assets rolled over from a qualified retirement plan have additional protection.46 By comparison, an inherited retirement account has virtually no protection from creditors.47 If a person intends to protect these assets when they pass to beneficiaries, he might consider specific creditor protection strategies.48

Continue on Page 6: Undoing a Conversion

Undoing a Conversion

A Roth IRA conversion might prove to be a very bad transaction because of developments that occur after the conversion. For example, the value of the investments may plummet after the conversion, which could trigger an inflated income tax liability on deflated assets. Or the individual may win the lottery so that income from the conversion is taxed at rates well above what had been planned.

Fortunately, there is a way to undo a Roth IRA conversion. It's called a “recharacterization.” In the typical situation, the individual instructs the trustee of the Roth IRA to make a trustee-to-trustee transfer of the converted amount (plus the net income earned while in the Roth IRA) to the trustee of a new traditional IRA.49 The trustee-to-trustee transfer must be completed before the due date (plus extensions) for filing the individual's federal income tax return.50 In most cases, a person who made a Roth IRA conversion in 2010 can recharacterize the conversion as late as Oct. 15, 2011.

The price for making a recharacterization is that the taxpayer is not eligible to make another Roth IRA conversion until the first day of the following taxable year or, if later, 30 days after the trustee-to-trustee transfer.51 For example, if an individual made a Roth IRA conversion in March 2010 and recharacterized it in August 2010, then he would have to wait until Jan. 1, 2011 to attempt another Roth IRA conversion.

Prudence, therefore, suggests waiting until November to make a recharacterization decision because the taxpayer probably then has better information about the year's tax situation and investment values. If, instead, the trustee-to-trustee transfer for this 2010 recharacterization occurred on Jan. 29, 2011, then the 30-day prohibition would be relevant and the individual would have to wait until March 2011 to attempt another Roth IRA conversion.

Proceed With Caution

For some people, a Roth IRA conversion in 2010 offers a wonderful estate-planning opportunity that hasn't been available before. For those who can benefit, the best results will occur if resources other than retirement plan assets are used to pay the income tax generated by the conversion and if other tax deductions can be claimed to reduce the sting of the tax bill. The ability to undo a Roth IRA conversion with a recharacterization provides remarkable flexibility for people to get out of a bad situation if circumstances change.

Still, a Roth IRA conversion is not a panacea. Each individual must examine his unique financial circumstances to determine whether the advantages outweigh the disadvantages.

Continue on Page 7: Endnotes

Endnotes

  1. Internal Revenue Code Section 408A(d)(2)(B).
  2. IRC Section 408A(d)(2)(A). The only permissible distribution before age 59 ½ is for disability or to acquire a first home. IRC Sections 408A(d)(2)(A)(iv), 408A(d)(5) and 72(t)(2)(F).
  3. IRC Sections 408(a)(6) (an IRA) and 401(a)(9) (a qualified retirement plan, including a Roth 401(k) and a Roth 403(b); see IRC Section 402A(e)(1)(B)). All required distributions were temporarily waived for the year 2009 because of the devastating hit to stock prices in 2008. See Section 201 of the Worker, Retiree and Employer Recovery Act of 2008, Public Law 110-458.
  4. Computed from Table A-2 of Treasury Regulations Section 1.401(a)(9)-9.
  5. IRC Section 408A(c)(5).
  6. Treas. Regs. Sections 1.402A-1, Q&A-1 and 1.408A-10.
  7. Distributions received from an inherited IRA are taxable income in respect of a decedent (IRD). Revenue Ruling 92-47, 1992-1 C.B. 198; Private Letter Ruling 200336020 (June 3, 2003).
  8. The most common types of retirement plans that permit employees to elect to defer income are 401(k), 403(b), 457(b) and Savings Incentive Match Plan for Employees (SIMPLE) plans. A SIMPLE plan is comparable to a 401(k) plan that uses multiple IRAs for investments rather than a single company trust. IRC Section 408(p). Self-employed individuals can establish a qualified “keogh” plan under IRC Section 401(a) or a Simplified Employee Pension, which is comparable to a profit-sharing plan that uses an IRA rather than an employer trust. IRC Section 408(k).
  9. IRC Section 219(d)(1).
  10. IRC Section 408A(c)(4); Treas. Regs. Section 1.408A-1, Q&A-2 (last sentence).
  11. The nine states that have no state income tax are Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming.
  12. Treas. Regs. Sections 1.408A-6, Q&A-14(b) (Roth IRA); and 1.401(a)(9)-5, Q&A-5(a) through (c) and Q&A-6 (traditional accounts).
  13. Stretch treatment is possible with both traditional and Roth accounts when all of the beneficiaries of the account are either “designated beneficiaries” (that is to say, human beings) or a trust that only benefits designated beneficiaries and meets certain other criteria. Ibid and Treas. Regs. Section 1.401(a)(9)-4, Q&A-5 and 6 (trusts). But such stretch treatment is generally not permitted if one of the beneficiaries of the account is not a human being (for example, the beneficiary is the decedent's probate estate). Treas. Regs. Sections 1.401(a)(9)-5, Q&A-5(a)(2) and 5(c)(3).
  14. Treas. Regs. Section 1.408A-6, Q&A-14(b).
  15. Compare Treas. Regs. Section 1.408A-6, Q&A-14(b) (Roth IRA: five years) with a traditional retirement account: IRC Section 401(a)(9)(ii); Treas. Regs. Sections 1.401(a)(9)-3; and 1.401(a)(9)-5, Q&A-5(b) (traditional account: five years if death before required beginning date (RBD)); 1.401(a)(9)-5, Q&A-5(c)(1) (traditional account: liquidate over life expectancy of someone who was the account owner's age if death after RBD, using life expectancy Table A-1 of Treas. Regs. Section 1.401(a)(9)-9, Q&A-1).
  16. IRS Notice 2008-102; 2008-45 Internal Revenue Bulletin 1106.
  17. Ibid.
  18. IRC Section 408(c)(3)(B)(2009) which will be deleted in 2010 pursuant to Section 512 of the Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222.
  19. Ibid.
  20. IRC Section 408A(d)(3)(A)(i) & (ii); and Treas. Reg. Sections 1.408A-4, Q&A-1(c); and 1.408A-4, Q&A-7. There is no 10 percent penalty for a Roth IRA conversion before age 59 ½, but the penalty can apply if a converted amount is distributed to the owner of a Roth IRA before attaining age 59 ½. Compare IRC Section 408A(d)(3)(A)(ii) with IRC Section 408A(d)(3)(F).
  21. IRC Section 408A(d)(3)(A)(i).
  22. IRC Section 408A(d)(3)(A)(iii). If, however, a person receives a distribution of a converted amount before the year 2012 (for example, there is a distribution in the year 2010) then the person must recognize the distribution as income in the year it was received. IRC Section 408A(d)(3)(E)(i). A similar acceleration occurs if a person dies before the year 2012, though there may be relief if a surviving spouse is the beneficiary. IRC Section 408A(d)(3)(E)(ii); Treas. Regs. Sec. 1.408A-4, Q&A-11.
  23. Ibid.
  24. IRC Section 408A(e)(1).
  25. A 401(k) plan is generally prohibited from making a distribution (other than a hardship distribution) to an employee until he separates from service. IRC Sections 401(k)(2)(B)(i) and 401(k)(2)(B)(i)(IV) (hardship). The Code permits a distribution from a profit sharing plan (which can include a 401(k) plan) once an employee attains age 59 ½, but many plans do not make this option available. IRC Section 401(k)(2)(B)(i)(III).
  26. 11 U.S.C. 522(n), as amended by Section 244 of the Bankruptcy Abuse and Prevention Act of 2005, P.L. 109-8.
  27. Treas. Regs. Section 1.408A-4, Q&A-4. Distributions during the first two years of an employee's participation in a SIMPLE IRA cannot be converted.
  28. IRS Notice 2008-30, Q&A-7 at 2008-12 IRB 638, 639 applies to inherited qualified retirement accounts described in section 402(c)(11). An inherited IRA is apparently not eligible for a Roth IRA conversion. IRC Section 408A(e)(1)(B)(i) runs into the prohibition in IRC Section 408(d)(3)(C). See Choate, Natalie, "Nonspouse Beneficiary Roth IRA Conversions", LISI Employee Benefits and Retirement Planning Newsletter No. 514 (February 18, 2010) at http://www.leimbergservices.com/. If there is a Roth IRA conversion of an inherited retirement account, distributions must commence the year following the decedent's death. That means a Roth IRA conversion of an inherited account produces a "pay now, enjoy later" result. By comparison, a person is not required to receive any lifetime distribution from his or her own Roth IRA. IRC Section 408A(c)(5).
  29. Treas. Regs. Section 1.408A-4, Q&A-1(b)(3).
  30. Treas. Regs. Section 1.408A-4, Q&A-1(b)(2).
  31. Treas. Regs. Section 1.408A-4, Q&A-1(b)(1). There is no one-rollover-per-year limitation for Roth IRA conversions as there is with a traditional IRA 60-day rollover. Treas. Regs. Section 1.408A-4, Q&A-1(a).
  32. Treas. Regs. Section 1.408A-6, Q&A-13.
  33. Treas. Regs. Section 1.408A-4, Q&A-12.
  34. Treas. Regs. Section 1.408A-4, Q&A-6(a).
  35. IRC Section 408A(d)(2)(A). The only permissible distribution before age 59 ½ is for disability or to acquire a first home. IRC Sections 408A(d)(2)(A)(iv), 408A(d)(5) and 72(t)(2)(F). If a taxable distribution is received before age 59 ½, it's generally subject to the usual 10 percent penalty that applies to early distributions from traditional retirement plans. Treas. Regs. Section 1.408A-6, Q&A-5(a).
  36. IRC Section 408A(d)(2)(B); Treas. Regs. Section 1.408A-6, Q&A-2. A similar five-year fermentation applies to the investment income of a Roth 401(k) account. IRC Section 402A(d)(2)(B); Treas. Regs. Section 1.402A-1, Q&A-4.
  37. Treas. Regs. Section 1.408A-6, Q&A-7 and Q&A-11.
  38. Ibid.
  39. IRC Section 408A(d)(2)(B); Treas. Regs. Section 1.408A-6, Q&A-2 (“first regular contribution is made to any Roth IRA”).
  40. Treas. Regs. Section 1.408A-6, Q&A-2.
  41. Treas. Regs. Section 1.408A-10, Q&A-4.
  42. Treas. Regs. Section 1.408A-6, Q&A-8. IRC Section 408A(d)(4)(B)(i) (conventional annual contributions) and IRC Section 408A(d)(4)(B)(ii) (conversion contributions). See also Treas. Regs. Section 1.408A-6, Q&A-9&10. But note that a special rule applies if a distribution is made before 2012 from a Roth IRA that was converted in 2010 with taxation deferred into 2011 and 2012: the distribution of the converted amount will be classified as taxable income in the year it was received. IRC Section 408A(d)(3)(E)(i) and (ii); Treas. Regs. Section 1.408A-6, Q&A-6.
  43. See the instructions to IRS Form 8606 for the rules governing non-deductible contributions made under IRC Section 408(o)(2). All IRAs are aggregated for purposes of calculating the taxable and tax-free portions of a distribution from a traditional IRA. Consequently, every distribution from any traditional IRA is partially taxable and partially tax-free if a taxpayer ever made a non-deductible contribution to any IRA, even when he or she receives a distribution from an IRA that never received a non-deductible contribution.
  44. IRC Section 408A(d)(3)(F) and Treas. Regs. Section 1.408A-6, Q&A-5(b)&(c) and Q&A-10, Examples (4) and (6). The 10 percent early distribution penalty of IRC Section 72(t) that normally applies only to a taxable distribution from a traditional retirement plan will apply to a tax-exempt distribution of a Roth IRA conversion amount. As a corollary, the exceptions that avoid the traditional 10 percent penalty (for example, a distribution after age 59 ½, disability, death or a medical hardship) also apply to exempt an eligible distribution of a conversion amount from the penalty. Treas. Regs. Section 1.408A-6, Q&A-5(b) (last sentence) and IRC Section 72(t)(2).
  45. IRC Sections 170(b)(1)(C)(ii), 170(b)(1)(D)(ii), and the last sentence of 170(b)(1)(B).
  46. 11 U.S.C. 522(n), as amended by Section 244 of the Bankruptcy Abuse and Prevention Act of 2005, P.L. 109-8.
  47. See In re Jarboe, 2007 WL 987314 (Bkrtcy S.D. Tex. 2007), In re Kirchen, 344 B.R. 908 (E.D. Wisc. 2006) and In re Greenfield, 289 B.R. 146 (S.D. Calif. 2003).
  48. See Robert Keebler, and Mark Merric, “Are Inherited IRAs Protected Under State Exemption Statutes?” Steve Leimberg Employee Benefits and Retirement Planning Newsletter #427 (Sept. 4, 2007).
  49. IRC Section 408A(d)(6); Treas. Regs. Section 1.408A-5, Q&A-10 (Example 1). Both trustees should be informed that the transaction is a recharacterization. On the individual's federal income tax return the original conversion amount is reported as having been transferred to the traditional IRA rather than the Roth IRA.
  50. Ibid, and Treas. Regs. Section 1.408A-5, Q&A-6(b).
  51. Treas. Regs. Section 1.408A-5, Q&A-9.

Christopher Hoyt is a professor at the University of Missouri (Kansas City) School of Law in Kansas City, Missouri

Is Income In a Roth Account Taxed at a Higher Rate?

A comparison of a traditional retirement account with a Roth account

Assume that an individual in a 30 percent income tax bracket (combined federal and state) earns $1,000 of income. That person could deposit the pre-tax $1,000 amount into a traditional retirement account, claim a tax-deduction for the contribution, and then pay income tax in the year of withdrawal. Alternatively, the person could pay $300 of income tax and deposit the remaining $700 into a Roth account and pay no income tax in the year of withdrawal. Assuming each account makes identical investments and grows ten-fold (to $10,000 and to $7,000, respectively) the individual would have an identical amount of after-tax wealth if he he is in a 30 percent tax bracket in the year of withdrawal: $7,000. But, if a person is in a lower income tax bracket in retirement years, the income deposited into a Roth account will likely be taxed at a higher rate and the individual will have less after-tax wealth. Another potential negative for the traditional account: the estate tax. If the person dies before withdrawing the accumulated amount and if there is a federal or state estate tax liability, the $10,000 in the traditional account would trigger a greater estate tax liability than the $7,000 in the Roth account.


Traditional Account Roth Account
Initial Contribution $1,000 $700
Income Tax Paid in Year of Initial Contribution 0 300
Tenfold Growth 10,000 7,000
Income Tax Paid in Year of Withdrawal (Retirement Years)

20% Tax Rate 2,000 0
30% Tax Rate 3,000 0
40% Tax Rate 4,000 0
After-Tax Wealth

20% Tax Rate 8,000 7,000
30% Tax Rate 7,000 7,000
40% Tax Rate 6,000 7,000
— Christopher Hoyt