Understanding the New Roth IRA Rules after TIPRA

Roth IRA rules were originally designed to prevent high income taxpayers from benefiting from the use of a Roth IRA. A Roth account provides a unique tax structure, giving no benefits to the taxpayer in the current year but allowing for tax-free growth in the future. Since the structure was designed to encourage low-income individuals to save, individuals earning more than $100,000 faced unique restrictions when forming or rolling over a Roth IRA. In 2005, Roth IRA rules were changed by the The Tax Increase Prevention and Reconciliation Act (TIPRA). This new act makes it possible for a high earner to use a Roth IRA without penalty.

Roth IRA Tax Considerations

A Roth IRA uses post-tax dollars to save for retirement. This means contributions are not deducted from this year's tax payments. Instead, the funds are permitted to grow tax-free once in the account, and the taxpayer does not pay any tax upon taking a distribution. This allows an individual at a very low current tax rate to deposit funds today at that low rate and then avoid paying taxes at an anticipated higher rate in the future.

Converting a Traditional IRA

Some taxpayers will see the advantage of changing a traditional IRA to a Roth IRA after the traditional IRA has been formed. In this case, a conversion is possible. However, since no taxes were initially paid on the funds in the traditional account, the taxpayer will owe upon the conversion. This means the taxpayer will pay a one-time fee for converting at his or her current tax rate. The conversion tax has always applied and continues to apply after TIPRA goes into effect.

High Income Roth IRA Options prior to TIPRA

Previously, any individual whose modified adjusted gross income (AGI) for a given year exceeded $100,000 was prohibited from making a qualified rollover from a traditional IRA to a Roth IRA. In addition, individuals earning an AGI of more than $95,000 were limited in the contributions and options they had for Roth IRA contributions. This meant most individuals earning at least $95,000, or $150,000 per couple, were not eligible to use the Roth IRA option or convert to this option for their benefit. Instead, these persons would have to stay with the traditional model, putting pre-tax dollars in the account and then paying the high taxes later in life. 

Current TIPRA Adjusted Options

TIPRA was signed in 2005 but goes into effect in 2010. With the TIPRA change, the individuals previously excluded from converting a traditional IRA to a Roth IRA due to their income will no longer face an exclusion. They can convert, and the estimated income that will be earned on deposits that have been previously placed in the account tax-free will be reported over a two-year period. One half of the estimated tax liability is paid each year. The taxpayer must pay this tax with funds outside of the IRA. It can be a significant amount of tax if the taxpayer has a large traditional IRA fund to convert.

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