Roth IRAs were designed to be a streamlined way to amass a tax-favored retirement nest egg, but over the years new features and new types of Roths have created rules that are confusing and sometimes contradictory. This article highlights the similarities and differences between the principal types of Roths available today, the regular Roth IRA, and the designated Roth IRA (and a subset of the latter, Roth 401(k)s).
Overview
Roth IRA. A Roth IRA can be set up by anyone who: (1) has taxable compensation (earned) income; and (2) has modified adjusted gross income (AGI) that doesn't exceed certain limits (explained below).
Designated Roth. A designated Roth account can be used by individuals only if their retirement plan offers this option.
A designated Roth is a separate account in a Code Sec. 401(k), Code Sec. 403(b) or Code Sec. 457 plan to which an employer allocates an employee's designated Roth contributions and their gains and losses. Instead of making elective, pre-tax contributions to his regular account, the employee directs that part or all of the contribution be made to a nondeductible designated Roth account within the plan. The employer must separately account for all contributions, gains and losses to a designated Roth account until its balance is completely distributed.
When a designated Roth account is set up within a Code Sec. 401(k) plan, it's called a Roth 401(k).
Eligibility to Make Contributions
Roth IRA. An individual with taxable compensation income may make an annual nondeductible contribution to a regular Roth IRA, but the contribution is phased out if modified AGI exceeds an inflation-adjusted limit. For 2011, for joint filers, the otherwise allowable contribution to a Roth IRA is phased out ratably for modified AGI between $169,000 and $179,000 (up from $167,000 and $177,000 for 2010). For singles and heads of household, the contribution is phased out ratably for modified AGI between $107,000 and $122,000 (up from $105,000 and $120,000 for 2010). For married taxpayers filing separate returns, the otherwise allowable contribution is phased out ratably for modified AGI between $0 and $10,000 (same as for 2010).
Designated Roth. There is no income limitation on annual contributions to a designated Roth. Workers of all income levels are eligible to contribute to such retirement accounts.
Contribution Dollar Limit
Roth IRA. The annual contribution limit to a regular Roth IRA is the lesser of (1) $5,000 ($6,000 if the taxpayer is age 50 or older), or (2) taxable compensation minus total contributions to regular IRAs (but employer contributions to a simplified employee pension (SEP) or SIMPLE IRA plan don't count). A contribution to a spousal Roth IRA also may be made if certain conditions are met.
Designated Roth. The annual contribution limit to a designated Roth account is equal to the annual contribution limit on elective deferrals. For 2011, this limit is $16,500, plus $5,500 if the plan participant is age 50 or older (same as for 2010). A contribution to a spousal designated Roth cannot be made.
Observation: A taxpayer may make a maximum contribution of $16,500 (plus $5,500 if the plan participant is age 50 or older) to a designated Roth and a maximum contribution of $5,000 (plus $1,000 if age 50 or older) to a regular Roth IRA, if the taxpayer is otherwise eligible to contribute to both.
Recharacterizations
Roth IRA. A taxpayer may recharacterize a contribution to a Roth IRA. For example, a taxpayer who made a contribution to a Roth IRA may later decide he would be better off with a regular, deductible IRA contribution. If he transfers the contribution from the Roth IRA to a regular IRA no later than the due date (including extensions) for the return for the year in which the contribution was made, the taxpayer can treat the contribution as having been made to the regular IRA, not the Roth IRA.
Designated Roth. A contribution to a designated Roth account is irrevocable. Once an employee's elective contribution is made to the designated Roth account, it cannot be recharacterized and changed into a regular, pre-tax elective deferral to the plan.
Rollovers
Roth IRA. A Roth IRA can accept rollovers from an employer sponsored plan (e.g., profit-sharing, 401(k)), or 403(b) or 457 plan) as long as it's an eligible rollover distribution. Rollovers can be made from a Roth IRA to another Roth IRA, but not to an employer-sponsored plan.
Designated Roth. A designated Roth account may accept an in-plan Roth rollover (IPPR); for details, including a two-year income inclusion rule for IPPRs made in 2010. Amounts in a designated Roth may be rolled over only to another designated Roth account or to a Roth IRA.
When Withdrawals Are Allowed
Roth IRA. A withdrawal from a Roth IRA may be made at any time (but premature distributions may have negative tax consequences, see discussion below). Taxpayers cannot get a direct tax-free loan from their Roth IRAs. However, taxpayers can indirectly borrow their Roth funds for a short-period by withdrawing them and rolling them over within 60 days.
Designated Roth. The same withdrawal restrictions that apply to regular pre-tax elective plan contributions also apply to designated Roth accounts. For example, a 401(k) plan generally may allow distributions only on account of death, disability, severance from employment, hardship, or attainment of age 59 1/2 (for profit-sharing or stock bonus plans). Participants may borrow from designated Roths, if the plan allows such loans to be made.
When Withdrawals Must be Made (Required Minimum Distributions)
Roth IRA. Roth IRA owners do not have to take required minimum distributions (RMDs) during their lifetimes. The beneficiary of a Roth IRA must, however, take required distributions from the account using the same rules that apply to a regular IRA account after the death of its owner (and a spouse beneficiary can treat the Roth IRA as his or her own).
Designated Roth. RMDs must be made during the account owner's lifetime, generally commencing no later than April 1 of the year following the year in which the owner attains age 70 1/2.
Observation: Lifetime RMDs can be avoided by rolling over a designated Roth account into a regular Roth IRA.
Taxation of Withdrawals
Roth IRA. Because Roth IRAs are funded with after-tax contributions, income tax isn't payable on those contributions when they are distributed. If the distribution is a qualified distribution, earnings also are tax-free.
A qualified distribution is one made: (a) after 5 years (measured from January 1 of the year for which the taxpayer first made any Roth IRA contributions to any Roth IRA, including rollover or conversion contributions, to the last day of the fifth year); and (b) on or after he attains age 59 1/2; because of death or disability, or to buy, build, or rebuild the taxpayer's first principal residence. Qualified distributions are not subject to the Code Sec. 72(t) additional 10% early distribution tax because they already meet an exception to that tax.
To calculate what portion, if any, of a nonqualifying Roth IRA distribution is subject to income tax (and/or the Code Sec. 72(t) penalty tax), distributions are treated as coming from these sources, in the order in which they appear below:
1. From regular Roth contributions (which aren't subject to income tax or the Code Sec. 72(t) additional tax).
2. From rollover and conversion contributions (on a first-in-first-out basis) and within each rollover or conversion, in the following order:
a. The taxable portion (the amount previously included in income at the time of the rollover or conversion). This portion is not subject to income tax but, unless some exception applies, is subject to the Code Sec. 72(t) additional 10% early distribution tax if distributed within 5 years of when these funds were rolled over or converted. A separate 5-year period applies to each conversion and rollover and is the not the same 5-year period used for determining whether a distribution is qualified (see above).
b. The nontaxable portion, which is not subject to income tax or the Code Sec. 72(t) additional tax.
3. Earnings, which are subject to income tax and, unless an exception applies, to the Code Sec. 72(t) additional 10% early distribution tax.
Designated Roth. A qualified distribution from a designated Roth generally is defined the same way as for a regular Roth IRA, except that the rule permitting distributions to buy, build, or rebuild the taxpayer's first principal residence does not apply.
Also, the five-tax-year period for designated Roths works differently. It begins on the first day of the employee's tax year for which the employee first made designated Roth contributions to the plan, and ends when five consecutive tax years have passed. If the employee makes a direct rollover from a designated Roth account under another plan, the period for the recipient plan begins on the first day of the tax year that the employee made designated Roth contributions to the other plan, if earlier.
More importantly, the tax on a nonqualifying distribution from a designated Roth account isn't calculated in the same way as for regular Roth IRAs. Rather, the Code Sec. 72 rules apply to determine the nontaxable and taxable portions of the nonqualifying distribution from the designated Roth account. The nontaxable portion is found by multiplying the amount of the nonqualified distribution by the ratio of total designated Roth contributions to the total designated Roth account balance. For example, if a nonqualified distribution of $5,000 is made from a designated Roth account when it consists of $9,400 of designated Roth contributions and $600 of income (earnings), the distribution consists of $4,700 of designated Roth contributions that are not includible in the employee's gross income ($5,000 × [$9,400 ÷ $10,000]) and $300 of earnings that are includible in gross income ($5,000 − $4,700).
A note about sources: This article is based primarily on final regs carried in T.D. 9237, IRS Publication 590 (Individual Retirement Accounts), at http://www.irs.gov/pub/irs-pdf/p590.pdf; IRS Publication 575 (Pension and Annuity Income), at http://www.irs.gov/pub/irs-pdf/p575.pdf, and IRS's “Retirement Plans FAQs on Designated Roth Accounts,” at http://www.irs.gov/retirement/article/0,,id=152956,00.html.
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