Thursday, October 30, 1997

Beware of tax land mines buried in new Roth IRA rules

By Mark Schwanhausser / Knight-Ridder Newspapers

The new Roth individual retirement account potentially offers taxpayers huge tax savings. But if you shake the Roth package, you'll hear something ticking, particularly if you're married and earn a combined income of more than $100,000 next year.

"I want you to put, 'Warning! Warning! Warning!' across the top of the page," said Doug Harrison, T. Rowe Price's marketing manager for IRAs.

In many ways, the Roth IRA is like the standard nondeductible IRA. Starting Jan. 1, you will be allowed to stoke it with $2,000 in after-tax dollars, pour it into virtually any investment you choose, and watch your money grow tax-free. The essential difference is your withdrawals will never be taxed, provided you wait five years and turn 59-1/2 before you start withdrawing money. In contrast, withdrawals from regular IRAs are taxed at ordinary tax rates that currently run as high as 39.6 percent.

In addition, you can convert all or part of your existing IRAs, immediately putting a sizable chunk of money to work tax-free, not just in $2,000 annual drabs. There are no early-withdrawal penalties, but you must pay income tax on untaxed assets you roll over. Still, if you convert in 1998 you can spread that bill over four years.

Generally, Ernst & Young figures you'll come out ahead converting to a Roth IRA if you don't touch the money for several years, don't trigger penalties by withdrawing it early and can pay the taxes on the rollover out of pocket, rather than from the IRA funds themselves. It's also better to convert nondeductible IRAs, because you already paid tax on the contributions and owe tax only on the earnings when you convert to a Roth.

But there are two land mines buried in the fine print, the latter of which could torment you into your retirement:

--You can't kick in the full $2,000 if your adjusted gross income is too high. If you're single, your maximum contribution ratchets down as your AGI rises between $95,000 and $110,000. For couples filing jointly, it's $150,000 to $160,000.

--You can't convert your existing IRAs into Roth IRAs if your AGI in 1998 exceeds $100,000 -- and that figure applies to all taxpayers, regardless of whether you're single or married. Many two-income couples in Silicon Valley will easily eclipse that threshold.

One risk is that you must convert during the calendar year, potentially before you know how high your AGI will ultimately rise. If you convert and your AGI exceeds $100,000, you must: 1) close the IRA 2) pay the 10 percent early-withdrawal penalty and 3) cough up the tax on the account. Even worse, you wouldn't be allowed to put your money back into an IRA -- exposing your investments to tax, year in, year out.

"If you are anywhere near $100,000, don't do it," Harrison advised. "The consequences are horrible. There is no going back."

Procrastination, then, is the best course if there's even a remote chance your AGI will eclipse $100,000 next year. Wait to convert existing IRAs until December 1998, when you can project your income exactly.