Hans Kasper, MS-CPA, PS

Roth IRAs
 

In general, a Roth IRA is subject to the same rules that apply to a traditional IRA. However, contributions to a Roth IRA are never deductible.  In addition, the buildup within a Roth IRA (e.g., interest, dividends and/or price appreciation) may be free from federal income tax when the individual withdraws money from the account.  The following material highlights additional rules that apply to Roth IRAs.

Contribution Limits.  For 2005 through 2007, the maximum annual contribution that may generally be made to Roth IRAs and traditional IRAs is $4,000.  For 2008, the maximum will be $5,000.  The maximum annual contribution is the amount that may be contributed to both types of IRAs combined, not the amount that may be contributed to each type.  However, rollover contributions into a Roth IRA are not counted against the annual maximum.  In addition, unlike traditional IRAs, individuals may make contributions to a Roth IRA after reaching age 70 1/2.  An individual who will be at least age 50 by the end of the tax year is permitted to make an additional contribution to a Roth or traditional IRA.  For 2005, the maximum annual amount of the catch-up contribution is $500.  Starting in 2006, the maximum amount will be $1,000.

Income Limits.  The ability of an individual to make a contribution to a Roth IRA depends upon the amount of the individual's modified AGI.  The maximum yearly contribution that can be made to a Roth IRA is phased out for a single individual with modified AGI between $95,000 and $110,000, for joint filers with modified AGI between $150,000 and $160,000, and for individuals who are married filing separately with modified AGI between $0 and $10,000.  These AGI limits are not adjusted for inflation.  Modified AGI is generally calculated under the same procedure as that used for traditional IRAs.  However, for Roth IRA purposes, modified AGI does not include the income reported from the conversion of a traditional IRA into a Roth IRA.

Taxation of Roth Distributions

“Qualified distributions” from a Roth IRA are not included in the recipient's gross income and are not subject to the additional 10% penalty for early withdrawals.  To be treated as a “qualified distribution,” the distribution must satisfy a five-year holding period and meet one of four requirements discussed below.

To satisfy the five-year holding period, the Roth IRA distribution (including distributions allocable to rollover contributions) may not be made before the end of the five-year period beginning with the first tax year for which the individual made a contribution to the Roth IRA.  The five-year holding period ends on the last day of the individual's fifth consecutive tax year after the holding period started.  Generally, each Roth IRA owner has only one five-year period for all of the Roth IRAs that the individual owns. 

Example 1:   Jack Martin made his first contribution to a Roth IRA on September 15, 1998.  The contribution was for the 1998 tax year.  On December 27, 1999, Jack made another contribution to a Roth IRA.  This contribution was for the 1999 tax year.  On December 30, 2000, he made another contribution to a Roth IRA.  This contribution was for the 2000 tax year.  The five-year holding period for all of Jack's Roth IRAs is considered to have started on January 1, 1998.  Distributions made after December 31, 2002, will have satisfied the five-year holding period. 

Example 2:   Mary Smith made her first contribution to a Roth IRA on April 15, 2005.  The contribution was for 2004.  The five-year holding period for this Roth IRA and all of her subsequent Roth IRA contributions will be considered to have started on January 1, 2004.

In addition to satisfying the five-year holding period, a distribution will constitute a “qualified distribution” only if it is:

(1)  made on or after the date on which individual attains age 59 1/2 ;

(2)  made to a beneficiary (or the individual's estate) on or after the individual's death;

(3)  attributable to the individual's being disabled; or

(4)  a distribution to pay for “qualified first-time homebuyer expenses”.

Distribution Ordering Rules.  When an individual receives a “nonqualified distribution” from a Roth IRA, a portion of the distribution may be included in gross income.  In order to determine the amount that is includible in gross income, specific “ordering rules” must be followed.  Under these rules, regular Roth contributions are deemed to be withdrawn first, then amounts transferred from traditional IRAs (starting with amounts first transferred).  Withdrawals of transferred amounts are treated as coming first from amounts that were included in income.  Earnings are treated as withdrawn after contributions.  Thus, no amount is included in gross income until all the after-tax contributions have been distributed.

If an individual receives a nonqualified distribution from a Roth IRA, a 10% penalty will generally apply to any portion of the distribution that is included in gross income.  However, the 10% early withdrawal penalty may not apply if the distribution satisfies one of the certain exceptions (e.g., qualified higher education expenses and, under limited circumstances, medical insurance and payments).  These are the same exceptions that apply to early distributions from traditional IRAs.  These exceptions are sometimes referred to as the “72(t) exceptions” because they are authorized by Code Sec.  72(t)(2).

Loss on Roth IRA.  When an individual has a loss on a Roth IRA account, the loss can be recognized on the individual's income tax return but only when all the amounts in all the Roth IRA accounts have been distributed and the total distributions are less than the individual's unrecovered basis, if any.  The basis is the total amount of the nondeductible contributions in the Roth IRAs.  The loss is claimed as a miscellaneous itemized deduction, subject to the two-percent floor that applies to certain miscellaneous itemized deductions on Schedule A, Form 1040 (Individual Retirement Arrangements).  A similar rule applies to traditional IRAs.  The loss rule applies separately to each kind of IRA.  Thus, to report a loss on a Roth IRA, all the Roth IRAs (but not traditional IRAs) owned by the individual have to be liquidated, and to report a loss on a traditional IRA, all the traditional IRAs (but not Roth IRAs) owned by the individual have to be liquidated ( IRS Pub.  590 (Individual Retirement Arrangements).

Example 3:   On January 5, 2005, Bill King made his first nondeductible contribution of $2,000 to a Roth IRA which invested the funds in a mutual fund.  This was the only Roth IRA owned by Bill.  On December 10, 2005, Bill sold all the mutual shares in the Roth IRA and received $1,500.  He did not roll the money over into another Roth IRA.  Because the $1,500 distribution is less than his $2,000 basis and he liquidated his only Roth IRA, Bill may claim the $500 loss as a miscellaneous itemized deduction, subject to the two-percent floor, on his Schedule A.  The $1,500 distribution is not subject to the 10% penalty generally imposed on early distributions because it is a nontaxable return of Bill's Roth contribution.  However, he would have to report the withdrawal on Form 8606, Nondeductible IRAs, even though it is not taxable.

Reporting Roth IRA Distributions.  Distributions from Roth IRAs are reported on Part III of Form 8606.  If the 10% early distribution tax applies, it is reported on Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.