Roth Rollovers; IRA vs. Roth; and Principal Residence Sale

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, January 25, 1998

Copyright 1998 Robert L. Sommers, all rights reserved.

Question: At 50 years old, I am considering rolling over my existing $100,000 IRA to a Roth. What factors should I consider and how would the rollover be taxed?

Answer: You may rollover your IRA to a Roth IRA if your adjusted gross income (AGI) is $100,000 or less and you do not file as married filing separately. You may rollover, or merely convert, an existing IRA or part of an IRA to a Roth IRA, without actually making a distribution, by notifying the IRA trustee. Although the rollover may be taxable, the 10% federal and 2.5% California penalties for early IRA withdrawal does not apply to the transferred funds.

When rolling over your IRA money into a new Roth IRA, you have two options for paying the tax on these funds. First, you may pay the tax with money from your IRA. This has two disadvantages; you have less money invested in your Roth and, you will pay an additional early-withdrawal penalties since you are under age 59. However, if you can afford the second option, paying tax with non-IRA funds, you avoid both the early distribution penalty, plus you maintain your overall IRA account balance for generating your future tax-free income.

In deciding whether or not to convert your IRA to a Roth, the key financial consideration is whether your overall return is greater with a taxable IRA worth $100,000 currently, or a Roth IRA worth $61,750 (assuming you pay a combined federal and state tax rate of 34% on a $100,000 rollover, plus 12.5% in penalties on the $34,000 used for taxes, or $38,250 in total). Obviously, if you are too close to retirement to make up the tax loss, a rollover would not be advantageous.

IRA contributions for which no tax deduction was taken escape tax. For instance, If your $100,000 IRA was comprised of $10,000 in non-deductible contributions, then only $90,000 would be taxable when it is converted to a Roth. The conversion, however, must occur by the due date of your tax return (not including extensions).

A rollover for tax year 1998, entitles you to four-year tax averaging. For example, if you rollover $100,000 to a Roth, you will claim $25,000 of ordinary income in 1998, 1999, 2000 and 2001. Rollovers initiated after 1998 will be considered as single-year ordinary income.

Question: Should I contribute to my existing IRA or a new Roth IRA?

Answer: A contribution to a traditional IRA is usually tax-deductible, but all distributions are fully taxable. The IRA deduction is of limited use to those taxed at 15%. The 15% bracket applies to single filers with taxable income of $24,650 or less, joint filers of $41,200 or less.

Note: Currently, the deductible IRA phases out for individuals with AGI of $30,000 to $40,000 and joint filers with AGI of $50,000 to $60,000, so most of those eligible for an IRA deduction will be in the 15% tax bracket.

In short, if you’re in the 15% bracket, with an IRA you’ll save a maximum of $300 in federal taxes, but will pay taxes upon distributions, versus paying the $300 tax on your contribution to enjoy the Roth’s fully tax-exempt distributions.

Invest in a Roth unless you need the tax write-off. Remember, the maximum annual contribution to all IRAs (excluding rollovers) is $2,000 for an individual, $4,000 for a couple.

Question: My wife and I have owned our principal residence in Ohio for 20 years; however, for the last four years, I have been teaching in California and lived by myself in a rented apartment during the nine-month school year. If we sell our home this month, are we entitled to a $250,000 (single) or $500,000 (couple) exemption?

Answer: You are only entitled to a $250,000 exemption since the Ohio home is not considered your principal residence – only your wife’s-- unless you have lived in the Ohio residence for periods aggregating two years or more in the last five years. To qualify for the $500,000 exemption, both husband and wife must own and use their home as a principal residence for two of the last five years prior to sale. In your situation, you apparently used your home as a residence for only 12 months.

Your principal residence is usually the dwelling you live in the majority of days during the year. Because you lived in California nine months a year, your principal residence is your rented apartment. Tax regulations state that whether a property qualifies as a principal residence depends on the facts and circumstances in each case, including the good faith of the taxpayer.

The Tax Court has ruled that where taxpayers lived in a second residence approximately nine months and resided in the first only the remaining months, the first home was not a principal residence.

Remember, the residency exception aggregates periods of ownership and use. You must show ownership and use for periods totaling at least two years over a five-year period ending on the date of sale. Taxpayers should count the months during the 5-year period to determine if two-year period (24 aggregate months) has been met. So, if you lived in your Ohio home during the three summer months for the past four years (a total of 12 months), plus full-time in your residency the first of the last five years, you should satisfy the two-year requirement.


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