Last year Congress enacted a rather sweeping tax act which changed several very visible areas of the tax law, notably the tax treatment of capital gain income (rates were lowered), the tax treatment on the gain from the sale of a personal residence (the tax was all but done away with entirely), and the inauguration of the new Roth IRA.
The Roth IRA rules were seemingly thrown together in the wee hours before the passage of the tax act they contained several inconsistencies and unexplained statements which left the appearance of some major loopholes in this part of the tax legislation.
This summer, Congress went back to work on the tax laws, and made changes to the Roth IRA which should clear up most of the gray areas of the prior law.
In particular, the following rules regarding the Roth IRA are now in effect. To the extent that there are changes to the Roth rules, the changes are retroactive to January 1, 1998. The 1998 changes to the Roth rules are shown in bold type.
The Roth IRA is an individual retirement account to which contributions are entirely non-deductible and on which earnings are entirely non-taxable, assuming the rules of the account are met.
An IRA which is to be treated as a Roth IRA must be designated as a Roth IRA when the account is established.
The annual contribution limit to a Roth IRA is limited to a maximum of $2,000, and the annual combined contributions to all IRA accounts cannot exceed $2,000. There is a phase-out for annual contributions to a Roth IRA beginning with an adjusted gross income of $95,000 for single taxpayers and $150,000 for joint filers. Married filing separate taxpayers are barred from contributing to a Roth IRA.
You may convert funds from traditional IRA accounts to a Roth IRA, as long as your adjusted gross income for the year does not exceed $100,000. For purposes of this computation only, all components of adjusted gross income are included without regard for the effects of including the income from the conversion. In other words, sometimes when you increase your adjusted gross income (as you would if you were adding the amounts from the conversion), certain losses may not be allowed. For purposes of computing if your AGI does not exceed $100,000, these losses will be allowed, even though once you add in the converted funds the losses may be disallowed.
Taxpayers may combine all Roth IRA amounts in a single account. Prior law implied that taxpayers would have to create a Roth IRA account for conversion amounts that was separate from the account used for contributions.
Distributions from a Roth IRA may not be made before the end of the 5-year period beginning with the first year for which a contribution is made. This 5-year rule is in effect for both the Annual Contribution Roth IRAs and the Conversion IRAs. (Previously, the 5-year period for Conversion IRAs began with the first year in which a contribution was actually made, as opposed to the first year for which the contribution was made. This is an important distinction, since you can make contributions for a tax year all the way up April 14 following the year for which you are making a contribution.)
Amounts converted from a traditional IRA to a Roth IRA during 1998 may be included in gross income spread out over a period of four years. The taxpayer has the option of electing to report all of the conversion amount as income in 1998.
If traditional IRA amounts are converted to a Roth IRA, and if those amounts were includible in gross income at the time of the conversion, any portion of the converted amount that is withdrawn from the Roth IRA prior to the participant reaching ate 59 ½, is subject to a 10% penalty on the amount withdrawn.
If, prior to December 31, 1998, you convert funds to a Roth IRA during the year, only to discover at the end of the year that your income exceeds the $100,000 limit so you are not eligible to make the conversion, you can transfer the amount back to your traditional IRA before the due date of your tax return, including extensions, without any negative tax consequences. Any income earned in the Roth IRA account while the converted funds were in the account must also be transferred to the traditional IRA. The transfer between accounts must be directly from one account to the other, you cannot withdraw the funds personally, as you can with a traditional IRA rollover.