Taking Care of Mom and Dad: Roth IRAs

There are several variations on the traditional IRA. The most common of these variations is the so-called Roth IRA (named after the U.S. Senator who championed it), created by the Taxpayer Relief Act of 1997.

To simplify slightly, a Roth IRA reverses the normal tax advantage of a defined-contribution plan. In other words, it requires the account owner to pay taxes on the money that goes in but allows that money to be taken out tax-free.

Because Roth IRAs do not have required distributions, your parents can leave the accounts to grow tax-free as long as they wish. If they don't need the money they pass their Roth IRA on upon their death to heirs -- who then have a lifetime stream of tax-free income.

If they qualify, your parents can deposit 100 percent of their earned income up to $3,500 each -- even if they're currently covered by a qualified retirement plan.

Your parents can also convert their traditional IRAs into a Roth IRA as long as their income is under $100,000. If they are below that income threshold, converting can be very advantageous. Note that any income resulting from a conversion would not count toward the $100,000 limit.

For a single person, the annual contribution is phased out between adjusted gross income (AGI) of $95,000 and $110,000; for a married person filing jointly, between AGI of $150,000 and $160,000; and for a married person filing separately, between AGI of $0 and $10,000.

To convert a traditional IRA into a Roth IRA, your parents' cur-rent-year AGI may not be more than $100,000. When they convert, the funds that are applied to their Roth IRA are taxed as ordinary income (excluding any nondeductible contributions they made).

Unlike contributions to traditional individual retirement arrangements, contributions to a Roth IRA are not deductible from gross income. However, distributions after five years that are made when the annuitant is 59½ years of age -- or older or on account of death, disability or the purchase of a first home -- are not included in gross income.

If paid as an annuity, an inherited Roth IRA must be payable over a period not greater than the designated beneficiary's life expectancy and distributions must begin before the end of the calendar year following the year of death. Distributions from another Roth IRA cannot be substituted for these distributions unless the other Roth IRA was inherited from the same decedent.

Unlike a qualified IRA, your parents are never required to take distributions from a Roth IRA. As a result, they can allow their account to continue building on a tax-free basis for future use -- at any age.

To convert, your parents have to pay tax on any pretax contributions contained in their traditional IRA along with any earnings on those contributions. If they have a 401(k) which only contains pretax contributions, and if they rolled that 401(k) account into a traditional IRA, they would owe income taxes on the entire IRA account balance upon conversion to a Roth IRA.

They can pay these taxes directly out of the IRA. If they have the cash, though, a better plan is to pay the taxes with money outside of the IRA. Doing so, your parents keep the IRA intact...and producing that much more tax-free income.

There is one pitfall with conversion, however. As we discussed in the Social Security chapter, if your parents make more than a certain amount, a portion their Social Security benefits becomes taxable. And, any amount converted would count as income in the year of conversion -- potentially triggering income tax on their Social Security benefits.

A different tax problem arises if your parents have a large IRA that they wish to convert. If the have a $500,000 traditional IRA that they wish to convert to a Roth IRA, the entire $500,000 counts as taxable income if they convert it all in one year. A conversion of this size would also certainly make their Social Security benefits taxable.

Your parents may be subject to a 6 percent tax on excess contributions if:

• they contributed to other individual retirement arrangements during the same tax year;
• their adjusted gross income for the tax year exceeds the applicable limits; or
• their compensation is less than the amount contributed by or for them for the tax year.

To avoid the excise tax, your parents would need to undo any excess Roth IRA contributions before their taxes were due for the year the contributions were made. In other words, they have between the end of the calendar year and the date they file their returns to make adjustments.

How could this be avoided? There is nothing that requires the entire traditional IRA be converted in a single year. Your parents, usually with the help of a CPA, can convert part of their traditional IRA each year, making sure that the amount converted doesn't trigger taxes on their Social Security benefits...and that they have enough other income to pay the taxes and keep the IRAs whole.

Why go to all of this trouble? Other than not having required distributions and being able provide an income tax free benefit to their heirs, converting to a Roth IRA can help eliminate the taxes that might have to be paid on their Social Security benefits.

The distributions your parents receive from traditional IRAs are included in their taxable income, which can, if large enough, make their Social Security benefits subject to tax. But the same is not true for Roth distributions. Because Roth distributions are tax-free they are not consider as taxable income and therefore do not count towards the income threshold that triggers taxation of their Social Security benefits.

Whether your parents should convert an existing IRA into a Roth IRA depends on many factors -- their age, tax bracket and when they plan to begin taking distributions. The key question: Will the taxes they pay today to switch be worth the tax breaks and flexibility later? If your parents are already over 65, the tax bite today will probably not be so severe. So, the answer is more likely to be yes.

If your parents' only income was their Social Security benefits and Roth IRA withdrawals, all of their retirement income would be then tax-free!