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Individual Retirement Accounts have been available since 1974, and have proven useful for people who do not have retirement plans through their employers, or for people who do have other retirement plans but have relatively low income. All taxpayers can contribute an amount equal to their earnings, up to $5,500 ($6,500 if over 50 years of age) to an IRA; if they have no other retirement plan, they can deduct that contribution from their taxable income, and earnings in the account are free of tax until withdrawn.
Persons with income under $61,000 (single) or $98,000 (married) can deduct their contributions to a traditional IRA even if they are covered by another retirement plan. Taxpayers covered by retirement plans whose income is above the limits for deducting contributions have for years been allowed to make their $5,500 or $6,500 contributions to an IRA, but can’t deduct the contributions. The non-deductible contribution comes out tax-free when withdrawn. While the earnings from the IRA are taxed when withdrawn, there would still be the advantage that income earned in the IRA compounds free of tax until withdrawn.
IRAs are generally subject to minimum distribution requirements once the owner reaches age 70-1/2. The minimum distribution requires people to withdraw funds from IRAs, creating a taxable event, making taxpayers pay income tax on the deferred contribution and on the earnings in the account.
Roth IRAs are a new breed of IRAs that were created in 1997. Roth IRAs have tax advantages for many people. Roth IRAs are created with after-tax funds. There is no deduction in the year contributions are made. When withdrawals are made the withdrawals are totally tax-free—not only the amount contributed, but the income earned in the account as well.
Roth IRAs are a good tool for transferring wealth to the next generation. Since withdrawal from a Roth does not create a taxable event, there is no minimum distribution requirement forcing a taxpayer withdraw his Roth IRA. The taxpayer leave his Roth IRA intact, and withdrawals from the Roth IRA will not be taxable income to whomever would inherit it. Beneficiaries are required to withdraw the Roth over their life expectancies (hopefully a long time), but the funds withdrawn are all tax-free.
Congress enacted an income limit for Roth IRAs—you cannot contribute to a Roth IRA if your income exceeds $132,000 (single) or 194,000 (joint). Contributions begin being limited at income levels about $20,000 below those figures.
The advantages of Roth IRAs are so great that Congress created a way for taxpayers to convert their traditional IRAs into Roth IRAs, by paying tax on the amount converted in the year of conversion. And the advantages are so great that many taxpayers are willing to pay the tax before they would otherwise be required to, in order to qualify for the Roth rules. Taxpayers making any amount are allowed to convert their traditional IRAs into Roth IRAs, so long as they pay the tax on the amount converted.
IRA account holders can convert their IRAs into Roths and then to “recharacterize” the conversion back to a regular IRA up to the extended time they could file their tax return for the year of the conversion. A tax wise strategy would be to convert one’s conventional IRA into two Roth IRAs on January 1 of year 1, with one Roth being invested in equities, and the other being invested in bonds. The account holder can wait until October 15 of year 2 to recharacterize whichever one of the Roths went down in value back into a conventional IRA. The other IRA, if it went up in value, would allow a conversion into a Roth of a higher value than the January 1 of year 1 reportable income.