Nine Frequently Asked Questions About IRAs

Here are nine of the most frequently asked questions about IRAs.

ROTH Withdrawal Rules
Question: How do I figure out the tax owed on an early withdrawal from a Roth IRA?
Answer: Good question. If you do a conversion, your Roth IRA can include money from (1) your annual after-tax contributions (2) contributions from one or more converted regular IRAs, and (3) earnings on both types of contributions. To figure out what happens when you later take Roth account withdrawals, you need "ordering rules."

Withdrawals are treated as coming first from your annual after-tax contributions. As advertised, this layer of money can always be taken out tax-free at any time. Beyond this easy-to-understand rule, be careful.

The next layer comes from contributions of converted traditional IRA money. Withdrawals come first from the taxable amount, then from the nontaxable amount (if any).

You'll generally owe a 10% penalty if you withdraw the taxable part of a conversion contribution within five years of the conversion. Withdrawals after age 59 1/2 are excepted, and the other exceptions to the 10% premature withdrawal penalty (death, disability, etc.) apply as well. The good news: After five years, this penalty no longer poses a threat. After you've yanked out the taxable part of the conversion contribution, you can withdraw the nontaxable part at any time without any tax or penalty.

To sum up, you don't have to worry about any adverse tax consequences if you wait at least five years before withdrawing any funds from conversion contributions. After all contributions are withdrawn, you are obviously dipping into Roth account earnings. This money comes out tax-free as long as (1) the account has been open more than five years and (2) you are at least age 59 1/2, disabled, or dead. Withdrawals of up to $10,000 for qualified home purchase costs can also be taken tax-free after five years. Withdrawals of earnings that don't meet these rules are hit with income tax and, in most cases, the 10% premature withdrawal penalty tax as well.

Spousal IRA Contributions
Question: Can a nonworking wife make a deductible contribution to her spousal IRA for 2005, assuming that the husband's earned income is $90,000, he is an active participant in an employer's retirement plan, and the couple file a joint return?
Answer: Yes. A spouse who is not covered by a qualified retirement plan can make a $4,000 deductible IRA contribution for 2005 ($4,500 if the nonworking spouse is age 50 or older at yearend) as long as the couple's adjusted gross income doesn't exceed $150,000. However, advises New York financial planner Joel Isaacson, it may be wiser for the wife to open a Roth IRA instead. The contribution is not deductible, but withdrawals from Roth IRAs are tax free. Traditional IRA withdrawals, on the other hand, are taxed as income. So, if retirement is still years away and you don't anticipate being in a much lower tax bracket after retirement, a Roth IRA is probably the better choice. For more information, see our story and interactive worksheet: "Which IRA Is Best?"

Deductible IRA Eligibility
Question: I am single and work two jobs. At one, I am covered by a pension plan. At the other, I am not. With regards to IRA deductibility, am I covered by a pension plan or not?
Answer: "Participation in a company plan at any time during the year triggers the deduction phase-out rules," says CPA Ed Slott, editor of the IRA Advisor newsletter. That probably makes you ineligible because IRA deductibility for singles phases out between $50,000 and $60,000 for 2005.

Evaluating a Roth Conversion
Question: Should I convert to a Roth IRA? Here's my situation. I have about $329,000 in my IRAs. I figure the tax bill on the rollover would be about $107,000, which I can pay from the $150,000 I have in taxable mutual fund accounts. I am 60 years old, semiretired and don't contribute anything to the IRAs. My dilemma: Would I still benefit from a conversion in the long run, considering the money the $107,000 is currently earning? I had planned to use the taxable funds during retirement if needed, and not the IRA money. All the programs and worksheets don't make allowances for calculating lost gains on the money used to pay taxes on the rollover.
Answer: You're on to something here. The tax bill on a Roth IRA rollover is actually larger than it seems at first because you pay the bill with money that would otherwise be invested. So to fairly evaluate the benefit of a rollover, you should compare the after-tax value of your traditional IRA at retirement to the following: the value of your converted Roth account on the same date, minus the future value of the money you would pay in income taxes on the conversion. Sound confusing? Don't worry. We built a Roth IRA Conversion Calculator (inspired by your question) to help you figure it out.

In most instances, the loss due to the tax on the rollover is overcome by the dual advantage of tax-free compounding and tax-free withdrawals from a Roth. But there are some occasions when a rollover definitely doesn't make sense, and it sounds like they may apply to you. Do not roll over if:

· Your tax rate will be much lower by the time you take your IRA withdrawals (say 15% versus 25% or 25% versus 35%).

· You plan to leave your IRA to heirs who will have a much lower tax rate than you do.

Don't forget about the likelihood that the rollover will put you into a higher tax bracket. (For example, if you?re married and have taxable income of $75,000 and you roll over a $200,000 IRA, your marginal tax rate will rise to 33% from 25%.) So subtract the future value of that money from your Roth balance at retirement, too.

Finally, at your age you probably don't have to worry about the possibility of the higher income triggered by the conversion disqualifying you for benefits such as higher education tax credits. But younger taxpayers should consider that as well.

Leaving a Roth to Heirs
Question: I am 74-year-old single male. I currently have a traditional IRA that is worth approximately $170,000. My main purpose is to give this to my children upon my death. Would it be better to leave it in the traditional IRA or convert it to a Roth IRA?
Answer: Converting to a Roth is probably the way to go. You will no longer have to take mandatory distributions. You will save your children the trouble of paying federal income tax on your IRA after your death. And you will reduce your taxable estate by the amount of the tax bill on your Roth conversion. (Because you are over 59 1/2, you can use your IRA assets to pay the tax, penalty-free. Or you can pay the tax from your other assets, preserving the value of your IRA.)

Once you die, a Roth IRA is treated like any other IRA. That means that if your spouse is your beneficiary, she can treat the Roth IRA as her own. So no minimum withdrawals are required as long as she lives. If your beneficiary is not your spouse, the following rules apply.

If your children are named as your IRA beneficiaries, they can start to liquidate the IRA beginning on Dec. 31 following the year of your death. That liquidation must be completed over a period based on their life expectancies. Your children would also have the option to leave the money in the account, and liquidate it by December 31 of the fifth year after your death.

Another thing to keep in mind is that earnings must be in the Roth for at least five years before they can be withdrawn tax-free. So, if the Roth IRA is not five years old, beneficiaries taking withdrawals need to follow the ordering rules for Roth IRAs. That means the first withdrawals will come from annual after-tax contributions. The next layer comes from contributions of converted traditional IRA money -- first the taxable amount, then from the nontaxable amount (if any). The last layer comes from Roth IRA earnings.

ROTH: Taxes on Partial Conversions
Question: Can I roll over only the nondeductible contribution portion of my traditional IRA to a Roth IRA and thereby avoid the taxes that would be due on a rollover of my IRA earnings?
Answer: No. "You can't just take out the cream," says Ed Slott, a CPA in Rockville Centre, N.Y., and publisher of the Ed Slott's IRA Advisor newsletter. If you choose to do a partial conversion, every dollar you convert will be treated as a "blended" dollar. For example, if 20% of your current IRA assets consists of nondeductible contributions and the remainder is deductible contributions and earnings, you will owe income tax on 80 cents of each dollar you convert to Roth IRA status. Note: If you have multiple IRAs, you must add the assets together when calculating what portion of your partial conversion will be taxable.

Question: My spouse and I are both self-employed and have each been contributing to a SEP IRA. Can we convert this SEP IRA to a Roth IRA?
Answer:Yes. The tax regulations explicitly allow you to directly convert a SEP account into a Roth IRA. However, after the conversion, you can't continue making deductible SEP contributions to what is now a Roth IRA. So, you'll have to set up a new SEP account if you want to make further deductible pay-ins.

How Are IRA Gains Taxed?
Question: If I convert from a traditional IRA to a Roth, is the gain considered ordinary income or a long-term capital gain?
Answer: The gain in your IRA is taxed as ordinary income. So, your federal tax rate can be as high as 35%.

IRAs and Unearned Income
Question: I am single and retired with an AGI under $95,000 but no earned income. Can I contribute to a Roth IRA?
Answer: Unfortunately not. Roth IRAs, just like traditional IRAs, can only be created with earned income. However, you can convert your traditional IRA into a Roth if you are willing to pay the up-front tax hit. There is no earned income requirement for conversions.