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Author: dpine Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121144  
Subject: More Roth Date: 1/30/1998 1:53 PM
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Like many of us, I'm pondering converting to Roth. It probably makes sense for me as I don't have a large IRA (yet) and I can't make deductable contributions anyway.
The other day I saw an article by Tobias on the Ameritrade web site that has me totally confused. It seemed to indicate that if you convert a traditional IRA to Roth it becomes a "conversion IRA" and one then can't make additional contributions. To make a 1998 Roth contribution you would have to set up a separate "contribution IRA" The two Roth IRAs can't be mixed. Yikes. Say it ain't so?

See article at
http://www.ameritrade.com/cgi-bin/tobiasart.cgi/19980126.html
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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1628 of 121144
Subject: Re: More Roth Date: 1/30/1998 3:22 PM
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[[ It
seemed to indicate that if you convert a traditional IRA to Roth it becomes a "conversion IRA" and
one then can't make additional contributions. To make a 1998 Roth contribution you would have to
set up a separate "contribution IRA" The two Roth IRAs can't be mixed. Yikes. Say it ain't so?]]

The IRS has suggested that you keep them separate. The brokerage houses have followed that suggestion.

And while there is no LEGAL reason that they can't be combined, you could get stuck with BIG penalties if you find that you have to remove funds "early" from a "combined" Roth IRA account.

For additional information, read part III of my Roth IRA post on this very issue (in the Fools School area). It will discuss how distributions are taxed (or not taxed). And, as far as the penalty issue, I'll give you a peek at next week's rough draft of the article on the Roth IRA penalty issues...

Roth IRA - Part IV

After discussing contributions, rollovers (or conversions), and distributions, we will now look at the penalties issues regarding "early" distributions from a Roth IRA.

Penalties on Earnings from Contributions

Unless an exception applies, any distribution from a Roth IRA before an individual reaches age 59 ½ will be subject to an "early withdrawal penalty" in the amount of 10% of the amount of the distribution required to be included in the taxpayer's gross income. Be very careful NOT to confuse the early withdrawal penalty with the taxes imposed on a non-qualified distribution (discussed in Part III): A non-qualified distribution imposes a tax on the distribution, but the early withdrawal penalty will be imposed in addition to the tax.

Example: Jim, age 30, makes a Roth IRA contribution of $2,000 in 1998. In year 2005, Jim's Roth IRA has a balance of $3,500. Jim decides to close his Roth IRA in a non-qualified distribution in year 2005. Since the distribution is non-qualified, Jim will owe taxes on his Roth earnings of $1,500, and will pay tax on this amount at his marginal tax rate. In addition, since the distribution took place before Jim reached age 59 ½, and since Jim did not meet any of the exceptions, Jim will also be assessed a 10% early withdrawal penalty on the earnings. If we assume that Jim is in the 28% marginal tax bracket, he will pay $420 in tax on the earnings, and will pay a penalty in the amount of $150 on the early distribution. This could be a very steep price to pay.

Exceptions

The 10% early withdrawal penalty does NOT apply to the following distributions:

1. to a beneficiary because of the death of the Roth IRA owner
2. due to the disability of the Roth IRA (disability as defined by IRS Code Section 72(m)(7)
3. that are part of a series of substantially equal periodic payments made at least annually for the life (or life expectancy) of the Roth IRA owner or the joint life (or expectancies) of the Roth IRA owner and the beneficiary
4. to the extent that the distributions do not exceed the amount allowable as an itemized medical deduction (regardless of whether you itemize your deductions or not)
5. to unemployed individuals for the purchase of health insurance premiums
6. to pay higher education expenses
7. to pay for qualified first-time homebuyer expenses

As you will note, these are the same penalty exceptions that apply to a regular IRA. For an additional discussion on these penalty exceptions, read IRS Publication 590 at the IRS web site (http://www.irs.ustreas.gov).

Penalties on Rollovers from a Regular IRA to a Roth IRA

The penalty rules regarding rollovers are a bit different from contributions. Remember that with contributions, you can withdraw your "principal" contribution at any time, and that principal withdrawal will not be subject to taxes or penalties (as noted in the example for Jim above, and as discussed in the Roth IRA Part III post).

But rollovers have a different twist. And the rollover rules are different for 1998 rollovers as compared to 1999 or later rollovers.

1999 and Later Rollovers

For a rollover that takes place in 1999 or later, the 10% penalty WILL apply to both rollovers and earnings in the Roth IRA account if the five-tax year rule has not been met. (We discussed the five-tax year rule in Part III, so you might want to take a few minutes to review it in detail at this time).

Example: Mary, who is 40, makes a qualified rollover from her regular IRA to a Roth IRA on December 30, 1999 in the amount of $20,000. Since Mary is in the 28% marginal tax bracket, she will pay $5,600 in income taxes in 1999 relative to this rollover. Mary withdraws the rollover "principal" of $20,000 on January 1, 2004. There is no tax or early withdrawal penalty on this amount, even though no other penalty exceptions apply. Why? Because the five-tax year rule was met.

Example: Using the same facts as above, but Mary takes her $20,000 distribution in December 2003. While Mary will not owe any income tax on this distribution, Mary WILL owe a 10% early withdrawal penalty in the amount of $2,000 on this distribution (assuming that none of the penalty exceptions are met). Why? Because the five-tax year rule was NOT met.

Example: Using the same facts as above, but Mary takes her $20,000 distribution in January 2004, and Mary also takes a $6,000 non-qualified distribution from her Roth IRA earnings at that same time. Mary will NOT pay tax or penalties on the $20,000 principal withdrawal, but she WILL pay additional tax on the $6,000 of earnings, and will also be charged a $600 penalty on the early withdrawal of those earnings (assuming none of the penalty exceptions can be met). Why? Because the distribution of the earnings was a non-qualified distribution and was made before age 59 ½.

1998 Rollovers

Remember (in Part II) we discussed that 1998 is a special year for Roth IRA rollovers in that the taxable income must be spread over a 4 year tax period. Well, 1998 is also a special year for IRA Rollover penalties. In addition to the regular 10% early withdrawal penalty, there will be an ADDITIONAL 10% penalty that will be imposed on early withdrawals made from 1998 rollovers. This additional 10% penalty will be assessed to penalize you for spreading your taxable income over a 4 year tax period. This means, in effect, a 20% early withdrawal penalty could be imposed on "early" withdrawals from a Roth IRA rollover that took place in 1998.

Example: Jim, age 35, makes a qualified rollover contribution from his regular IRA to a Roth IRA in the amount of $60,000 on December 30, 1998. Jim is required to spread this income over a 4 year period, and is required to report $15,000 per year in 1998, 1999, 2000, and 2001. In January 2003, Jim takes a principal distribution of $40,000. Jim will not be assessed any tax or penalty on this distribution. Why? Because the five-tax year exception has been met.

Example: Same facts as above, but assume that Jim takes this $40,000 distribution in 2002. Jim will pay no income tax on this distribution. But, since the five-tax year period was not met, and assuming that none of the penalty exceptions are met, Jim WILL pay a 20% early withdrawal penalty of $8,000 on this distribution. This 20% represents the normal early withdrawal penalty of 10% PLUS the additional 10% early withdrawal penalty assessed against 1998 rollovers.

Example: Same facts as above, but assume that Jim takes the entire $60,000 principal distribution in 2002, plus an additional $12,000 which represents a non-qualified distribution from the Roth IRA earnings. Assuming that no penalty exceptions apply, Jim will get smacked with a $12,000 penalty on the principal (20% of $60,000), and a $1,200 penalty on the earnings (10% of $12,000). Jim will also pay regular income taxes on the earnings of $12,000 in 2002. Why? Since the five-tax year exception was not met, and both the principal and earnings were taken out "early", the principal is subject to the increased penalty, and the earnings are subject to both taxes and penalties. As you can see, this is a VERY SEVERE price to pay for this distribution.

IRS Ordering Rules

It gets worse. The IRS has stated that contribution withdrawals will be treated as being distributed in the following order:

1. First from qualified rollover contributions made from a regular IRA to a Roth IRA in 1998
2. Next, from any other qualified rollover contribution (1999 and later rollovers)
3. Finally, from any contribution to a Roth IRA other than a rollover contribution (regular contributions)

What does this mean? It means that if a distribution is made from a Roth IRA before the five-tax year exclusion date, and that the Roth IRA contains mixed contributions (some from regular contributions, some from rollovers), the distribution would be deemed made from the type of contribution that would result in the highest penalty tax first.

Do you NOW see why the IRS has recommended that that you use separate Roth IRA accounts to hold qualified rollover contributions? I certainly hope so. Combining rollover accounts with regular contribution funds could subject you to penalties far in excess what you might have paid if separate accounts were maintained should you have to take the funds "early".

There are a number of other issues regarding Roth IRAs that we have not discussed in detail. And while those provisions may be important to you, I believe that we have discussed the Roth IRA rules in enough detail to make this the final installment on the Roth IRA. Of course, if you have any additional questions on the Roth IRA, I'll be glad to try to answer them in the Tax Strategies folder.

TMF Taxes
Roy

SPECIAL NOTE: I try to answer as many questions as I can each week, and I generally select those that have not been asked before. If you don't get a detailed answer to your question, it is probably because my time is so limited during tax season, or because it has already been asked and answered in this folder in the past, or because it has been discussed in the Taxes Frequently Asked Questions area. In order to visit the Taxes FAQ area, go to the Fool's School area (http://www.fool.com/school.htm) and check out "Other Features" in the list box, OR you can jump directly to the Taxes FAQ area (http://www.fool.com/school/taxes/taxes.htm). Additionally, if any references were made to the IRS Web Site, you can get there by pointing your web browser to (http://www.irs.ustreas.gov)




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