by Elizabeth R. Salasko, Esq.
© 1998 Smith, Stratton, Wise, Heher & Brennan
Original Publication Date: May/June, 1998
The Taxpayer Relief Act of 1997 overhauled the rules applicable to traditional deductible and nondeductible IRAs, and created two new IRA options, the "Roth IRA" and the "Education IRA." Most of the new provisions went into effect on January 1, 1998. To take advantage of the new opportunities created by the '97 Act, taxpayers must begin to plan now for how to best allocate their IRA savings among the available choices. This client alert will summarize the rules for traditional and nondeductible IRAs, and will set forth the rules for the new Roth and Education IRAs.
An IRA is a savings vehicle which allows an individual to make contributions into his or her own individual retirement account, or "IRA." Earnings on the contributions are not taxed until withdrawals are taken from the account. Contributions may be deductible to the individual, subject to certain income and other limitations. Taxpayers generally have until April 15 to make a contribution to an IRA on account of the previous calendar year. Contribution amounts are limited, generally to $2,000 per year, and an excise tax of 6% on excess contributions applies. There is generally a penalty for taking a distribution prior to age 59 1/2, equal to 10% of the taxable amount of the distribution. Distributions must generally begin after age 70 1/2.
Prior to the '97 Act, a taxpayer could contribute an amount equal to his or her earned income, up to $2,000 per year, into a traditional IRA. If both the taxpayer and his or her spouse (if any) did not participate in a qualified retirement plan, the full $2,000 was deductible. If either the taxpayer or his or her spouse participated in a qualified retirement plan, the contribution was deductible only if the taxpayer's adjusted gross income ("AGI") did not exceed certain limits.
· Pre-'97 Act Limits on Deductibility
Prior to the '97 Act, the deductibility of IRA contributions "phased out" at relatively low AGI levels. For taxpayers who were married filing jointly, where one or both spouses participated in a qualified retirement plan, an IRA contribution was fully deductible only if the couple's AGI was less than $40,000. The deduction was ratably reduced if the couples' AGI was between $40,000 and $50,000, and was unavailable to couples with AGI above $50,000. For single taxpayers who participated in a qualified retirement plan, an IRA contribution was fully deductible only if the taxpayer's AGI was below $25,000, was phased out for AGI between $25,000 and $35,000, and was unavailable for AGI above $35,000.
· '97 Act Changes to Deductibility Limits
The '97 Act changed two things: the rules regarding participation by a spouse in a qualified retirement plan, and the phase out limits for deductibility of IRA contributions. Both changes will make deductible IRAs more widely available to taxpayers.
Under the new law, participation by a spouse in a qualified retirement plan will not count against a taxpayer who does not participate in such a plan. For a married taxpayer who does not participate in a qualified retirement plan, an IRA contribution is now fully deductible as long as the couple's AGI does not exceed $150,000. The deduction is phased out for couples with AGI between $150,000 and $160,000, and unavailable for couples with AGI above $160,000.
For taxpayers (married or single) who do participate in a qualified retirement plan, the phase out range for single taxpayers is now $30,000 to $40,000, and for married taxpayers is $50,000 to $60,000. The phase out range for single taxpayers will increase each year until 2005, when it will be $50,000 to $60,000. For married taxpayers, the phase out range will increase each year until 2007, when the range will also be spread, to between $80,000 and $100,000.
Abigail is a participant in a qualified retirement plan. Benjamin, her husband, does not participate in a qualified retirement plan. Their AGI for 1997 was $140,000. Under the pre-'97 Act, neither of them could make a deductible IRA contribution, because their combined AGI exceeded the 1997 phase out limit of $50,000. Assume that Abigail and Benjamin again have an AGI of $140,000 for 1998. Abigail may not make a deductible IRA contribution because she is a participant in a qualified retirement plan, and their joint AGI exceeds the 1998 phase out limit of $60,000. Benjamin, however, may make a $2,000 deductible IRA contribution, because he is not a participant in a qualified retirement plan, and their joint AGI is below the $150,000 limit. Assume that in 1999, Abigail and Benjamin's AGI increases to $250,000. Neither of them may make a deductible IRA contribution, because their joint AGI exceeds the $160,000 limit.
Generally, withdrawals from a traditional IRA prior to the time that the IRA owner attains age 59 1/2 will result in a 10% penalty. Under the pre-'97 Act rules, penalties would not apply to certain withdrawals, such as upon death or disability or for the payment of certain medical expenses or health insurance premiums for unemployed individuals. The '97 Act has added two more exceptions to the penalty rules:
· To Fund Higher Education
No penalties will apply to withdrawals made in 1998 or future years, where the amounts withdrawn are used by the taxpayer to pay for qualified higher education expenses for the taxpayer, his or her spouse, and children and grandchildren of the taxpayer or his or her spouse. The expenses must be for tuition, room and board, fees, books, supplies and equipment required for enrollment or attendance, and are limited to qualified post-secondary eligible educational institutions, including graduate courses. There is no limit to the amount of the withdrawals a taxpayer may make for qualified higher education expenses, although a taxpayer can't use withdrawals to pay for expenses for which a Hope Scholarship Credit is also taken.
The Hope Scholarship Credit is available only to students who cannot be claimed as a dependent by another taxpayer. The Hope credit is limited to $1,500 per year (100% of the first $1,000 plus 50% of the next $1,000 of qualified tuition paid) during a taxpayer's first and second year of post-secondary education. The Hope credit phases out for single taxpayers with AGI between $40,000 and $50,000 (between $80,000 and $90,000 for taxpayers filing jointly).
Although penalties will not apply, withdrawals from a traditional IRA will continue to be taxable, as under prior law. Taking withdrawals from a traditional IRA to fund higher education may be less appealing than some other alternatives. For example, a participant in a 401(k) or other qualified plan which allows for plan loans can borrow tax and penalty free. The catch is that a loan from a qualified plan must generally be repaid over a five year term, while an IRA withdrawal does not require repayment.
· First-Time Homebuyer Expenses
A taxpayer may now make penalty-free withdrawals from a traditional IRA to finance up to $10,000 of "qualified first-time homebuyer expenses." The first-time homebuyer may be the taxpayer, his or her spouse, or the child, grandchild, or ancestor of the taxpayer or his or her spouse. The withdrawal must be used within 120 days to pay qualified acquisition expenses with respect to the principal residence of a first-time homebuyer, such as a downpayment, the cost of construction, financing a mortgage (e.g., points), and other closing costs. The "first-time" requirement is not what it seems. A first-time homebuyer is defined under the new law as any taxpayer who has not had an ownership interest (severally or jointly with his or her current spouse) in a principal residence for the two year period prior to signing a contract of sale or beginning construction on a new home. As under prior law, amounts withdrawn will be taxable, even though the 10% penalty no longer applies.
For those taxpayers who can not take full advantage of deductible contributions to traditional IRAs (because of participation in qualified retirement plans and/or AGI limitations), nondeductible contributions equal to earned income up to $2,000 per year are allowed less any contributions made to traditional or Roth IRAs (see below). Distributions of earnings are taxable and subject to a 10% penalty under the same rules governing traditional IRAs. Distributions of previously-taxed contributions are tax-free. None of these provisions were changed by the '97 Act.
A new type of IRA, named for the Senate Finance Committee Chairman William V. Roth, Jr., is now available as an alternative to the traditional and nondeductible IRAs. Distributions from a Roth IRA are not required to commence at age 70 1/2, as is required with a traditional IRA. This is the difference that makes the Roth IRA particularly attractive. A taxpayer who lives beyond age 70 1/2 and who does not need the funds to live on can continue to make contributions (to the extent he or she qualifies) and to defer taxes until death. Amounts in the fund would continue to be tax deferred until distributed to beneficiaries as required under the distribution rules applicable to beneficiaries.
Under the new Roth IRA, a taxpayer whose AGI does not exceed certain limits can make a nondeductible (after-tax) contribution of up to $2,000 per year. Contributions may be made to nondeductible, traditional and Roth IRAs, but a combined annual limit of $2,000 (and 100% of compensation) applies. Generally, a contribution must be made during the tax year or by the next April 15, if the post-tax-year contribution is designated as on account of the previous year. Proper identification of the tax year for which a contribution is made is necessary to start the counting of a five year waiting period for withdrawals (see below). For married taxpayers, the full contribution is allowed as long as the couple's AGI does not exceed $150,000. The maximum contribution is phased out for couples with AGI between $150,000 and $160,000, and is unavailable for couples with AGI above $160,000. The full contribution is allowed for single taxpayers with AGI below $95,000, is phased out between $95,000 and $110,000, and is unavailable for single taxpayers with AGI above $110,000. There is no limitation based on active participation in a qualified plan.
Contributions may be withdrawn from a Roth IRA at any time, tax and penalty free. Compare this to withdrawals from a nondeductible IRA, where withdrawals are considered to consist in part of previously taxed contributions and in part taxable earnings. A withdrawal of earnings from a Roth IRA will be tax and penalty free only if taken at least 5 years after the tax year for which the first contribution was made, (or 5 years after the tax year in which a rollover was made), and must be made upon death, disability or after age 59 1/2, or otherwise qualify for the first time homebuyer exception. The 5 year period may in fact be less than 5 full years. For example, if a contribution is made on April 15, 1999 on account of tax year 1998, the five year period would be from 1998 to 2002, and distributions after 2002 would satisfy the 5 year waiting period. The earnings on amounts withdrawn before that time will be taxable, though no penalty will apply before age 59 1/2 if the withdrawals are used to fund first time homebuyer or higher education expenses.
Amounts remaining in a Roth IRA upon death are not taxable as income in respect of a decedent. If the Roth IRA owner's spouse is the sole beneficiary of the Roth IRA, he or she will be treated as the account owner. The surviving spouse need not take distributions at age 70 1/2, as with a traditional IRA, but may leave the full Roth IRA to his or her nonspouse beneficiary. Distributions would then be made (at the election of the account owner, or if not made, at the election of the beneficiary) over the life expectancy of the named beneficiary (only if payments start by December 31 of the calendar year following the account owner's death) or by the end of the calendar year in which the fifth anniversary of the account owner's death occurs. In either event, it is obvious that a Roth IRA can accrue tax-free earnings for many years before distributions will be required.
Partial distributions from any of a taxpayer's Roth IRAs are considered to come first from nontaxable contributions of any Roth IRA.
Certain taxpayers have the option of rolling over monies from their traditional and/or nondeductible IRAs to a Roth IRA within 60 days, or converting those traditional IRAs to a Roth IRA (by notifying an existing IRA trustee, or by making a direct trustee-to-trustee transfer). To qualify, a taxpayer who is single or married filing jointly must have AGI of less than $100,000, excluding the income from the rollover. Taxpayers who are married filing separately may not make rollovers to a Roth IRA. Earnings from the traditional or nondeductible IRA, and contributions to the extent previously deducted, will be taxed at the time of the rollover. For this calendar year only, taxes on the amount rolled over will be spread ratably over a four year period. The full amount of the taxes will be due in the year of any rollover that takes place after 1998. The 10% penalty will not apply to amounts rolled over.
Rollovers to a Roth IRA make sense where an IRA held mostly nondeductible contributions and has accumulated little in taxable earnings, or where a traditional IRA (with deductible contributions) has been open for only a short period of time. A rollover would also make sense if a taxpayer does not expect to need to make withdrawals from the IRA upon retirement, because a Roth IRA will allow for a significantly longer deferral period.
A rollover may also make sense for a younger taxpayer, who expects to keep monies in the IRA for a longer period of time. Tax deferral of the earnings may be more advantageous than current deductions for contributions, especially if the taxpayer expects his or her marginal tax bracket to be as high or higher on retirement than at the time contributions are made.
A transfer of nondeductible IRA contributions for any given year to a Roth IRA may be made at any time during that year, or by April 15 of the following year (if designated as on account of the previous year) without incurring any taxable income.
The '97 Act created a new tax deferred savings vehicle for funding higher education. Though called an "IRA," an Education IRA is not technically an individual retirement account. An Education IRA may be set up by taxpayers who fall below the AGI limitations, to benefit individuals under the age of 18.
Contributions of up to $500 per beneficiary may be made to an Education IRA by married taxpayers with "modified" AGI below $150,000, and by single taxpayers with "modified" AGI below $95,000. Modified AGI is adjusted gross income increased by certain excludable non-U.S. income. Contributions are phased out in the same manner as for the Roth IRA. An individual may be a beneficiary of multiple Education IRAs, and beneficiaries need not be dependents of or related to the contributors. The IRS is taking the position, however, that the total contribution per beneficiary per year cannot exceed $500. Contributions, which are not tax-deductible, are in addition to the $2,000 combined limit for traditional, nondeductible, and Roth IRAs. Contributions will qualify for the annual $10,000 per donee gift tax exclusion. Contributions to an Education IRA are not allowable in any amount in the same year that contributions are also made on behalf of the beneficiary to a qualified state tuition program. Contributions in excess of the allowable limit are subject to a 6% excise tax unless returned, with earnings, prior to the filing of the contributor's tax return.
Withdrawals of contributions by a beneficiary from an Education IRA are always tax-free, and the withdrawal of earnings will be tax-free to the extent that the total amounts withdrawn (contributions plus earnings) are used to pay for the post-secondary education expenses (including tuition, books, and supplies for students enrolled at least half-time, and the minimum room and board allowance applicable for a full time student as determined by the institution in accordance with guidelines for determining financial aid) of the designated beneficiary. Qualified education expenses are then reduced by nontaxable scholarships, fellowship grants, and educational assistance allowances.
The Hope Scholarship Credit (discussed above) and the Lifetime Learning Credit cannot be taken in a year in which a student makes withdrawals from an Education IRA. The Lifetime Learning Credit is available to students who are not claimed as dependents by another taxpayer, for 20% of up to $5,000 in qualifying post-secondary education (including graduate-level courses) after June 30, 1998. The $5,000 limit increases to $10,000 in 2003. The Lifetime Learning Credit phases out for single taxpayers with AGI between $40,000 and $50,000 ($80,000 and $90,000 for taxpayers filing jointly).
To the extent the amounts withdrawn from an Education IRA are greater than qualified education expenses, a pro rata share of the earnings will be taxable to the beneficiary, and a 10% penalty will apply to the taxable amount (unless made on account of death or disability). Funds which are not used for education expenses of the beneficiary by the time he or she reaches age 30 may be rolled over within 60 days to an Education IRA for another member of the beneficiary's family. "Member of the family" includes any relative described below, or a spouse of such relative. These would be:
· a son or daughter of the taxpayer, or a descendent of either;
· a stepson or stepdaughter of the taxpayer;
· a brother, sister, stepbrother, or stepsister of the taxpayer;
· a father or mother of the taxpayer, or an ancestor of either;
· a stepfather or stepmother of the taxpayer;
· a son or daughter of a brother or sister of the taxpayer;
· a brother or sister of the father or mother of the taxpayer; or
· a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law of the taxpayer.
To the extent the new beneficiary is in the same generation as the prior designated beneficiary, there will be no gift tax consequences. If the new beneficiary is a generation below the first beneficiary, the transfer will be a taxable gift, though the present interest exclusion will apply. Funds may also be rolled over prior to age 30 to another member of the beneficiary's family (but no more than once in a 12 month period), and a named beneficiary may be redesignated at any time to a different member of the named beneficiary's family, without tax consequences. If not rolled over, unused funds at age 30 must be distributed to the beneficiary, and the earnings will be taxable and subject to a 10% penalty. If a beneficiary dies prior to age 30 with funds still in an Education IRA, those funds will be included in his or her estate. The earnings will not be subject to the 10% penalty. Withdrawals may also be made by a disabled beneficiary, penalty free. An Education IRA may be transferred to a spouse or former spouse pursuant to the terms of a divorce decree without tax consequences. Like traditional IRAs, if an Education IRA is used as security for a loan, the amount used as security is treated as a taxable distribution.
There are many factors which a taxpayer must take into account in evaluating which IRA will be most beneficial. While a full examination of all of those factors is beyond the scope of this article, there are a few basics which a taxpayer should consider. If a taxpayer is eligible to make a contribution to either a Roth IRA or a nondeductible IRA, a Roth IRA will generally be a better choice because earnings in a nondeductible IRA will be taxed on withdrawal, while earnings in a Roth IRA will not be taxed under most circumstances. However, because there are AGI limitations on contributions to a Roth IRA, but no AGI limitations on contributions to a nondeductible IRA, a taxpayer may be able to make a greater contribution to a nondeductible IRA. A combination of the two in such a case may be the best alternative.
Likewise, the AGI limitations of a Roth IRA may preclude a full contribution by a taxpayer who is not an active participant in a qualified plan, while a traditional IRA would have no such limitation. If a taxpayer could make full contributions to either a Roth or traditional IRA, the choice of which will be better involves predicting how a taxpayer's income (and thus tax rates) will change over time, how long he or she will live, and when (if at all) he or she may need to make withdrawals from the IRA.
Taxpayers with higher tax rates at the time contributions are made than at the time withdrawals will be needed will generally benefit by using a traditional IRA. Contributions will be deductible when they are at a higher tax bracket, and withdrawals will be taxed at a lower rate.
Taxpayers who expect to remain in the same marginal tax bracket from the time contributions are made until the time withdrawals will be made can expect similar results from the traditional and Roth IRAs.
For taxpayers who expect their marginal tax rates to be higher at the time withdrawals are needed than at the time contributions are made, a Roth IRA would be a better choice than a traditional IRA. This is particularly true for a younger taxpayer. Even a teenager who has earned income could benefit greatly from the growth of tax-free earnings. And there is nothing to stop a parent from making a gift to a child to "replace" the amount the child has contributed to an IRA.
In all cases, contributions to an Education IRA can be made in addition to
contributions to other types of IRAs, and should be considered as part of every family's
planning for college tuition.
Author:
The substance of this Client Alert first appeared in an article authored by Elizabeth R.
Salasko, entitled "Beyond Plain Vanilla: The New Flavors of IRAs," published in
the May/June 1998 issue of Probate & Property: The Magazine of the Real Property,
Probate and Trust Law Section of the American Bar Association. If you have any questions
or need further information, please contact Elizabeth R. Salasko at 609-987-6686 or ers@sswhb.com.
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The information contained in this client advisory is intended for information only and is not to be considered legal advice. For specific legal questions, please consult one of our attorneys.