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Dorothy Rosen -- The Dollar Diva Ask the Dollar Diva

Is the Roth IRA too good to be true?

Dear Dollar Diva,
In your column What's the difference between a 401(k) plan and an IRA? you state that "If you hold the funds in a Roth IRA for at least five years and make your withdrawals after you reach age 59-1/2, none of your withdrawals will be taxable. You heard that right. Neither your contributions nor the interest/dividends/capital gains earned are taxable. Ever. Even if you die. Your beneficiary doesn't have to pay taxes on it."

I have a booklet stating that monies are distributed from a Roth IRA as follows:

  1. Original after-tax contributions -- non taxable
  2. Remaining earnings -- taxable

I'm not trying to be a smart-ass, but what you say about the Roth IRA seems too good to be true. How can all interest and dividends accumulated in a Roth IRA not be taxable? Any source of reading would be appreciated.

There are two types of distributions from a Roth IRA: those that are qualified, and those that are not. The Diva's quote refers to qualified distributions, it looks like your booklet refers to those that are not.

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Qualified distributions

According to current law, there is no income tax on any part of qualified distributions from a Roth IRA. You heard that right: none. Accumulated interest, dividends and capital gains go to you tax-free in a qualified distribution. It's very sweet indeed.

To be qualified, the distribution has to be made at least five years after the first contribution to your Roth IRA was made. Once that period has passed, a distribution is qualified if any of the following are true:

  • You have reached age 59-1/2
  • You are disabled
  • You die and the distribution is made to a beneficiary or your estate
  • It's for qualified first-time home buyer expenses, up to a lifetime maximum of $10,000

Non-Qualified distributions

If your distribution is made before the five year period is up, or it doesn't fall into any of the qualifying categories, then it's a non-qualifying distribution, and part of it may be taxed. The IRS has a set order in which it considers contributions and earnings to be withdrawn from a Roth IRA.

Order Tax Consequences
Regular contributions Non-taxable
Conversions from traditional IRA to Roth IRA Taxable portion first, if applicable; then non-taxable portion
Earnings: dividends, interest, capital gains Taxable

For more information on Roth IRA qualifying and non-qualifying distributions read IRS Publication 590, Individual Retirement Arrangements (IRAs) (Including Roth IRAs and Education IRAs).

What's so good about the Roth IRA?

The Diva likes the Roth IRA. It has some lovely features:

  • Qualified distributions are tax-free
  • Contributions can be made as long as you work, even if you're 100 years old
  • Distributions don't have to start at age 70-1/2, or ever. That baby can fatten up on non-taxable, compound earnings into eternity

But in spite of these pluses, if you're marginal tax rate is 28 percent or more, she recommends that you fund the following before you ante up for a Roth:

  • 401(k) plans, at least up to the amount the employer matches
  • All other tax-deferred options, such as traditional IRA, SEP, Keogh

If you're in the 15 percent tax bracket, and expect to be in a higher tax bracket in the future, the Roth makes more sense.

What's not so good about the Roth IRA?

The Diva likes the Roth IRA, but it's not perfect. Here are some of the negative things you need to think about:

  • Roth contributions are not tax-deductible. A taxpayer in the 28 percent tax bracket is only out-of-pocket $1,440 when he makes a $2,000 contribution to a tax-deferred plan because of the tax savings. That's $560 more he has to invest elsewhere. In other words, he only has to spend $2,000 to have $2,560 working for him.
  • Watch out for the hidden costs of converting from a traditional IRA to a Roth IRA
    • It can push you into a higher tax bracket
    • If you're collecting Social Security, more of it probably will be taxed
    • The addition to adjusted growth income may cause you to lose benefits such as education and child tax credits or deductions for student loans.
  • Current federal law protects qualified Roth IRA distributions from tax. Will future law do the same? Up to 85 percent of Social Security can be subject to tax. Will that be the fate of the Roth IRA 30 years from now?
  • Most states have not updated their laws to protect Roth IRAs from lawsuits and creditors in the same way that traditional IRAs are protected.

-- Posted: July 27, 2000

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