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Traditional vs.

Roth IRA

Traditionally, retirement saving have been made on a pre-tax basis. Tax on contribution

and future earning are delayed until distribution. In contrast, with a Roth Retirement

account, the account owner pays tax on his contribution before it is made. At the time of

the distribution, if certain requirements are met, the entire distribution is free of income

tax. Moreover, an individual who have reached age 70 ½ is not eligible to set up a

traditional IRA, but there is no age limit to set up a Roth IRA. With a traditional

retirement plan, distribution are required to begin in the year the account owner reaches

age 70 ½ or the year after death, if earlier. In a Roth retirement account, distributions are

not required to begin at any ages if the owner is alive, so distributions may be deferred

until the year after death.

Contribution to IRAs

A. Traditional IRA Contribution Deductions and Limits

Assuming an individual has earned income and otherwise meets the requirements for an

traditional IRA contribution, the most that can be contributed his/her IRA is the smaller

of the following amounts: 1) $5,000 ($6,000 if age 50 or older) or 2) his/her taxable

compensation of the year 1. This general limit may be increase to $8,000 if the individual

participated in a 401(K) plan maintained by an employer, and the employer went into

bankruptcy in an earlier year.

Generally, an individual can deduct the lesser of the two amounts: his/her contributions to

the traditional IRA for the year or the general limit. However, if an individual is an active

participant in a retirement plan at work, the IRA deduction is reduced where the

individual’s modified adjusted gross income exceeds the applicable dollar limit 2. The
deduction is also affected by the filing status of the individual. For 2009, the applicable

dollar limit is more than $89,000 but les than $109,000 for a married couple filing a joint

return or qualifying widow.

B. Roth IRA Contribution

The contribution limit for Roth IRAs generally depends on whether contributions are

made only to Roth IRAs or to both traditional IRAs and Roth IRAs. If the contribution

are made only to Roth IRAs, the contribution limit is same the as the limit for traditional

IRAs. However, if contributions are made to both Roth IRAs and traditional IRAs, the

contribution limit for Roth IRA generally is the same as the limit would be if contribution

were made only to Roth IRAs, but then reduced by all contributions for the year to all

IRAs other than Roth IRAs 3. This means that the contribution limit is the lesser of: 1)

$5,000 ($6,000 if age 50 or older) minus all contributions for the year to all IRAs other

than Roth IRA, or 2) individual’s compensation minus all contributions for the year to all

IRAs other than Roth IRAs.

Contribution to Roth IRA is not deductible 4 and there is no age limit for the

contribution.. Moreover, contributions are not allowed if adjusted gross income exceeds

$110,000 for single taxpayer and $160,000 for married filling jointly. These amounts are

indexed for inflation beginning in 2007. IRC 408A(C). In 2009, the amount is $116,000

for single taxpayer and $169,000 for married filling jointly.

Distribution from IRAs

A. Traditional IRA Taxation

Section 408(d)(1) provides that any amount paid or distributed out of an individual

retirement plan shall be included in gross income by the payee or distributee, as the case
may be, in the manner provided under Section 72. This means that, except for amounts

that are timely rolled into another eligible tax-deferred vehicle, for example, to another

IRA, distribution from an IRA are treated as ordinary income and includible in income

for the year of distribution.

Section 408(d) (2) set forth three Special rules for applying Section 72: 1) all individual

retirement plans shall be treated as 1 contract, 2) all distributions during any taxable year

shall be treated as 1 distribution, and 3) the value of the contract, income on the contract,

and investment in the contract shall be computed as of the close of the calendar year in

which the taxable year begins.

The owner of an IRA is deemed to have a zero basis in the IRA, so distribution is fully

includible in income except for nondeductible contributions. With respect to any

nondeductible contributions made to the IRA, the portion of nondeductible contribution

constitutes a return of the owner’s basis and thus is returned tax free. Unfortunately,

except for certain rollover situations, a taxpayer cannot withdraw the nondeductible

portion before withdrawing amount includible in taxable income. According each

distribution has both a nontaxable and taxable component.

To determine the nontaxable portion of a distribution form an IRA that includes

contributions with tax basis, Notice 87-16 provides the formula below:

Total nondeductible contributions

-------------------------------------------------------------------- X distributed amount

IRA account balance + amount distributed + outstanding

in all IRA at year during year rollover


end

“Outstanding rollover” means any amounts distributed before year end, but rolled into

another IRA in the following year under the 60 rollover rule. When calculating the

nontaxable portion of distributions, the total fair market value of all traditional IRA the

individual owns must be included in the computation. An individual may not designate a

particular distribution as being from a segregated or particular nondeductible IRA. All

distributions during the tax year are to be aggregated and treated as one distribution both

for purposes of reporting the distribution as well for purpose of determining the

nondeductible portion of a distribution.

Example 1. Jane, age 60, has four traditional IRA accounts; their fair market values at

year end are as follows:

Account FMV

1 $30,000

2 16,000

3 33,000

4 10,000

Total $89,000

Jane has made nondeductible contributions totaling $10,000 to account #4. He has made

no other nondeductible contributions and would like to withdraw his $10,000

nondeductible contribution from account #4. Jane cannot withdraw the nondeductible
portion (basis) before withdrawing the amounts treated as taxable income. He must

include the value of all IRA accounts in calculating the nontaxable portion of the

distribution. The nontaxable portion of his distribution is calculated as follows:

$10,000

--------------------- X $10,000 = $1,124

$79,000 + $10,000

Accordingly, $1,124 of the distribution is h return of basis; the remaining $8,876 is

taxable income, even though the value of account #4 was made up entirely from

nondeductible contributions.

In period of tough economic times and falling investment performances, one of the

questions that invariably arises is whether losses in an IRA can be recognized by the

owner. It is possible for an individual to recognize a loss in the year an IRA is liquidated.

If the basis in the account exceeds the total value of IRA distributions in the final year, a

loss is recognized on the IRA distribution; see Notice 89-25 .The taxpayer may recognize

a loss only when all amounts in all IRAs have been distributed, and total distributions are

less than unrecovered basis; see Notice 87-16. Moreover, the ability to claim any such

loss is subject to the 2% of adjusted gross income limit that applies to miscellaneous

itemized deductions.

Planning strategy

Individuals who have taken a distribution from nondeductible traditional IRA are

contemplating rolling over a lump-sum distribution from a qualified plan into an IRA. If

possible, they should consider deferring the rollover into the following year. This will
keep the IRA account balances lower during the distribution year, thus allowing a higher

basis calculation for the distribution form the nondeductible IRA and lowering the

taxable amount from that distribution.

All individuals who have made nondeductible contributions should have filed copies of

Form 8606, Nondeductible IRAs, for each year such contribution were made. If the

individual failed to file Form 8606 to report nondeductible contributions, the contribution

is presumed to have been deductible. However, this presumption can be rebutted with

satisfactory evidence that the contributions were nondeductible. Copies of prior year

showing no deductible IRA contribution would be suffice.

The potential for an IRA contributor to increase his or her retirement income can be

significant, as all income and realized gains in the account are accumulated tax-deferred.

Thus, the additional filing requirements and computations for nondeductible

contributions and distributions should not deter a taxpayer from making nondeductible

IRA contributions. However, when available, a nondeductible contribution to a Roth IRA

will often be preferable

B. Roth IRA Taxation

1. Qualified distributions

Unlike a traditional IRA, an individual cannot deduct contributions to a Roth IRA.

However, if the individual satisfies the requirements, qualified distributions from Roth

IRA are tax-free. A qualified distribution is any payment or distribution from an

individual Roth IRA that meets the following requirements.


1. It is made after the 5 year period beginning with the first taxable year for which a

contribution was made to a Roth IRA. and

2. The payment or distribution is:

a. made on or after the date the individual reach age 59.5

b. made because the individual is disabled,

c. made to a beneficiary or to the estate of the individual after the death of the

individual

d. used to purchase or rebuild a first hom for the individual or a qualified family

member, this is limited to $10,000 per lifetime.

The 5 year period begins on the first day of the individual’s tax year for which the first

regular contribution is made, or if earlier, the first day of the individual’s tax year in

which the first conversion contributions is made to any Roth IRA of the individual. The

period ends on the last day of the individual’s fifth consecutive tax year beginning with

the tax year described previously. If the distribution is made to a beneficiary of the estate

of the owner, the period held by the decedent is included in the period held by the

beneficiary to determine whether the 5-year period is satisfied (408A(d)(2)(A) and Reg.

§1.408A-6, Q&A-1(b)).However, generally this tacking rule does not impact the holding

period of other Roth IRA owned by the beneficiary. So the five year period for an

individual in his/her capacity as a beneficiary of a deceased Roth IRA owner is

determined independently of the five-year period for the beneficiary’s own Roth IRA.

There is, however, one exception. If the surviving spouse treat the Roth IRA as his or her

own, the five year period with respect to the surviving spouse’s Roth IRA ends at the

earlier of the five year period end of either the decedent or the spouse’s own Roth IRA.
2. Nonqualified distributions

If the Roth IRA distribution fails to meet either one of the two requirements for qualified

distributions, the taxpayer is not subjected to double taxation. The amount contributed is

not subject to tax since taxpayers paid tax on contributions, only the earnings in excess of

that amount are taxed. Nonqualified distributions are taxable to the extent the amount of

the distributions, added to all prior distributions less prior amounts that were includible in

income, exceed the direct Roth contributions. Thus, the taxpayer is generally allowed to

recover his/her contributions before taxable earning are treated as distributed.

Further, where the distribution does not constitute a qualified the distribution, the 10%

early distributions tax of Section 72(t) applies to amounts includible in income. If, within

the 5-year period starting with the first day of the tax year in which an individual first set

up and contributed to a Roth or convert an amount from other qualified retirement plan to

a Roth IRA, he/she takes a distribution from a Roth IRA, he/she may have to pay the

10% additional tax on early distribution unless one of the exceptions is met.

The 5 year period used for determining whether the 10% early distribution tax applies to

a distribution from a conversion is separately determined for each conversion, and is not

necessarily the same as the 5 year period used for determining whether a distribution is a

qualified distribution.

Example 2. Jane makes a conversion contribution on March 25, 2009, and makes a

regular contribution for 2008 on the dame date. The 5 year period for the conversion

begins January 1, 2009, while the 5-year period for the regular contribution begins on

January 1, 2008.
The tax implication of a nonqualified distribution depends on the source of the Roth IRA

assets. To determine the source of assets distributed from a Roth IRA, the IRS uses the

'ordering rules'. According to the ordering rules, assets are distributed from a Roth IRA in

the following order (once assets from one source run out, the assets from the next source

are distributed):

1. regular Roth IRA contributions.

2. taxable Traditional IRA conversions.

3. nontaxable Traditional IRA conversions.

4. earnings on all Roth IRA assets.

Distributions of Roth IRA assets from regular participant contributions and from

nontaxable conversions of Traditional IRA can be taken at anytime, tax and penalty free

if the distribution is in line with the rules that exempt assets from income tax and early-

distribution penalties. A nonqualified distribution of taxable Traditional IRA conversion

assets may be subjected to early-distribution penalties. And finally, a nonqualified

distribution of earnings may be subjected to income tax and the early-distribution

penalty.

Example 3. Jane established his first Roth IRA in 2000 and made a participate

contribution of $2,000 a year. In 2004, he converted his traditional IRA to his Roth IRA.

In 2005, john is 55 years old, and balance is John’s IRA at that time is represented as

follows:

Assets Source
$10,000 Roth IRA participant contributions 2000 through 2004
$50,000 Taxable Traditional IRA conversions from 2004
$10,000 Non-taxable Roth IRA conversions from 2004
$5,000 Earnings
$75,000
If John takes a distribution of $75,000, the first $10,000 comes from his regular Roth IRA

contributions and is therefore tax and penalty free. The additional $50,000, however, comes from

his taxable conversion assets. Because these assets were taxed when converted, there will not

be any income tax owed on the distribution. However, they are subjected to the 10% early-

distribution penalty since it hasn't been five years since John's conversion. But, the penalty may

still be waived if John meets one of exceptions above. The additional $10,000 is attributed to

nontaxable conversion assets. These will not be subjected to taxes or the early-distribution

penalty because no deduction was allowed when they were contributed to the Traditional IRA.

Finally, the earnings of $5,000 will be subjected to taxes and the 10% early-distribution penalty

the distribution is nonqualified distribution and doesn’t meet one of the exceptions.

The following chart summarizes the tax treatment of all possible Roth IRA distributions:

Distributed Qualified Nonqualified Comment


Assets Distributions Distributions
Regular Tax free and Tax free and Income tax and early-distribution
participant penalty free penalty free penalty are never applied to
contributions distributed assets for which no
deduction was allowed when the
assets were contributed to the
IRA.
Taxable Tax free and Tax free but These are already taxed when
conversion penalty free penalty may converted. Penalty is waived if
apply any one of the exceptions apply.
Nontaxable Tax free and Tax free and Income tax and penalty is never
conversion penalty free penalty free applied to distributed assets for
which no deduction was allowed
when the assets were initially
contributed to the IRA.
Earnings Tax free and Taxes apply and Penalty is waived if any one of the
penalty free penalty may exceptions apply.
apply

3. Planning Strategy

Currently, the ability to convert a contribution from a traditional IRA to a Roth is

dependent upon the individual’s modified adjusted gross income. However, the adjusted

gross income limitation is scheduled to disappear altogether in 2010, opening up a


significant planning opportunity for anyone with an IRA. While this opportunity

continues beyond 2010, there is a one-time sale of Roth conversions implemented in

2010: the IRA owner will have the option to spread the income realized from a 2010 Roth

conversion over the following two years, half in 2011 and half in 2012. Other

considerations will go into the decision whether to convert. One of the important

questions is whether the individual needs the IRA funds for living expenses. One of the

greatest benefits of the Roth is the ability to avoid the lifetime required minimum

distribution. Those individuals who do not need the IRA assets for living and who would

prefer to leave IRA assets to another generation will likely wish to consider the

conversion option.

Some with earned income who has already reached age 70.5 is prohibited from making a

traditional IRA contributions, but not for a Roth IRA contributions. He would consider

doing so if his adjusted gross income is modest enough to allow it.

A teenager with modest earnings would be well advised to contribute up to the maximum

to a Roth IRA when the tax cost of doing so is low on non-existent. A parent, who wants

to encourage good saving and investment habits, might make a corresponding gift to the

child.

Many taxpayers experience years with low taxable income, perhaps as a result of

retirement. Such year present an opportunity to convert a portion of an existing to convert

a portion of an existing traditional IRA to Roth IRA at low tax cost.

Required Minimum Distribution from IRA and Retirement plans

The required minimum distribution rules are designed to ensure that funds in tax-

qualified retirement plan or a traditional IRA are actually used for retirement, rather than
for estate planning purposed. If an individual doesn’t need the funds for currently living,

the scenario is that the individual would defer distribution as long as possible to take

advantage of the tax-free build up available in an IRA or a qualified plan. Ordinarily,

individuals who have reached the age of 70 ½ must take a certain amount of money out

of their qualified plans every year. The penalty for failing to do so is 50% of the

difference between what was distributed and what ought to have distributed according to

IRS rule. The Roth IRA is not subject to the pre-death required minimum distribution.

A. Required Payout During Owner’s Life

Distributions from a qualified plan or a traditional IRA are generally required no later

than the participant’s required beginning date. The required beginning date depends on

whether the plan is a qualified plan or an IRA and, in the case of a qualified plan, whether

the individual is or is not a 5% owner.

If the individual in a qualified plan is not a 5% owner, the required beginning date means

April 1 of the calendar year following the later of: 1) the calendar year in which the

employee attains age 70 ½, or 2) the calendar year in which the employee retires.

In the case of a 5% owner in a qualified plan, the required beginning date means April 1

of the calendar year following the calendar year in which the employee attains age 70 ½ .

Whether the individual has terminated employment is disregarded here. An individual is

treated as a 5% owner if the employee is a more than 5% owner of the employer with

respect to the plan year within the calendar year in which the individual attains age 70 ½ .

Once distribution has begun for a 5% owner, distribution must continue in subsequent

years even if the individual ceases to be 5% owner.


For traditional IRA, the required beginning date starts April 1 of the calendar year for the

calendar year in which the individual attains age 70 ½.

Even though the first distribution must be made by April 1 of the year the participant is

70 ½ , all subsequent distributions must be made by December 31 of the distribution year.

So if an individual defer the first distribution into the second year, he/ she will have 2

year of distribution in that second year.

The minimum amount distributed is determined by taking the value of the account as of

the last valuation date immediately preceding calendar year and dividing it by applicable

distribution period. The applicable distribution period is determined using the Uniform

Lifetime table set forth in the regulations. Essentially, the minimum amount is

determined by dividing the account balance by the participant’s anticipated life

expectancy determined by the Uniform Lifetime Table. The only exception for the use of

Uniform Lifetime Table is where the participant’s spouse is the sole designated

beneficiary and the spouse is more than 10 years younger than the participant. The

participant may use another table that takes into account the actual joint life expectancy

of the owner and designated beneficiary.

While the distribution process is fairly standardized, it still lend to some planning

opportunities. First, a participant with a younger spouse can consider whether to

designate the spouse as the sole beneficiary, thus use the more advantageous joint table to

defer the distribution. Next, thought should be given when the first required minimum

distribution should be taken. If an individual chose to start the requirement minimum

distribution in the year following the year in which he/she attains age 70 ½, the individual

will be forced to take two distributions that year: one by April and other by December 31.
This might push the individual to a higher tax bracket. If that is the case, the individual

might consider taking the first distribution in the calendar year in which the individual

reaches age 70 ½. Once the first distribution is satisfied, the taxpayer can decide when to

take each subsequent year’s required minimum distribution. Generally, individual can

take only one distribution at the end of the year in order to better allow the earning to

grow and accumulate throughout the year.

2. Required Payout on Owner’s Death

The required Minimum distribution after the owner’s death depends on whether the

beneficiary is the owner’s spouse, a designated beneficiary other the owner’s spouse, or if

there is no designated beneficiary. For the most par, Required Minimum distribution after

an owner’s death are determined based on Table V of the 72 regulations and beneficiary’s

age is used.

A. Spouse as Designated Beneficiary

If the spouse is the sole designated beneficiary, there are tow options available to the

spouse. The spouse may leave the assets in the owner’s account or rollover the assets in

to the spouse’s own account. The exact distribution requirements depend on whether the

owner died before or after the owner’s required beginning date.

If the owner dies before required beginning date and the spouse chose to leave the fund in

owner’s account, The distributions should be made using the Table V Divisor for the

owner’s (may use surviving spouse’s age if younger) each year, recalculated annually.

The distribution must begin by December 31 of the year the owner would have attained

age 70 ½. If the surviving spouse dies before distribution to the surviving spouse have
begun, use the Table V divisor for designated beneficiary named by the surving spouse,

as if the surviving spouse were the account owner.

It is usually advisable for surviving spouse to leave the fund in owner’s account if the

owner is actually younger than the surviving spouse. However, if the surviving spouse is

younger the owner, it is advantage to roll over the owner’s account into the spouse’s

account. So the distribution should begin by the spouse’s required beginning date and be

calculated based on the spouse’s life expectancy using the divisor form the uniform

distribution table.

If the owner dies after required the beginning date and the surviving spouse chose to

leave the fund in owner’s account, the distribution should be made as follows: the

owner’s required minimum distribution for the year of death should be distributed;

distributions of the balance should be made using the Table V divisor for the owner’s age

each year (may use surviving spouse’s age if younger). Distributions are recalculated

annually and must begin by December 31 of the year following the owner’s death. If the

surviving spouse dies before distributions to the surviving spouse have begun, use the

Table V divisor for ht e designated beneficiary named by the surviving spouse, as if the

surviving spouse were the owner.

Similarly, it is better to roll the owner’s account into the surviving spouse’s account if the

spouse is younger than the owner. Then the distribution should begin by the surviving

spouse’s required beginning dated and be calculated based on the surviving spouse’s life

expectancy using the divisor form the Uniform Distribution table. If the owner dies after

the owner’s required beginning date, the surviving spouse must also take the own’s
required distribution for the year of the owners’ death. Prop. Reg. 1.402(c)-2, A-12

(2001)

B. Designated Beneficiary Other Than Spouse

Distribution must be made by December 31 of the year following the owner’s death to

the designated beneficiary over the designated beneficiary’s life expectancy. The

calculation should use Table V divisor based on oldest designate beneficiary’s age in the

calendar year after participant’s death, reduced by one for each year thereafter. In

addition, if the account owner dies after his required beginning date, the owner’s required

minimum distribution must be made for the year of death.

C. No designated beneficiary

If there is no designated beneficiary, and if the owner has not reached the required

beginning date, the account must be distributed by December 31st of the fifth year

following the account owner’s death. If the owner has reached the RBD, then the account

must be distributed over the owner’s nonrecalculated life expectancy based on the

owner’s age in calendar year of the owner’s death, reduced by one for each year after the

year of the owner’s death.

Early Distribution Tax

While the required minimum distribution rules are there to prevent individuals from using

tax-deferred amount for estate planning purpose rather than for actual retirement, the

early distributions tax of Section 72(t) is to prevent individuals form receiving tax-

preferred retirement income too early and for non-retirement purposed. There is generally

a 10% penalty tax on retirement income includible in income which is paid before an
individual attains age 59 ½. The 10% is in addition to any other tax otherwise due and

applies unless taxation is avoided by rolling the amount into another eligible tax-deferred

vehicle such as an IRA.

If an individual in a qualified plan does not elect direct rollover, he/she would be subject

to the 20% federal income tax withhold. If the individual subsequently rolls over the

distribution actually received within 60-day rollover period, the 10% penalty tax will still

apply to the 20% withheld and not received if the individual is under age 59 ½.

Despite the general rule, the early distribution tax is subject to a number of exceptions:

• Distribution made to a beneficiary on or after the death of the employee

• Distribution attributable to the employee’s being disabled as defined in Section

72(m)

• Distributions that are part of a series of substantially equal periodic payments

made for the life or life expectancy of the employee or the joint lives or joint life

expectancies of the employee and the employee’s designated beneficiary.

• Distribution paid with respect tot stock of a corporation that are described in

Section 404(k)

• Distribution made to the employee to the extent such distribution do not exceed

the amount allowable as a deduction under Section 213 to the employee for

amounts paid during the tax year for medical care.

The following exceptions are only available to IRAs:

• Distributions to unemployed individuals for health insurance premiums.

• Distributions for higher education expenses.

• Distribution for certain qualified first time home purchase.


1 Code Sec. 219(a)

2 Code Sec. 219 (g)

3 Code Sec. 408A(c)(2)

4 Code Sec. 408A(c)(1)

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