1.8 SOLUCIÓN DE PROBLEMAS O CONFLICTOS
1.8.1 PRINCIPIOS DE LA LEY DE ARBITRAJE Y MEDIACIÓN
ROTH IRA
Overview
The Roth IRA, the nondeductible alternative to Traditional IRAs, was enacted into the Internal Revenue Code in 1988. According to the Investment Company Institute, the Roth IRA has become the fastest growing IRA. Contributions to a Roth IRA are not tax deductible, and distributions are potentially tax and penalty-free if certain requirements are met. The Roth IRA is governed under IRC Section 408A.
This chapter will provide an in-depth review of the Roth IRA. It will define a Roth IRA, discuss how to set up and fund the Roth IRA, review the conversion rules mandated by the Tax Increase and Prevention Reconciliation Act (TIPRA) of 2005, and review the rules of the designated Roth 401(k) account (DRAC).
Learning Objectives
Upon completion of this chapter, you will be able to: Structure a Roth IRA;
Explain the three methods to fund a Roth IRA;
Apply the rules for Roth IRA contributions and conversions; Identify assets eligible for a Roth IRA conversion;
Present the opportunity and prospects for a Roth IRA conversion;
Explain the uses of Roth IRA recharacterizations and reconversions; and Observe the rules of the designated Roth 401(k) plan.
Roth IRA Background
Prior to 1998, all IRAs had the same basic tax structure, as we discussed in Chapter 2. All of that changed with the passage of The Taxpayer Relief Act of 1997 (TRA-97), and specifically Section 302(a), which created IRC § 408A, and the Roth IRA. The Roth IRA, named after former Senate Finance Committee Chairman William Roth, Jr. (R- Del.), created an individual retirement arrangement providing tax advantages for “eligible” taxpayers, which became effective January 1, 1998.
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Creating a Roth IRA
Many of the rules governing the Roth IRA are similar to those rules of the Traditional IRA under IRC 408, except for those rules explicitly defined in IRC § 408A (See Table 8.1).
Similar to a Traditional IRA, a Roth IRA can be either an account [IRC § 408(a)] or an annuity [IRC § 408(b)]. To be a Roth IRA, the account or annuity must be designated as a Roth IRA when it is set up. A deemed-IRA can be a Roth IRA, but neither a SEP-IRA nor a SIMPLE IRA can be designated as a Roth IRA.
Table 8.1
Traditional IRA vs. Roth IRA
Traditional IRA [IRC § 408] Roth IRA [IRC § 408A]
Contributions made with pre-tax and after-tax dollars
Contributions made with after-tax dollars IRC § 408A(c)(1)
Principal grows tax-deferred Principal grows tax-free
No contributions allowed after age 70½
Contributions allowed after age 70½ with earned income [IRC § 408A(c)(4)]
Required Minimum Distributions (RMDs) at age 70½
No Required Minimum Distributions for participant [IRC § 408A(c)(5)]
Distribution of pre-tax dollars 100% taxable; after-tax dollar recovery limited by pro-rata
rules.
“Qualified” distributions are tax-free¹; “Nonqualified” distributions follow the “ordering rules” (first from contributions, next from converted amounts and last from earnings, which may have tax implications and
penalty).
To be considered “qualified,” a distribution of earnings must meet the following two criteria: the distribution must be made after a five-year holding period, and the individual must have reached age 59½. Earnings are tax-free only if withdrawn as qualified
distributions.
Funding a Roth IRA
There are three ways to fund a Roth IRA. They are:
First, regular annual contributions on behalf of an individual who has compensation;
Second, conversion (rollover) of a Traditional IRA and/or a qualified plan to a Roth IRA, and
Designated Roth IRA (DRAC) rollover from a qualified plan to a Roth IRA. Each method to fund a Roth IRA has its own rules and eligibility requirements, let’s review those requirements beginning with annual contributions.
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Regular Annual Contributions
In order for an individual to make a regular annual contribution to a Roth IRA, the
individual must have compensation [Reg. § 1.408A-3]. The individual’s contribution to a Roth IRA will be limited to the amount of such individual’s compensation income for such year (or, if less, the dollar limit described below). Similar to all IRAs, contributions to a Roth IRA must be made in cash [IRC § 219(e)(1)].
The major difference between regular annual contributions to a Traditional IRA and a Roth IRA is that Roth IRA contributions are not deductible [IRC § 408A(c)(1)].
Accordingly, contributions to a Roth IRA are made with after tax non-deductible dollars instead of pre-tax deductible dollars.
Also, any individual regardless of his or her age, even if over age 70 ½, and regardless of whether he or she participates in a company retirement plan, may make a regular annual contribution to a Roth IRA. But of course, they must have compensation (similar rules for a Traditional IRA as discussed in Chapter 2).
Applicable Dollar Limit Defined
The amount that can be contributed depends on whether a contribution is made only to a Roth IRA or Traditional IRAs and Roth IRA.
Roth IRAs only. If a contribution is made only to a Roth IRA, the maximum contribution limit is the lesser of:
o $5,500 ($6,500 if participant is age 50 or older) in 2015 (same as in 2014), or
o Taxable compensation.
However, if the participant’s modified adjusted gross income (MAGI) is above a certain amount, the contribution limit may be reduced (phased-out) as explained below.
Roth IRAs and Traditional IRAs. If contributions are made to both Roth IRAs and Traditional IRAs established for the participant’s benefit, their contribution limit for Roth IRAs generally is the same as their limit would be if contributions were made only to Roth IRA but then reduced by all contributions (other than employer contributions under a SEP-IRA and SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs. [IRC § 408A(c)(2)(B)]. This means that a participant’s contribution limit in 2015 is the lesser of:
o $5,500 ($6,500 if participant is age 50 or older) minus all contributions (other than employer contributions under a SEP-IRA or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs, or
o Participant’s taxable compensation minus all contributions (other than employer contributions under a SEP-IRA or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs.
146 Table 8.2
Roth IRA Applicable Dollar Limits (ADL)
Tax Year Basic Dollar Limit Catch-up Contribution
2014 $5,500 $1,000
2015 $5,500 $1,000
Source: IRS Publication 590
However, if the participant’s modified AGI is above a certain amount, their contribution limit may be reduced (phased-out) as explained below (see Table 8.3).
Catch-Up Contribution. The $1,000 catch-up contribution to the basic dollar amount is available to a participant who has attained age 50 by the end of the taxable year [IRC § 219(b)(5)(B)]. After the year 2008, IRC § 219(b)(5)(D) applies a cost of living adjustment (COLA) to the basic dollar limit (but not to the over 50 catch-up contribution amount) in increments of $500 per year. As a result of the Pension Protection Act of 2006, the above contribution limits will not “sunset” after 2010. The catch-up contribution is $1,000 for 2015 (same as in 2014).
Table 8.3
2014-2015 Effect of Modified AGI on Roth IRA Contribution*
If you have taxable compensation and your
filing status is…
And your MAGI is…
2014 2015
Then…
Married Filing Jointly or Qualifying Widow(er)
$181,000 or less $183,000 or less
You can contribute up to $5,500 ($6,500 if age 50 or older). At least $181,000 but
less than $191,000
At least $183,000 but less than
$193,000
The amount you can contribute is reduced.
$191,000 or more $193,000 or more
You cannot contribute to the Roth IRA.
Single or Head of Household or Married Filing Separately (and did not live with spouse
at any time during the year)
$114,000 or less $116,000 or less
You can contribute up to $5,500 ($6,500 if age 50 or older).
At least $114,000 but less than
$129,000
At least $116,000 but less than
$131,000
The amount you can contribute is reduced.
$129,000 or more $131,000 or more
You cannot contribute to the Roth IRA.
Married Filing Separately and lived with
your spouse at any time during the year
Less than $10,000 Less than $10,000
You can contribute up to $5,500 ($6,500 if age 50 or
older).
$10,000 or more You cannot contribute to the
Roth IRA.
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MAGI Defined
Modified adjusted gross income (MAGI) is a measure of income used to determine how much of a nondeductible contribution can be made to a Roth IRA. The IRS says that MAGI for Roth IRA purpose is adjusted gross income (AGI) as shown on line 37 of the 1040 modified as follows:
Subtract the following:
o Conversion income. This is any income resulting from the conversion of an IRA (other than a Roth IRA) to a Roth IRA.
o Minimum required distributions from qualified retirement plans, including IRAs, (for conversions only).
Add the following:
o Traditional IRA deduction,
o Student loan interest deduction,
o Tuition and fees deduction,
o Foreign earned income exclusion,
o Foreign housing exclusion or deduction,
o Exclusion of qualified bond interest shown on Form 8815,
o Exclusion of employer-provided adoption benefits shown on Form 8839, and
o Domestic production activities deduction from Form 1040, line 35, or Form 1040NR, line 33.
For purposes of the income limits applicable to both regular Roth IRA contributions and Roth IRA conversions, MAGI does not include the deemed distribution amount that results from converting a Traditional IRA to a Roth IRA [IRC §408A(c)(3)(C)(i)]. So if, in the year being tested, the participant converts a Traditional IRA to a Roth IRA, resulting in the inclusion of some or all of the conversion amount in his/her gross income, the gross income resulting from the conversion is disregarded solely for purposes of determining whether the taxpayer’s MAGI is low enough to make him or her eligible to contribute.
Roth IRA Annual Contribution Phase-out Rules
Table 8.4 shows the MAGI phase-out rules for making a regular annual contribution to a Roth IRA [IRC § 408A(c)(3)(C)]:
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Table 8.4
2014-2015 Effect of Modified AGI on Roth IRA Contribution*
If you have taxable compensation and your
filing status is…
And your MAGI is… 2014 2015
Then…
Married Filing Jointly or Qualifying Widow(er)
$181,000 or less $183,000 or less
You can contribute up to $5,500 ($6,500 if age 50
or older). At least $181,000 but
less than $191,000
At least $183,000 but less than
$193,000
The amount you can contribute is reduced.
$191,000 or more $193,000 or more
You cannot contribute to the Roth IRA. Single or Head of
Household or Married Filing Separately (and did not live with spouse
at any time during the year)
$114,000 or less $116,000 or less
You can contribute up to $5,500 ($6,500 if age 50
or older). At least $114,000
but less than $129,000
At least $116,000 but less than
$131,000
The amount you can contribute is reduced.
$129,000 or more $131,000 or more
You cannot contribute to the Roth IRA.
Married Filing Separately and lived with
your spouse at any time during the year
Less than $10,000 Less than $10,000
You can contribute up to $5,500 ($6,500 if age 50
or older).
$10,000 or more
You cannot contribute to the Roth IRA.
Source: IRS Publication 590
The general maximum contribution formula is as follows:
Maximum
Compensation -- MAGI
Maximum Threshold = Maximum Allowable Contribution Possible Maximum Minimum
Contribution Compensation - Compensation
Threshold Threshold
Example: Tom, age 45, files as a single taxpayer with MAGI of $121,000 in 2015. The maximum contribution he can make to a Roth IRA for 2015 is $4,400 computed as follows:
149 $5,500 $ 131,000 - $119,000 = Maximum Allowable $ 131,000 - $116,000 Contribution $5,500 $ 12,000 = $4,440 $ 15,000
Above the phase-out levels, taxpayers can still contribute to a Traditional, nondeductible IRA, even if their AGI exceeds the phase-out amounts for deductible or Roth IRAs. There is no maximum age limit for contributing to a Roth IRA, as there is for contributions to a Traditional IRA; an individual (who earns compensation) can contribute to a Roth IRA even after age 70½ [IRC § 408(c )(4)].
Also, a person who meets the income test and has compensation income may contribute to a Roth IRA regardless of whether he or she is an “active participant” in an employer plan during the same year.
Spousal Roth IRA Contributions
An individual is allowed to make Roth IRA contributions on behalf of his or her spouse, only if they meet the income eligibility requirements (as discussed above). The same contribution amounts are allowed for a Spousal Roth IRA.
Excess Contributions to Roth IRAs
Excess contributions to a Roth IRA will be subject to the same 6% excise tax as
discussed in Chapter 2. Excess contributions are considered to be contributions made by a participant to his or her Roth IRA for a year that equals the total of:
Amounts contributed for the tax year to the Roth IRA (other than amounts properly and timely rolled over to a Roth IRA or properly converted from a Traditional IRA) that are more than the participant’s contribution limit for the year, plus
Any excess contributions for the preceding year, reduced by the total of:
o Any distributions out of the participant’s Roth IRAs for the year, plus
o Participant’s contribution limit for the year minus their contributions to all their IRAs for the year.
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Withdrawals of Excess Contributions
For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing the participant’s tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and
received in the year the excess contribution was made.
Example, suppose an individual makes a $5,500 contribution to a Roth IRA early in 2015, then later realized that his income would only allow him to a contribution of only $4,300. His excess contribution was $1,200. If he does not correct the excess contribution for 2015, he’ll have to pay $72 excess contribution tax (6% of $1,200). And if he left the problem uncorrected beyond the end of 2016, he will owe another $72. He’ll continue to owe this tax each year until he corrects the excess contribution.
Corrective Action
There are four ways to correct an excess contribution to a Roth IRA. Two of them can be used to completely avoid the excess contribution penalty, and the other two prevent it from applying to later years after it has applied to one or more years. Depending on the specific situation, you may find that one or more of these correction methods are
unavailable.
First, withdrawing excess by due date of return. If a contribution to a Roth IRA was improper or too large, the participant (owner) can avoid the 6% penalty tax by taking the money out. Relief from the penalty is available only if the following are true:
o The participant receives a distribution from the Roth IRA on or before the due date (including extensions) for filing the tax return for the year of the contribution.
o The distribution includes the amount of the excess contribution and the amount of net income attributable to the excess.
Choosing this method of correction, the participant must report and pay tax on the net income attributable to the excess in the year of the contribution, even if the participant takes it out during the following year, before the return due date. The earnings will be taxed like any other taxable distribution of earnings from a Roth IRA, and will be subject to the early distribution penalty if under age 59½ unless one of the exceptions applies.
Second, do a recharacterization. Another way to correct an excess contribution is to have the trustee of the Roth IRA make a direct transfer from the Roth IRA to a Traditional IRA. To avoid penalties, there are requirements that must be met (as was discussed above):
o The transfer must occur on or before the due date (including extensions) for filing your return for the year of the contribution.
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o The transfer must include the amount of the excess contribution and the amount of net income attributable to the contribution.
If the participant can meet these requirements, he/she will be treated as if the contribution went to the Traditional IRA in the first place. That means the participant will not have to pay tax on the earnings that are transferred from one IRA to another. The IRS calls this a recharacterization.
Example: Suppose you contribute $5,500 to a Roth IRA early in 2015, expecting your MAGI to be below the income limitation for Roth IRA contributions. At the end of the year you find that your MAGI is higher than expected and your Roth IRA contribution limit is $3,500. Before October 15, 2016 you have the trustee of your Roth IRA transfer $2,000 plus the earnings attributable to that $2,000 directly to a Traditional IRA. You’re treated as if you originally contributed $3,500 to the Roth IRA and $2,000 to the Traditional IRA.
Note: Many people mistakenly believe a recharacterization can be used only as a way to undo a Roth conversion, but it can also be used to change the type of IRA to which a contribution was made.
A recharacterization transfer provides a bonus. Besides eliminating the 6% penalty tax, it allows you to keep the earnings you may have built up during the year in an IRA, instead of taking the earnings out and paying tax on them. But you’ll benefit from a recharacterization only if you’re permitted to contribute to a regular IRA. If your excess contribution to the Roth IRA would also be an excess contribution in a regular IRA you can’t use this method to avoid a penalty. For example, if you waited more than 60 days to complete a rollover, or didn’t have enough earned income to support your contribution, you won’t be able to fix the problem by making a recharacterization.
Third, make a later withdrawal. If the participant fails to take a corrective distribution within the time period described above, he/she will incur the excess contribution penalty for the year of the contribution and incur it again for each subsequent year it remains uncorrected. The participant can prevent it from applying to a subsequent year by withdrawing the excess from his/her Roth IRA, but the rules here are different than for the type of correction described earlier: The participant needs to act by the end of the year, not by the due date of the return for that year. If the participant’s excess contribution was made in 2015, he/she must act by December 31, 2016 to avoid a penalty for 2016. Note that this is only 2½ months after the deadline for correcting the original year, as described earlier. When using this correction method the participant doesn’t have to
withdraw earnings. The participant simply withdraws the amount of the excess contribution.
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Fourth, contribute less than maximum. The last way to correct an excess contribution is to contribute less than the maximum in a subsequent year. For example, if the participant has a $2,000 excess contribution in 2015 and he/she contributes at least $2,000 less than the maximum allowed to contribute in 2016,