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Subject:  Roth IRA Contriubtions & Conversions Date:  2/1/1998  5:06 PM
Author:  TMFPixy Number:  1564 of 79085

Greetings, All.

The following is excerpted from a booklet I am writing for my day job on various provisions of the Taxpayer Relief Act of 1997. It deals with the Roth IRA from the standpoint of contributions and rollovers of traditional IRAs. I provide it for your information and reading pleasure. Comments are welcome.

QUOTE:

General. The Roth IRA introduced by TRA 97 provides a new, powerful means to save for retirement and accumulate wealth. It's unlike any savings tool with which we're familiar. We can't get a tax deduction for making a contribution to it, but after the Roth IRA is established all contributions and earnings may be withdrawn free of taxes provided we meet a few relatively simple conditions. Unlike traditional IRAs, no withdrawals are mandatory,
and should we die our heirs will receive the entire balance tax-free. Additionally, provided our AGI is no more than $100,000 and we pay all taxes previously deferred, we may convert existing traditional IRAs to a Roth IRA. On conversion, these IRAs will also enjoy the tax-free benefits provided by the Roth.

Despite the potential for tax-free withdrawals, the Roth IRA may not be the best retirement accumulation tool for everyone. Each of us must look at our own situation to determine what course of action is best for us. Our age, the length of time before we need the money, our tax rates today versus those of tomorrow, and our net worth all play a part in deciding how to use this new option.

Contribution Comparisons. A traditional IRA is "back-loaded." This means that, subject to limits, the contribution is untaxed when it enters the IRA, but it and all earnings thereon will be taxed on withdrawal. A Roth IRA is "front-loaded," which means contributions create no deduction in today's taxes, but on withdrawal they and all earnings are received free of tax. Thus, our problem becomes one of comparing the "front-loaded" Roth IRA to the
"back-loaded" traditional IRA. Should we pay taxes at today's rates to receive tax-free proceeds tomorrow (Roth IRA)? Or should we take today's tax deduction and postpone taxes until tomorrow when we may be in a lower tax bracket (traditional IRA)?

To examine this issue, we need to look at two scenarios.

Scenario 1. John makes a tax-deductible contribution of $2,000 per year to a traditional IRA. He is considering the new Roth IRA, but must maintain the same net income he has today using the traditional IRA. John is in the 28% marginal tax bracket, which means he may only contribute $1,440 to a Roth IRA to keep his net income the same as it is by using the traditional IRA. He wonders how he would fare in the Roth IRA as compared to the
traditional IRA over time, assuming the latter will be taxed at the same marginal rate in the future. He also wonders what the comparison would be if his marginal tax rate decreases when he begins IRA withdrawals. Both investments will earn a 9% annual rate of return.

Table 1 reveals that if John's tax rate remains the same, the Roth IRA and the traditional IRA will provide the same net income after consideration of income taxes. However, if John's marginal tax rate declines at withdrawal, as it does for many retirees, then he is better off in the traditional IRA.

Annual Contributions to Roth IRA
As Compared to Traditional IRA (After Taxes)

Year Roth Before Tax After 28% After 15%
5 $9,394 $13,047 $9,394 $11,090
10 $23,847 $33,121 $23,847 $28,152
15 $46,085 $64,007 $46,085 $54,406
20 $80,301 $111,529 $80,301 $94,800
25 $132,947 $184,648 $132,947 $156,951
30 $213,948 $297,150 $213,948 $252,578
35 $338,580 $470,249 $338,580 $399,712


Table 1

Scenario 2. Assume John's circumstances are the same as before except that he will deposit $2,000 annually into the Roth IRA. To do so, he will forego contributions he was making to a regular investment account that has an after-tax return of 8.244% per year. (Note: The total return on this account is 9%, of which 30% comes from taxable dividends and 70% comes from long term capital appreciation.) For fairness, the lost principal and
growth on this additional $560 deposit must be added to traditional IRA proceeds because the foregone investment would have been available for withdrawal in later years. Assume growth in this investment account will be taxed at a long-term capital gain rate of 20% on withdrawal for a taxpayer in the 28% marginal bracket and at 10% for one in the 15% bracket. Table 2 shows the results of this approach.

$2,000 Annual Contribution to Roth IRA As Compared to Traditional IRA & Taxable Investment Account (After Taxes)

28% Bracket 15% Bracket
Ded IRA Inv Acct IRA/Inv Ded IRA Inv Acct Ded IRA
Year Roth After Tax After Tax Total After Tax After Tax Total
5 $13,047 $9,394 $2,859 $12,253 $11,090 $3,216 $14,306
10 $33,121 $23,847 $7,107 $30,954 $28,152 $7,995 $36,148
15 $64,007 $46,085 $13,420 $59,505 $54,406 $15,097 $69,503
20 $111,529 $80,301 $22,800 $103,101 $94,800 $25,651 $120,450
25 $184,648 $132,947 $36,740 $169,687 $156,951 $41,333 $198,284
30 $297,150 $213,948 $57,455 $271,403 $252,578 $64,637 $317,215
35 $470,249 $338,580 $88,237 $426,816 $399,712 $99,267 $498,979

Table 2

Notice that if John remains in the 28% marginal tax bracket when he takes his savings, then in every time period the Roth IRA will provide a greater income than the combination of the traditional IRA and the taxable investment account after both have been taxed. However, if John's tax rate declines in retirement, the Roth IRA is definitely inferior to the traditional IRA when the latter is used in concert with the taxable investment account.

Note: Based on 1997 marginal tax brackets, taxpayers in the top three tax rates (i.e., 31%, 36%, and 39.6%) are ineligible for a tax deductible traditional IRA. Those in the 39.6% bracket are also ineligible for a contributory Roth IRA. For eligible 31% and 36% taxpayers, the contributory Roth IRA is a better alternative than is the nondeductible regular IRA. Neither results in a current tax deduction, but all Roth proceeds are untaxed on
withdrawal. In the nondeductible traditional IRA, earnings are subject to taxation when withdrawn. For the 39.6% taxpayer, the only IRA alternative is the nondeductible traditional IRA.

Conclusions Regarding IRA Contributions. In choosing between a tax deductible traditional IRA and a Roth IRA, our marginal tax rate today versus that of tomorrow is important. If the tax rate declines when the money is withdrawn, those who end up in a 15% tax bracket will not benefit from Roth IRA contributions. If the tax rate stays the same in retirement, neither choice has an income tax advantage over the other during the owner's
lifetime. (Note: Because the Roth IRA passes tax free to heirs at death, it has the advantage from that standpoint.) To beat the traditional deductible IRA, an after-tax contribution to a Roth IRA must be exactly equal in dollars to that made to the traditional IRA.

Traditional IRA Conversions to a Roth IRA. TRA 97 allows taxpayers to convert traditional IRAs to Roth IRAs provided their AGI is under $100,000 in the year of conversion. (Note: Based on 1997 tax brackets, this means only those with a 15% or 28% marginal rate are eligible for a Roth IRA conversion.) No penalty applies, but ordinary income taxes must be paid on previously untaxed IRA proceeds. If the conversion occurs in 1998, the income
from the IRA must be spread equally over four years for taxation. Conversions made in 1999 or later will be fully taxed in the year they occur. If money is withdrawn from the converted IRA to pay taxes, the 10% early withdrawal penalty will apply for those younger than age 59 ½.

Scenario 3. Jane, who is younger than age 59 ½, has $50,000 in a previously untaxed IRA. She wants to rollover that IRA to a Roth IRA. Her return in either the Roth IRA or the traditional IRA will be 9% per year. Jane cannot afford to pay the income taxes due on the conversion, so she will keep enough money from the rollover to pay all taxes due in 1998 and later years. She wants to know if conversion will result in a better income for
her in retirement.

In this situation, the first problem is to determine how much she must withdraw from the traditional IRA to pay her taxes and the 10% penalty that will be due on the entire withdrawal because she is younger than age 59 ½. This can be done by using the formula W = T + 0.1W in which W is the total amount of withdrawal and T is the total amount of taxes due on the value of the converted IRA. The formula can be reduced to 0.9W = T.

If Jane is in the 15% marginal bracket and if her IRA is worth $50,000, then on conversion she will owe $$7,500 in ordinary income taxes. That means:

0.9W = T
0.9W = $7,500
W = $7,500 / 0.9 = $8,333

Jane can then withdraw $8,333 from her traditional IRA, convert the remainder ($41,677) to the Roth IRA, and have enough to pay her ordinary taxes of $1,875 over each of the next four years (a total of $7,500) plus her $833 early withdrawal penalty in 1998. The $833 is 10% of the total amount withdrawn from the converted IRA. For the purposes of this illustration, we will ignore any earnings she may receive on the amount she has retained to pay
future taxes on the rollover.

The procedure described above was used to calculate the results of converting her IRA assuming she was in the 15%, 28%, or 31% tax bracket in 1998. After-tax comparisons of the Roth IRA to the traditional IRA for each marginal tax rate are at Table 3. In every case, the Roth IRA fails to match the after-tax results of the traditional IRA. This failure is due to the lost investment opportunity on the money she withdrew from the converted IRA to pay
her taxes on the conversion.

Roth IRA Conversions Taxes and Penalty Paid from Converted IRA
15% Bracket 28% Bracket 31% Bracket
Ded IRA Ded IRA Ded IRA
Year Roth after Tax Roth after Tax Roth after Tax
5 $64,110 $65,392 $52,996 $55,390 $50,433 $53,083
10 $98,641 $100,613 $81,541 $85,225 $77,597 $81,674
15 $151,771 $154,806 $125,462 $131,129 $119,393 $125,666
20 $233,519 $238,187 $193,038 $201,759 $183,701 $193,352
25 $359,298 $366,481 $297,013 $310,431 $282,647 $297,496
30 $552,824 $563,876 $456,992 $477,636 $434,888 $457,735
35 $850,589 $867,594 $703,139 $734,903 $669,129 $704,282

Table 3

Scenario 4. Jane is in the 28% tax bracket and has a $50,000 traditio