Everything You Always Wanted to Know About Roth IRA's *But Were Afraid to Ask

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Note: The following article touches on tax aspects of certain investments. Mr. Szabo is not offering tax advice. The article is not a substitute for the expert tax advice that an accountant or tax lawyer might customize to meet the needs of an individual client.

Q. Why would I want to contribute to a Roth IRA in the first place rather than to traditional retirement plan?
A. It depends whether you expect to do better contributing pre-tax dollars or post-tax dollars. Traditional qualifying retirement plans include the traditional IRA, SEPP IRA, 401(k), 403(b) [for non-profit entities] and 457(b) [for government entities]. You can make contributions to such plans from income without paying any federal or state income tax—subject to restrictions—although you do have to pay Social Security and Medicare withholding tax. In such plans, you must begin mandatory distributions from such plans no later than the age of 70 1/2. Any distributions will be taxed as ordinary income, even if some of those same distributions would otherwise be eligible for preferred tax treatment as long term capital gains. In contrast, with a Roth IRA, you make contributions post income tax, but any distributions in retirement are entirely free of income tax, including those that would otherwise be taxable as interest and dividends or short- or long-term capital gains.

Q. When does it make sense to contribute to a Roth rather than to a traditional retirement plan?
A. Mainly, if you think you will be investing for a long period of time and/or if you think your marginal tax rate will be relatively high at the time you take distributions, then you may want to maximize your Roth contributions relative to retirement plans.

Q. Are there any other advantages to the Roth format?
A. Yes. There are no mandatory distributions, so you can maintain your investments in the account as long as you wish. Also, with traditional IRA's, most early withdrawals face full income tax plus a 10% penalty. With the Roth, you may first withdraw all your regular and conversion contributions free of tax or penalty. You can make further withdrawals without penalty if you have reached age 59 ½ and your Roth has been established at least five years before. Finally, as Roth IRA's contain post-tax dollars, they effectively pack in more in useable assets for retirement.

Q. What has been the main obstacle in the past for investors to build Roth retirement accounts?A. The main obstacle has been highly restrictive income qualifying tests and small annual contribution limits.

Q. What are the current limits for contribution to a Roth IRA?
A. You can contribution as much as $5,000 for the 2009 tax year (or $6,000 if you reach 50 or older by the end of the tax year, a so-called "catch-up contribution"). However, you must have "qualifying income" at least equal to the amount contributed. What's more, to make the maximum allowable contribution, your modified adjusted gross income cannot be greater than $101,000 for single individuals and $159,000 for married couples filing joint returns; above these limits, your contribution limits quickly fade down to zero.

Q. Are there any ways to mitigate the tax bite resulting from a Roth IRA conversion?
A. Generally speaking, there are very few allowable mean of creating deductions to offset the gains from Roth IRA conversion. However, one strategy that could be very potent is to harvest deductions from investment in independent oil and gas drilling partnerships. While such deals can be attractive, they require a serious due diligence effort. I steer clients away from wildcat or highly speculative drilling efforts. Instead, I recommend focusing on so-called "fully blanketed formations," in which drilling will commence adjacent wells that have proved productive. Deductions from such investments for intangible drilling costs typically comprise 70% to 85% of initial investment. The deduction may be taken in year one or spread over a term of years. There is also a 15% exclusion of oil and gas income under the Oil and Gas Depletion Allwance. Moreover, in the case of independent oil and gas drillers, as defined under the IRS Code, Congress has provided significant relief from the danger of being taxed under unfavorable Alternative Minimum Tax (AMT); in many cases, investment will reduce calculated AMT income or even prevent taxation under the AMT regime. I am glad to discuss such matters with your accountant.

Q. I fear that federal and state income taxes will rise significantly in the coming years. Should this affect my decision on whether to convert to a Roth IRA?
A. If you expect to be a taxpayer in the years when you take distributions from a retirement account, and if you expect to be in a high tax bracket at that time, then your fear of higher tax rates is very relevant to your decision. In fact, the bigger the increase you expect in federal and state marginal tax rates, the greater will be your motivation to convert to a Roth IRA at this time. Your decision, of course, may be affected by the tax impact in the current tax year of making the Roth conversion.

Q. Is there any special reason why I should convert in 2010, rather than wait?
A. Yes. For the year 2010 only, Congress has provided an opportunity to defer any income from the conversion. This deferred income can then be spread evenly between tax years 2011 and 2012. After 2010, you will face the full tax bite in the same year as conversion.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/. Securities offered only through Choice Investments, Inc., headquartered in Austin, TX; Member FINRA/SIPC.