Editor’s Note: This is a series of Articles on the new Roth IRA’s. They are complex instruments and need to be considered individually. If you are contemplating conversion to a Roth, you would be well-advised to contact us. We have a systematic method for evaluating different scenarios and can help you with a decision.

A Comparison

Although the Roth IRA clearly has the same bloodline as its older brother, the

regular IRA, this younger sibling also has many unique characteristics. The

new section of the law that defines and authorizes Roths, 408A (pronounced 408

"cap-A"), follows immediately after the IRA section (408(a)). The first

sentence of 408A tells us that except as otherwise specifically provided in

this section, Roth IRAs are to operate under the rules that apply to regular

IRAs. While that leads us to certain assumptions, we will have to wait to see

whether the IRS interprets things the same way as the rest of us.

Let's first look at how Roth IRAs work, and then maybe we can evaluate the

pros and cons of using them.

Regular IRA       Roth IRA

Annual Dollar Limit

$2,000           $2,000 (Roth)

Percentage of Compensation Limit

100% 100% (Roth)

Contribution allowed after age 701/2

NO YES (Roth)

Distributions must start by age 701/2

YES NO (Roth)

Accepts tax-free rollovers from regular IRAs

YES NO (Roth)

Accepts taxable rollovers from regular IRAs

NO YES (Roth)

Accepts tax-free rollovers from Roth IRAs

NO YES (Roth)

Accepts Rollovers From Employer Plans

YES NO (Roth)

Contributions might be deductible

YES NO (Roth)

Distributions might be tax-free

NO YES (Roth)

Basis Recovery Approach

Prorata FIFO (Roth)

AGI Limit on Allowable Contributions

N/A $115,000 for Single /

160,000 for Joint (Roth)

AGI Limit on Accepting Rollovers from Regular IRAs

N/A $100,000 (Roth)

While some people who are ineligible to contribute to regular IRAs are

permitted to make Roth IRA contributions, and vice versa, most persons can

choose between contributing to regular or Roth IRAs, or may contribute to

both, subject to a combined limitation.

People who have been contributing to regular IRAs may also choose to allow

their accumulations to remain there as tax-deferred growth. But they must

eventually take distributions that will be taxed at ordinary income tax rates.

With the advent of Rollover Roth IRAs, people will now be able to move assets

from regular to Roth IRAs, with the possibility of enjoying tax-free access

from the Roth IRAs in future years.

Those who are eligible for either the contributory or rollover Roth IRA

opportunities will, however, be faced with a number of tricky decisions. In

the future, many articles will be written, seminars conducted, and media ads

developed that will espouse or debate the merits and faults of Roth IRAs. Tax

and financial advisors will make thousands of projections for confused

clients. And people will either act nimbly, or freeze like deer caught in the

Congressional headlights. Congress has clearly outdone itself in creating

this new vehicle. Never known for using a simple approach, it has made this

program far more cumbersome than necessary. As confusing as the original

legislation is, the correcting piece of legislation, the Technical Corrections

Act, promises to be just as complex.

You can convert to a Roth IRA from either another Roth IRA or from a regular

IRA. Rollovers from other Roth IRAs are subject to the same basic rules as

apply to rollovers from one regular IRA to another. That means:

· Rollovers may be made regardless of the participant's income level

· No deduction is allowed for rollovers

· Both the taxable and nontaxable portion of the account being distributed may

be rolled over

· Only one rollover is permitted within a 12-month period

· The amount rolled over is not added to the person's taxable income in the

year of the distribution

· Only a participant or a surviving spouse may roll between Roth IRAs

· Distributions from contributory Roth IRA accounts may not be taken free from

income tax until the participant has participated in a contributory Roth IRA

for at least five years, including the year of the initial contribution. For

example, let's say that the initial contribution is made to an individual's

Roth IRA for the 1998 year, whether during 1998 or 1999. In that case, the

first time that a tax-free distribution could possibly be taken from that

individual's contributory Roth IRA by the individual or any beneficiary is on

January 1, 2003 (so long as certain other requirements are also met). Also,

any distribution from any contributory Roth IRA maintained by that individual

taken after that date might be eligible for tax-free treatment. (I will

discuss the tax and penalty treatment of Roth IRA distributions in more detail

in a future article in this series).

Rollovers From Regular IRAs to Roth IRAs are subject to the following special

rules:

· Such rollovers are only permitted if the participants' AGI for the year of

the rollover distribution does not exceed $100,000 (without regard to the

rollover).

· The taxable portion of the distribution from the regular IRA must be added

to the recipient's federal taxable income. If the distribution to be rolled

over occurs during 1998 the amount is added to the recipient's taxable income

in four equal parts for the years 1998-2001.

* If the person who is making the rollover is under age 59 1/2, the 10%

premature distribution tax penalty that would normally apply is waived.

· If the individual has ever made nondeductible contributions to regular IRAs,

the standard IRA basis recovery rules (requiring a prorated calculation) must

be applied to determine the taxable amount of the transaction.

· Both the taxable and the tax-free portion of the funds received from the

regular IRA may be rolled over to the Roth IRA.

· Distributions from rollover Roth IRA accounts may not be taken free from

income tax until the participant has participated in the particular rollover

Roth IRA for at least five years, including the year of the rollover

contribution. For example, let's say that a distribution that is taken from a

regular IRA during the 1998 year is rolled over to a Roth IRA within 60 days

of receipt (even if completed during 1999). The first time that a tax-free

distribution could possibly be taken from that particular rollover Roth IRA by

the individual or any beneficiary is on January 1, 2003 (so long as certain

other requirements are also met). The measuring period for tax-free

distributions from that Roth IRA does not affect the measuring period for tax-

free distributions from any of the participant's other Roth IRAs. (These

rules, which were the focus of much of the attention of the Technical

Corrections Bill, will be detailed in a future article in this series.)

It should be noted that while an individual is permitted to roll amounts over

from regular to Roth IRAs, they must not make rollovers from 401(k)s, 403(b)s

or other employer plans to Roth IRAs. In some situations, however, they may

be able to accomplish the desired result by rolling from the employer plan to

a regular IRA, and then to a Roth IRA.

The complexity of the Roth rules as well as the proposed technical corrections

will cause many people to fall into a variety of traps. The financial industry

that is promoting these plans is ill equipped to provide proper guidance, and

the vast majority of the people are probably going to be unwilling to pay the

significant fees required to receive the proper advice before acting.

Starting from Scratch

As we noted before, there are two ways to get a Roth; start from zip or

rollover from another retirement plan. Any person who is eligible to

contribute to a regular IRA is also eligible to contribute the same amount to

a Roth IRA, so long as the person's federal adjusted gross income (AGI) for

the year is within allowable limitations. Whereas there is no upper limit on

the amount of income a person may have and still be able to contribute to a

regular IRA, single persons with AGIs greater than $110,000, and married

persons filing jointly with AGIs over $160,000 are not permitted to contribute

to a Roth IRA.

Whereas contributions to a regular IRA may either be deductible or

nondeductible, contributions to a Roth IRA are always nondeductible.

Persons who are not actively participating in an employer sponsored plan may

choose between a deductible contribution to a regular IRA, a nondeductible

contribution to a regular IRA, or a nondeductible contribution to a Roth IRA.

For 1998, persons who are active participants in an employer plan begin losing

their ability to deduct IRA contributions at an AGI level of $30,000 for

unmarried individuals, and $50,000 for married couples filing jointly. At

$40,000 and $60,000, respectively, such persons are unable to deduct any

contributions to their regular IRAs. They may, however, still opt to make

nondeductible contributions to regular IRAs.

For 1999 and beyond these AGI limits are subject to scheduled increases.

Persons whose AGI exceed these limits will have to choose between making

nondeductible contributions to regular IRAs or to Roth IRAs. As will be

discussed in a later article, the Roth IRA, to the extent available, is

probably a far better choice.

The ability to contribute to Roth IRAs begins to phase out for unmarried

individuals at an AGI of $90,000, and for married couples filing jointly at

$150,000. At AGI levels of $115,000 and $160,000, respectively, no

contributions may be made to Roth IRAs. At that level, persons will be

relegated to using regular IRAs, whether or not deductible.

The $2,000 annual Roth IRA contribution limit must be reduced if the saver's

federal AGI exceeds the following limits.

If the Marital Status Is:Unmarried

The AGI Base Is: $ 95,000

The Range Is: $ 15,000

The AGI Max Is: $110,000

If the Marital Status Is: Married Filing JointlyMarried Filing Separately

The AGI Base Is: $150,000 $

0

The Range Is: $ 10,000

$10,000

The AGI Max Is: $160,000

$10,000

For example, Marge and Milton have an AGI of $154,000. Each spouse received

compensation in excess of $2,000 for the year. Although each spouse could

make a $2,000 contribution to a regular IRA, because their joint AGI exceeds

$150,000, each spouse would only be able to contribute $1,200 to a Roth IRA

computed as follows:

The couple's AGI: $154,000

The AGI base: $150,000

Excess AGI: $ 4,000

Adjustment rate: 20%

Reduction amount: $ 800

Maximum contribution limit: $ 2,000

Adjusted contribution limit: $ 1,200

Although savers are permitted to contribute to both a regular and a Roth IRA

during the same year, the combined amount may not exceed $2,000.

For example, Marge and Milton could each contribute up to $800 to a regular

IRA without creating an excess contribution that would be subject to a 6%

penalty.

The spousal rules that apply to regular IRAs also apply to Roth IRAs. That

means that even if only one spouse has compensation during the year, each

spouse may contribute up to $2,000 to his or her own Roth IRA.

While contributions to regular IRAs must stop at age 70 1/2, they may continue

to Roth IRAs so long as the participant has earned income, and the AGI is

within the allowable limits. That means that persons who work well into their

senior years will be able to continue to make tax-deferred nondeductible

contributions to their Roth IRAs, which could eventually be distributed tax-

free to themselves or to their heirs.

For example, Dick, who is age 72 with earned income of $80,000, is an active

participant in his employer's pension plan. His wife Ginny is age 63 with no

earned income. The couple's AGI is $120,000. For 1997 Dick would be unable

to contribute to a regular IRA because he is over age 70 1/2. For 1998 he

could contribute $2,000 to a Roth IRA.

For 1997, his wife Ginny could contribute $2,000 to a regular IRA under the

spousal IRA rules, but any such contribution would be nondeductible. That's

because she is deemed to be an active participant in an employer sponsored

plan simply because her husband is an active participant. For 1998, Ginny has

several choices. The spousal rules permit her to contribute to either a

regular or a Roth IRA or both. Her regular IRA contributions could be

deductible because under the new laws, her active participant status is not

dependent upon her husband's unless the couple's AGI exceeds $150,000.

Alternatives to Roth

That rumble you hear is not your stomach. It is the slap and crash of a fleet

of mutual funds rushing forward in the wake of the mighty Roth to tout their

own tax-favored savings vessels. Each claims to know how to navigate the

tricky tax rules, and each vessel insists that it is right for you.

The articles in this section describe tax favored investments (such as

municipal bonds and your house), tax-favored vehicles (such as variable

annuities and SEPs) and touch on the new Education IRA and Medical Savings

Accounts. 'Tax favored' refers to anything that lets investors defer or

decrease the taxes they pay. The tax favored investments listed in the

article are available to anyone, regardless of age or income level, while the

tax favored vehicles come with more restrictions and limits, all laid out in

nifty tables. Our thorough author, breaks these investments down

for individuals, employers, and the self-employed. If you got whomped by

capital gains tax recently, you know how important tax-savvy investing is.

Finally, the last bit of articles touches on who's who among investors. For

example, a 15-year old who dishes pizza in the summer is perfect for a Roth

IRA, whereas a 48 year old executive raking in $150K might want to consider

another alternative, such as making after-tax contributions to her employer's

plan. Likewise, a 75 year old investor who no longer has an income on which

to base a Roth contribution might look to a variable annuity or a non-

sheltered investment in a capital asset to answer his needs.

How Does the Roth Stack Up?

In this section of our Roth series, we compile a list of criteria important to

many investors, and see how the Roth measures up. This list is in

alphabetical order. Scroll at will.

Ability to Restructure Portfolio -- Are you able to change the investment mix

on a frequent enough basis (if desired) to maximize your return, and minimize

your risk of loss. Unless the investments in the particular Roth IRA account

are restricted, investments may generally be restructured at will.

Access to the Funds -- While most Roth IRA funds may be withdrawn upon

demand, employer plans usually involve substantial restrictions. And,

although variable annuities may usually be cashed out, surrender charges often

serve as a deterrent .

Annual Reporting -- How cumbersome are the annual reporting requirements?

There is no annual reporting requirement imposed on investors under variable

annuities or employer plans. This is one of the biggest complaints, however,

about making nondeductible contributions to regular IRAs. In the case of Roth

IRAs, we will have to wait for the IRS to announce its procedures. While the

original statute does not appear to require the same level of complex record

keeping and reporting for Roth IRAs as for regular IRAs, all of that may

change if the amendments being proposed by Congress in the Technical

Corrections Bill of 1997 are enacted as they appear in the legislation's

present form.

Available to Creditors -- May a trustee in bankruptcy or any creditor gain

access to the funds? Unlike certain employer-sponsored plans, Roth IRAs,

regular IRAs and variable annuities are not protected from the rights of

creditors by federal law. In some states, however, state law protects them.

Basis Recovery Method -- If after-tax (i.e., nondeductible) contributions have

been made, what method is used to recover the investor's basis tax-free in the

case of nonannuitized distributions: LIFO (Last In - First Out); FIFO (First

In - First Out); or Prorata? Annuities use the LIFO basis recovery method.

That means that no amounts are available tax-free until all built up earnings

have been distributed, and included in taxable income. For regular IRAs and

employer plans, it's a prorated method. That means that part of each

distribution is tax-free, and the remainder is includable in taxable income.

In the case of Roth IRAs, basis is recovered under a FIFO method. That's the

best of all. It means that nothing is included in the recipient's federal

taxable income until all after-tax contributions have been recovered tax-free.

Diversification -- Is there a sufficiently broad choice of investments to

provide adequate diversification? Investments under annuities and most

employer plans are part of a structured portfolio. In the case of Roth IRAs,

that's totally within the control of the investor.

Effect on Educational Aid -- How much will this amount impact the amount of

financial aid that you will be able to get for your child's college education?

Annuities, regular IRAs and employer plan assets are not generally considered

as resources available to the applicant. Custodial accounts are considered to

be assets of the student, and are considered to the tune of 35%. It's not yet

clear how, if at all, balances in Education IRAs and Roth IRAs will be taken

into account for purpose of determining availability of financial aid. My best

guess is that while Roth IRAs will be treated like regular IRAs, Education

IRAs might be considered to be a resource of the student.

Investment Alternatives -- Will the underlying investments provide a

sufficient return? Because of many employers' concern with potential fiduciary

liability in selecting anything too aggressive, investments under many plans

tend to be very conservative. In the case of Roth IRAs, regular IRAs and

variable annuities, that's totally within the control of the investor.

Liquidity -- Are the underlying investments easily convertible into cash? In

most of these vehicles there is some type of cash investment available, such

as a money fund. Unless the investments in the particular Roth IRA account are

themselves illiquid, they are generally readily convertible to cash.

Noncontributory Beneficiary's Access to the Funds -- Will the person for whom

the moneys are being set aside (or their creditors) have access to the funds

at any time? While parents might contribute to their own Roth IRAs in order

to provide a fund for their child's college education, unlike UGMAs and UTMAs

for example, the funds remain the property of the respective parent. If the

Roth IRA is established as a working child's own account, it is the child's

property at all times. In the case of an Education IRA, the contribution

represents a competed gift. That suggests control in the hands of the

recipient. However, the "contributor" seems to have the unilateral right to

change the person for whom the account is established. It's not clear what

impact this has on the rights of the "designated beneficiary".

Participant Loans -- May you have access to any part of the balance on a tax-

free basis by way of a participant loan? Participant loans are permissible

under many employer plans. In the case of regular IRAs, variable annuities, or

Roth IRAs, balances are never accessible by way of participant loans.

Penalty for Premature or Nonqualified Distribution -- With most of these

vehicles, including Roth IRAs, taxable distributions before age 59 ½ that

don't qualify for an exception will also be subjected to a 10% penalty.

State Tax Treatment -- Is there any tax-favored treatment available under your

state's income tax laws? In the case of qualified employer plans, state tax

laws usually follow the federal tax law. While some states will automatically

follow the federal tax law treatment of Roth IRAs, others might not. Also,

Roth IRA balances might be subjected to certain states' taxes on intangibles.

Surrender Charges -- Do the underlying investments routinely impose contingent

deferred surrender charges for withdrawal before a stated time? If employer

plans, regular IRAs or Roth IRAs are not placed in investments that impose

their own surrender charges, such as a variable annuity, none apply.

Tax-favored Treatment of Contributions -- Are contributions either excludable

from your federal taxable income, as in the case of a 401(k) or 403(b); or

deductible, as in the case of an IRA or MSA? Contributions to a Roth IRA are

never "tax-favored;" they are always nondeductible.

Tax-deferred Growth -- Are earnings subject to federal income taxes during the

accumulation period? Roth IRA earnings are always tax-deferred during the

accumulation period.

Tax-free Distributions -- Is it possible that distributions of otherwise

taxable earnings could be received tax-free?

Neither employer plans, regular IRAs nor variable annuities offer the

possibility of tax-free distributions. Roth IRA, Education IRA and Medical

Savings Account distributions might be available on a tax-free basis. In

order to receive a tax-free distribution from any of these vehicles, certain

requirements must have been met. In the case of the Education IRA, the amounts

must be used for the payment of qualified higher education expenses. In the

case of the MSA, the person must have incurred qualified medical expenses. And

for the Roth IRA, the individual for whom the account was originally

established must have been a participant in a Roth IRA for at least five

years. Also, the distribution must either have been received by a participant

who has turned 59 1/2, or has become disabled, or is a qualified first-time

home buyer, or by a beneficiary if the participant has died.

Rolling Into A Roth IRA

Beginning January 1, 1998, money in a Regular IRA may be rolled over to a Roth

IRA in a taxable rollover transaction. Before we debate the merits of this

transaction, let's see how it's done. Let us immediately mention that

Congress is already formulating "oops" legislation, its proposed Technical

Corrections Act of 1997, that will, among other things, review the new

statutory provisions that allow rollovers to Roth IRAs. The material that

follows will discuss the law in its present form but will include some

commentary about a few of the potential rule changes.

Since some rollovers depend on what type of money built up a particular IRA,

we'll list ways that money can get into an IRA in the first place.

· Contributed by the participant

· Rolled in by the participant from a qualified employer plan (i.e., Keogh,

401(k), etc.)

· Rolled in by the participant from a 403(b) arrangement

· Rolled in by a spouse who had received a distribution from a former spouse's

pension or profit sharing plan, or 403(b) plan as the result of a QDRO

(Qualified Domestic Relations Order)

· Rolled in by a surviving spouse who had received a death benefit

distribution from a deceased spouse's pension, profit sharing, 403(b) or IRA

plan

· Contributed by an individual's employer to an IRA pursuant to a SEP, SARSEP

or SIMPLE Retirement Plan

· Inherited by a nonspouse beneficiary of a deceased IRA participant

Amounts that are presently on balance in an employer's 401 or 403 plan may not

be distributed, and can not be rolled into a Roth IRA. Different rules might

apply to amounts on balance in SEPs, SARSEPs or SIMPLE Retirement Plans. If a

nonspouse inherits IRA assets upon the death of an IRA participant, such

amounts are not eligible to be rolled to the beneficiary's own Regular or Roth

IRA.

Taxing Rollover Distributions

Regardless of whether you've made nondeductible contributions to your IRA or

not, beginning in January 1998, you will be able to roll all, or part, of your

Regular balance to a Roth.

Rollovers To Regular IRAs From Employer Plans -- The concept of the rollover

came into being in 1974 under ERISA (The Employee Retirement Income Security

Act of 1974). People were allowed to take otherwise taxable distributions and

reinvest them either in successor employer plans or in IRAs, in order to

further delay the paying of federal income tax on the amount received. The

income tax on both the principal and the subsequent appreciation in value was

deferred until a distribution was eventually taken from the receiving plan.

While distributions received from these employer plans may not be rolled into

Roth IRAs under the new rules, in some instances they may be rolled to a

Regular IRA, and then subsequently rolled from the Regular IRA to a Roth IRA.

Certain employer plan distributions are ineligible to be rolled into a Regular

IRA. Installment distributions that are received as substantially equal

payments are ineligible for rollover, as are Minimum Required Distributions

received by certain plan participants who have reached the age of 70 ½. Also,

if a person has made nondeductible contributions to an employer plan, such

amounts are ineligible to be rolled over. The recipient must determine how

much of the distribution represents such after-tax dollars (i.e., basis), and

exclude them, tax-free from the amount being rolled over. This function is

referred to a basis-recovery.

In orderto roll anything from an employer plan to a Regular IRA, an individual

must be eligible to receive a distribution from the employer plan. There are

certain times when the law does not permit an employer plan to let

participants take distributions. For example, in the case of a 401(k) or

403(b) plan, salary reduction amounts, and certain other types of

contributions may not be withdrawn before the participant has either reached

the age of 59 ½, has separated from service or has incurred a hardship. While

current law permits the rollover of distributions that satisfy these statutory

requirements, the Technical Corrections Act of 1997would prohibit the rollover

of any hardship distributions that have been taken from salary reduction

contributions. Even though the law might not restrict a particular amount

from being distributed from an employer's plan, the amount might not be

available under the terms of the plan itself. Only amounts that are not

subject to such restrictions are available for rollover.

Under the new Roth IRA rules, once amounts have been successfully rolled from

an employer plan to a Regular IRA, they are immediately (after 12/31/97)

eligible for rollover to a Roth IRA.

For example, Raoul is eligible for a distribution from his employer's

qualified profit sharing plan. His balance of $120,000 includes $20,000 of

after-tax contributions. If he receives a distribution of the entire $120,000

on December 31, 1997, only $100,000 is eligible for rollover to a Regular IRA.

None of it is eligible, however, for rollover to a Roth IRA either during 1997

or 1998. If Raoul rolls the entire $100,000 into a regular IRA, either by

direct rollover, or by a rollover transaction completed within 60 days (which

takes him through the end of February 1998) none of the $120,000 that he

received will be included in his 1997 federal taxable income. Also, since

nothing is includable in the federal taxable income, none is subject to the 10

percent the federal tax penalty on premature distributions.

Rollovers From Regular to Roth IRAs, without Nondeductibles -- Let's first

look at the taxation of a rollover from a Regular to a Roth IRA where the

person has never made nondeductible contributions to any IRAs. Normally, the

income generated by the rollover distribution is included in the recipient's

federal taxable income in the year of the receipt. However, if the rollover

distribution is received during 1998, even if the rollover is completed during

early 1999, the income is included in four equal parts for the years

1998-2001.

For example, Horace takes a distribution of $100,000 from his Regular IRA on

December 30, 1998. He rolls it into a Roth IRA on February 12, 1999. He must

add $25,000 to his taxable income for each of the four years 1998-2001. Had

he taken the distribution on January 2,1999 and rolled it over to a Roth IRA

on the same date, the entire $100,000 would have to be included in his 1999

federal taxable income.

In either event, the income that is generated from the rollover transaction

does not trigger a 10 percent IRS penalty on premature distributions.

Rollovers From Regular to Roth IRAs, with Nondeductibles -- Persons who have

ever made nondeductible contributions to Regular IRAs are required to make a

prorated calculation to determine how much of their distribution is taxable.

This is true even in the case of a rollover to a Roth IRA. Also, if there are

more than one IRA, all must be treated like they are part of the whole

(something like the BORG in Star Trek).

For example, Jason maintains IRA accounts with five different financial

organizations.

· The rollover of a distribution from a 403(b) arrangement Balance $100,000

· $10,000 in nondeductible contributions Balance $ 15,000

· Employer contributions under a SEP Balance $ 28,000

· Rollover from inheritance from wife's IRA Balance $ 75,000

· SIMPLE Retirement Plan contributions as a

Self-employed

Balance $ 6,000.

Total $ 224,000

On February 19,1998 Jason withdraws $10,000 from the IRA (#2) to which

nondeductible contributions were made; $446 would be tax-free

($10,000/$224,000 x $10,000). The remaining $9,554 would be taxable. Since

the distribution transaction took place during 1998, $2,388 ($9554/4) would

be taxable in each of the years 1998-2001.

If, on the other hand, he had taken a distribution of $28,000 from the SEP on

March 18,1998, the tax-free amount would be $1,250 ($10,000/$224,000 x

$28,000), and the remaining $26,750 would be taxable (at the rate of $6,688

per year for four years). Once again, there would be no 10 percent premature

distribution penalty tax on the resulting income.

Immediate Conversions -- Some people who have never made any IRA contributions

might want to consider doubling up on the first year's contribution to a Roth

IRA. While Roth contributions may not be made for the 1997-year, a person

could make a contribution to a Regular IRA for the 1997-year, and immediately

roll it into a Roth IRA early in 1998. By doing so, they would achieve the

same benefit as having contributed $4,000 to a Roth IRA for 1998 (were that

permissible).

For example, Daphne and her husband Darwin had never contributed to a Regular

IRA. Darwin who earns $75,000 participates in his employer's 401(k) plan, and

Daphne has recently stopped working to start their family. On January 10,

1998, the couple contributed $2,000 per spouse to Roth IRAs.

When Daphne and Darwin went to a tax preparer on March 3,1998 to do their 1997

federal income tax return, they realized that they still had time to

contribute to a regular IRA for 1997. Under the spousal cross-testing rules

that apply for 1997, since Darwin is an active participant in an employer

sponsored plan, Daphne is considered to be one as well. As a result, neither

spouse's contribution is allowed to be made on a deductible basis. Even

though the couple's regular IRA contributions for 1997 were made later than

their Roth contributions for 1998, the Regular IRA contributions may still be

rolled into a Roth IRA during 1998, or thereafter.

Handling The Five Year Requirement For Tax-free Distributions - As indicated

above, in order for distributions to be received tax-free from a Roth IRA a

five year participation requirement must be satisfied. On the surface, that

seems to be a fairly simple and straightforward requirement. But we all know

that if Congress perceived it, it can't possibly be simple.

In the case of contributions to Roth IRAs - Here, the five year period is

measured from the year for which the Roth IRA contribution was made. For

example, if a contribution were made to a Roth IRA for the 1998-year, even if

made during early 1999, the first year during which tax-free distributions

could be taken would be 2003.

The making of a contribution to any Roth IRA starts the clock running with

respect to all contributory Roth IRAs of an individual. It does not however,

start the clock of any rollover Roth IRAs (see below).

In the case of rollovers from Regular IRAs to Roth IRAs - Here, the five-year

rule is measured from the year during which the rollover is received into the

IRA. For example, if an amount is distributed to a person during 1998, but is

not rolled into a Roth IRA until 1999, the five year period would expire on

December 31,2003. That means that the first tax-free distribution could not

occur before 2004.

In cases where rollover amounts are commingled with contributed amounts, or

where rollovers from different years are commingled with each other, the five-

year rule is measured from the most recent rollover year, or the year in which

the initial amount is contributed, whichever is later. For example, if a

person make a contribution to a Roth IRA during 1998 the initial tax-free

distribution could possibly occur during 2003. But if a rollover is alsomade

to that account from a Regular IRA during 2001, no amount could be taken from

that account tax-free before 2006.

Paying the Tax On the Rollover Distribution -- If we decide to roll from a

Regular to a Roth IRA we will have to pay the resulting federal income tax,

and possibly some state and/or local income tax as well.

Do you know what tax bracket you're in?

SINGLE

Your taxable income: Your marginal rate:

Up to $24,650 15%

$24,650 to $59,750 28%

$59,750 to $124,650 31%

$124,650 to $271,050 36%

Over $271,000 39.6%

MARRIED FILING JOINTLY (MFJ)

Your taxable income: Your marginal rate:

Up to $41,200 15%

$41,200 to $99,600 28%

$99,600 to $151,750 31%

$151,750 to $271,050 36%

Over $271,050 39.6%

Therefore, a person with taxable income of $70,000, (who is filing MFJ) who

receives a distribution of $130,000 during 1998 would probably have his or her

taxable income increased by $32,500 (25 percent of $130,000). That means that

the distribution is pushing part of the amount received into a higher tax

bracket. The actual amount of the change to the person's taxable income might

be more or less because of the many things that are tied to a person's federal

AGI, such as the deductibility of medical expenses, the taxation of social

security benefits, etc.

What's the resource for the payment of the taxes? -- A person electing to roll

from a Regular to a Roth IRA must decide whether to take the resulting income

tax from the distribution being received, while rolling the remainder to the

Roth IRA. In the alternative they could take the funds to pay the tax from

another resource, if there is one.

If they take the funds from the distribution to pay the tax, that amount is

ineligible for the special tax and penalty treatment afforded rollovers to

Roth IRAs. For example, a person receives a distribution of $80,000 from his

regular IRA, which is being rolled into a Roth IRA during 1998. If $3,500 is

held out to pay the tax on the distribution, not only is that amount going to

be included in the recipient's federal taxable income for 1998,ineligible to

be spread over four years, but if the person is under age 59 1/2 it would also

be subject to the 10 percent federal tax penalty. If, on the other hand they

took it from another source, there might neither be any additional taxable

income, nor any premature distribution penalty.

Most people try any number of methods to increase the amount of income they

receive during the year. Now, along comes a Congressional tax-deferred

quagmire in the form of a Regular to Roth IRA rollover that contains an

incentive to either make less money, or step up the amount of taxable income

that we report to the IRS.

Josh & Monica

Josh and Monica are victims of the hype over the benefits of converting their

taxable IRA balances to Roth IRAs. The rules require persons to have an AGI of

no more then $100,000 in order to take advantage of this opportunity.

Josh, whose annual salary is $75,000, anticipates his federal adjusted gross

income for 1998 to be about $87,000. His wife Monica is a skilled consultant

who has been out of the job market for a couple of years while she has stayed

home to care for the two little ones. She has never earned an annual salary

of more than $50,000. In January 1998, the couple rolled over their IRA

balances of $120,000 to Roth IRAs. Based upon Josh's annual salary at the

beginning of the year, he felt that even with a substantial raise there would

be no way for them to exceed the $100,000 AGI limit for the year. In August

1998, Monica is offered a position that commands an annual salary of $88,000,

plus a bundle of corporate perks. The only problem is that if she accepts it,

the couple's federal taxable income for 1998 will increase by her

compensation, plus another $90,000. And, in addition to the income tax that

they will have to pay on this amount, the couple will be subject to an

additional penalty tax of $12,000.

What, you ask, could possibly cause this strange result? Another 'gotcha' in

the law. One of the best yet.

Along comes this rare employment opportunity for Monica. Let's see what

happens if she accepts it. First, the couple's gross income will increase by

the amount that she receives during the year. Let's say that is about

$35,000. That would easily push the couple's AGI over the $100,000 limit,

unless they have some additional method to reduce their AGI. It should be

noted that although the portion of the rollover amount that is included in

their 1998 income would increase their AGI, that amount is ignored for purpose

of the rollover AGI limit.

Had the transaction qualified for rollover, a special rule would have

permitted the couple to add the amount received to their federal taxable

income ratably over the four-year period, 1998-2001. That means increasing

their income by $30,000 for each of those years. Failing the AGI limit would

result in the entire $120,000 being added to their 1998 federal taxable

income, an increase of another $90,000 over their anticipated taxable income

for the year. In addition, had the rollover qualified, the 10% premature

distribution penalty would have been waived.

Now, since the rollover is disqualified, the couple is also subject to a

penalty tax of 10% of the amount distributed from the Regular IRA ($12,000).

How's that for a gotcha?

Eric & Evelyn

But it could be even worse. How about Eric and Evelyn who have been courting

for several years, but he has never been able to get up the courage to pop the

question? Finally, on April 1, 1998 he goes for it. Her response, why yes,

of course my love. I would have accepted your proposal years ago. But, we'll

have to wait until at least January 1999. He asks "why so long?" Sadly she

must tell him that she just rolled over her IRA to a Roth, and their combined

AGI would invalidate her rollover. Is that an April Fools gotcha, or what?

Phillip

Hold on, I've got one more. Phillip, an unmarried individual, waits until the

end of 1998 to roll $150,000 from his Regular IRA to a Roth IRA. He wants to

be absolutely sure that his AGI is within the limits. He sits down with his

accountant, who calculates it to be $88,000. He also makes $2,000

nondeductible contributions to his Roth IRA for 1998, 1999, and 2000. In

January 2001, the IRS audits a firm in which he is a minority partner for the

1998 year, and makes audit adjustments that increase his share of the 1998

partnership income by $25,000. How about that for a belated gotcha? But,

hold your breath.

Since the rollover is disqualified, it now represents an excess contribution

in his Roth IRA for the year of the rollover, and each subsequent year during

which it remains uncorrected. His contributions to the Roth IRA are also

disqualified since his AGI for 1998 now exceeds $110,000.

That means that he has excess contributions as follows:

Year Excess 6% Penalty

1998 $152,000 $9,120

1999 $152,000 $9,120

2000 $152,000 $9,120

Total penalty for 3 years $27,360

Premature Distribution Penalty $12,000

Total Penalties $39,360

NOW THAT'S A GOTCHA!

Ok, one final point. In those cases where the rollover takes place during

1998, the taxpayer had only reported ¼ of the taxable amount each year. As a

result, not only did the person enjoy the time value of money on the deferred

taxation, but the smaller annual inclusions would be less likely to be pushed

into a higher tax bracket than full reporting in the year of the distribution.

But wait, maybe there's a glimmer of hope. In the proposed Technical

Corrections Act, Congress has included a provision that permits transfers of

contributions from one type of IRA to the other. The transfer must occur by

the individual's tax filing deadline (including extensions), and must include

the attributable earnings. If we are properly interpreting this provision,

the first two situations could be salvaged.

Monica could transfer her transaction by her 1998 tax deadline (including

extensions) to a Regular IRA. In that case, she would be able to accept the

new position without all of the dire consequences.

Evelyn will similarly be able to transfer her funds to a Regular IRA within

the allotted time and proceed to marry dear Eric on a more timely basis.

But alas, poor Phillip will be beyond the TCA deadline, and will have to

suffer all of the aforementioned consequences.

In summary, the later in the year a person waits to make a Regular to Roth IRA

rollover the better. But, as indicated here, in extreme cases even that's not

long enough.

Hopefully Congress will reevaluate this rule and move to a "prior year AGI"

test.

Congress Proposes New Technical Corrections Changes to Roth IRAs

On November 5, 1997 the House passed a bill that would make certain technical

corrections to the Taxpayer Relief Act of 1997, which among other things,

introduced Roth IRAs. Now Congress has revisited those proposals and has made

further modifications. Some of the major changes that will be part of this

legislation, if it passes in its present form are:

o Changing the 4-year income spread on rollovers from Regular to Roth IRAs

from mandatory to optional.

o Eliminating the application of a second 10% penalty on conversion proceeds

withdrawn within the first five years ( as originally proposed in November) in

favor of an income acceleration on amounts withdrawn.

o Providing for a single starting point for calculating the five year

period, rather than restarting the clock with each new year's conversion.

o Providing a mechanism for correcting improper conversions without the

imposition of federal income taxes or penalties.

Although this is not yet law, and could be changed further before final

passage, we felt it appropriate to bring our readers up to date on the status.

We will be providing a further analysis of these changes in an upcoming

commentary.

The following material is based on the text of the explanation of the proposed

changes from the Congressional Joint Committee on Taxation.

Roth IRAs

Amendments to Title III of the 1997 Act Relating to Savings Incentives

1. Conversions of IRAs into Roth IRAs [sec. 302 of the 1997 Act and secs. 408A

and 72(t) of the Code]

Present Law

A taxpayer with adjusted gross income of less than $100,000 may convert a

present-law deductible or nondeductible IRA into a Roth IRA at any time. The

amount converted is includible in income in the year of the conversion, except

that if the conversion occurs in 1998, the amount converted is includible in

income ratably over the four year period beginning with the year in which the

conversion occurs.

(10) Amounts includible in income as a result of the conversion are not taken

into account in determining whether the $100,000 threshold is exceeded. The

10-percent tax on early withdrawals does not apply to conversions of IRAs into

Roth IRAs.

In general, distributions of earnings from a Roth IRA are excludable from

income if the individual has had a Roth IRA for at least five years and

certain other requirements are satisfied. The five year holding period with

respect to conversion Roth IRAs begins from the year of the conversion.

Distributions that are excludable from income are referred to as qualified

distributions.

Present law does not contain a specific rule addressing what happens if an

individual dies during the four year spread period for 1998 conversions.

Description of Proposal

Distributions of converted amounts and distributions before the end of the

four year spread

The proposal would modify the rules relating to conversions of IRAs into Roth

IRAs in order to prevent taxpayers from receiving premature distributions from

a Roth conversion IRA while retaining the benefits of four year income

averaging.

In the case of conversions to which the four year income inclusion rule

applies, income inclusion would be accelerated with respect to any amounts

withdrawn before the final year of inclusion. Under this rule, a taxpayer that

withdraws converted amounts prior to the last year of the four year spread

would be required to include in income the amount otherwise includible under

the four year rule, plus the lesser of (1) the taxable amount of the

withdrawal, or (2) the remaining taxable amount of the conversion - i.e., the

taxable amount of the conversion not included in income under the four year

rule in the current or a prior taxable year.

In subsequent years - assuming no such further withdrawals -, the amount

includible in income under the four year will be the lesser of (1) the amount

otherwise required under the four year rule - determined without regard to

the withdrawal - or (2) the remaining taxable amount of the conversion.

Under the proposal, application of the four year spread would be elective. The

election would be made in the time and manner prescribed by the Secretary. An

election with respect to the four year spread could not be changed after the

due date for the return for the first year of the income inclusion , including

extensions.

The following example illustrates the application of these proposed rules.

Taxpayer A has a nondeductible IRA with a value of $100 and no other IRAs. The

$100 consists of $75 of contributions and $25 of earnings. A converts the IRA

into a Roth IRA in 1998 and elects the four year spread. As a result of the

conversion, $25 is includible in income ratably over 4 years @$6.25 per year

. The ten percent early withdrawal tax does not apply to the conversion.

At the beginning of 1999, the value of the account is $110, and A makes a

withdrawal of $10. Under the proposal, the withdrawal would be treated as

attributable entirely to amounts that were includible in income due to the

conversion. In the year of withdrawal, $16.25 would be includible in income,

the $6.25 includible in the year of withdrawal under the 4-year rule, plus

$10 . $10 is less than the remaining taxable amount of $12.50 ($25 -$12.50 )

. In the next year, $2.50 would be includible in income under the four year

rule. No amount would be includible in income in year four due to the

conversion.

Application of early withdrawal tax to converted amounts

The proposal would modify the rules relating to conversions to prevent

taxpayers from receiving premature distributions -i.e., within five years -

while retaining the benefit of the nonpayment of the early withdrawal tax.

Under the proposal, if converted amounts are withdrawn within the five year

period beginning with the year of the conversion, then, to the extent

attributable to amounts that were includible in income due to the conversion,

the amount withdrawn would be subject to the ten percent early withdrawal

tax.(11)

Applying this rule to the example above, the $10 withdrawal would be subject

to the ten percent early withdrawal tax -unless as exception applies.

Application of five year holding period

The proposal would also eliminate the special rule under which a separate five

year holding period begins for purposes of determining whether a distribution

of amounts attributable to a conversion is a qualified distribution; thus, the

five year holding rule for Roth IRAs would begin with the year for which a

contribution is first made to a Roth IRA. A subsequent conversion would not

start the running of a new five year period.

Ordering rules

Ordering rules would apply to determine what amounts are withdrawn in the

event a Roth IRA contains both conversion amounts - possibly from different

years - and other contributions. Under these rules, regular Roth IRA

contributions would be deemed to be withdrawn first, then converted amounts -

starting with the amounts first converted. Withdrawals of converted amounts

would be treated as coming first from converted amounts that were includible

in income.

As under present law, earnings would be treated as withdrawn after

contributions. For purposes of these rules, all Roth IRAs would be considered

a single Roth IRA.

Corrections

In order to assist individuals who erroneously convert IRAs into Roth IRAs or

otherwise wish to change the nature of an IRA contribution, contributions to

an IRA - and earnings thereon - may be transferred from any IRA to another

IRA by the due date for the taxpayer's return for the year of the

contribution, including extensions. Any such transferred contributions will be

treated as if contributed to the transferee IRA , and not to the transferor

IRA.

Effect of death on four year spread

Under the proposal, in general, any amounts remaining to be included in income

as a result of a 1998 conversion would be includible in income on the final

return of the taxpayer. If the surviving spouse is the beneficiary of the Roth

IRA, the spouse could continue the deferral by including the remaining amounts

in his or her income over the remainder of the four year period.

Calculation of AGI limit for conversions

The proposal would clarify that, for purposes of applying the $100,000 AGI

limit on IRA conversions into Roth IRAs, the conversion amount - to the extent

otherwise includible in AGIi- is subtracted from AGI as determined under the

rules relating to IRAs [sec. 219].

Thus, for example, the AGI-based phase out of the exemption from the

disallowance for passive activity losses form rental real estate activities

[sec. 469(i)(3)] would be applied taking into account the amount of the

conversion that is includible in AGI, and then the amount of the conversion

would be subtracted from AGI in determining whether a taxpayer is eligible to

convert and IRA into a Roth IRA.

Effective Date

The provision would be effective as if included in the 1997 Act, i.e., for

taxable years beginning after December 31, 1997.

Limits on Modified AGI

3. Limits based on modified adjusted gross income [sec. 302(a) of the 1997 Act

and sec. 72(t) of the Code]

Present Law

The $2,000 Roth IRA maximum contribution limit is phased out for individual

taxpayers with adjusted gross income (AGI) between $95,000 and $110,000 and

for married taxpayers filing a joint return with AGI between $150,000 and

$160,000. The maximum deductible IRA contribution is phased out between $0 and

$10,000 of AGI in the case of married couples filing a separate return.

Description of Proposal

The proposal would clarify the phase-out range for the Roth IRA maximum

contribution limit for a married individual filing a separate return and

conform it to the range for deductible IRA contributions. Under the proposal,

the phase-out range for married individuals filing a separate return would be

$0 to $10,000 of AGI.

Effective Date

The proposal would be effective as if included in the 1997 Act, i.e., for

taxable years beginning after December 31, 1997.

Contribution Limits for Roth IRA

4. Contribution limit to Roth IRAs [sec. 302 of the 1997 Act and sec. 408A(c)

of the Code]

Present Law

An individual who is an active participant in an employer-sponsored plan may

deduct annual IRA contributions up to the lesser of $2,000 or 100 percent of

compensation if the individual's adjusted gross income (AGI) does not exceed

certain limits. For 1998, the limit is phased-out over the following ranges of

AGI: $30,000 to $40,000 in the case of a single taxpayer and $50,000 to

$60,000 in the case of married taxpayers.

An individual who is not an active participant in an employer-sponsored

retirement plan (and whose spouse is not an active participant) may deduct IRA

contributions up to the limits described above without limitation based on

income.

An individual who is not an active participant in an employer-sponsored

retirement plan (and whose spouse is such an active participant) may deduct

IRA contributions up to the limits described above if the AGI of the such

individuals filing a joint return does not exceed certain limits. The limit is

phased for out for such individuals with AGI between $150,000 and $160,000.

An individual may make nondeductible contributions up to the lesser of $2,000

or 100 percent of compensation to a Roth IRA if the individual's AGI does not

exceed certain limits. An individual may make nondeductible contributions to

an IRA to the extent the individual does not or cannot make deductible

contributions to an IRA or contributions to a Roth IRA. Contributions to all

an individual's IRAs for a taxable year may not exceed $2,000.

Description of Proposal

The proposal would clarify the intent of the Act that an individual may

contribute up to $2,000 a year to all the individual's IRAs. Thus, for

example, suppose an individual is not eligible to make deductible IRA

contributions because of the phase-out limits, and is eligible to make a

$1,000 Roth IRA contribution. The individual could contribute $1,000 to the

Roth IRA and $1,000 to a nondeductible IRA.

Effective Date

The proposal would be effective as if included in the 1997 Act, i.e., for

taxable years beginning after December 31, 1997.

III. DIFFERENCES BETWEEN PROPOSED TECHNICAL CORRECTIONS

CONTAINED IN THE CHAIRMAN'S MARK AND THE PROVISIONS

OF TITLE VI OF H.R. 2676

Title VI of H.R. 2676, as passed by the House on November 5, 1997,(21)

contains technical corrections to the 1997 Act and other legislation. Except

for one instance noted below, the Chairman's mark generally contains the

provisions of Title VI of H.R. 2676. Some of these provisions would be

modified by the Chairman's mark. In addition, the Chairman's mark contains

additional proposed technical corrections. The differences between the

proposed technical corrections in the Chairman's mark and the provisions

contained in Title VI of H.R. 2676 are briefly described below.

2. Savings Incentives of the 1997 Act

The Chairman's mark would modify the technical corrections relating to

individual retirement arrangements (IRAs) in H.R. 2676 as passed by the House

bill as follows.

Conversion of IRAs into Roth IRAs

In the case of conversions of IRAs into Roth IRAs, the taxpayer would be able

to elect whether to have the amount converted includible in income in the year

of the conversion -or the year of withdrawal if the conversion is accomplished

through a roll over - or ratably over four years

If an individual elects application of the four year spread and withdraws

amounts before the entire amount of the conversion has been included in

income, the amount withdrawn would be includible in income - in addition to

any amount required to be included under the four year spread. In no case

would the amount includible under this proposal exceed the amount converted.

This proposal would replace the additional 10-percent tax under H.R. 2676 for

1998 conversions. Under the proposal, a new five year holding period for

determining whether distributions from a Roth IRA are qualified distributions

would not apply to converted amounts. The proposal would eliminate the rules

in H.R. 2676 regarding separate accounts. The proposal would also clarify

calculation of adjusted gross income for purposes of applying the $100,000

adjusted gross income limit on individuals eligible to convert IRAs to Roth

IRAs.

Penalty-free distributions for education expenses and purchase of first homes.

The Chairman's mark would modify the provision in H.R. 2676 as passed by the

House intended to prevent avoidance of the 10-percent early withdrawal tax in

the case of hardship distributions under qualified plans and similar

arrangements by providing that hardship distributions from qualified cash or

deferred arrangements and similar plan are not eligible rollover distributions

- and not subject to 20 percent withholding. The Chairman's mark would also

modify the effective date of the House bill provision.

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