The Roth IRA and Why Most People Should Have One
by Ernest Tew

To encourage working people to save for their retirement, Congress has created a variety of plans that offer certain tax advantages. Except for the Roth IRA, almost all retirement plans allow us to defer taxes on the contributions and/or its earnings until withdrawn. With a Roth IRA, the taxes on profits earned by our retirement account are actually eliminated.

Congress hopes that Americans will save a small amount of money each year and invest it in assets that will grow in value. The objective is to supplement other retirement income by withdrawing the funds when we retire, at which time we are expected to be in a lower tax bracket.

In January of 1998 the Roth IRA, named in honor of Senator Roth, became law. Although the intent of Congress was similar, the Roth IRA is a major improvement over the traditional IRA and other retirement plans.

Why Have A Roth IRA

Unlike the traditional IRA, contributions to a Roth IRA are not tax-deductible. However, that is but a small disadvantage when compared to the enormous benefits that can be gained through the creative use of a Roth IRA. Here are some of the more important benefits:

1. There is no limit on the amount of profits a Roth IRA can earn. Enormous tax-free profits are being earned by Roth IRAs that invest in carefully chosen assets, such as real estate options. In a recent transaction, our investors earned a tax-free profit of $260,000 on a real estate option that cost $8,000 sixteen months earlier.

2. With a self-directed IRA, the owner decides where the IRA funds will be invested. Funds in a self-directed Roth IRA can be invested in almost any assets the owner chooses.

3. Roth IRA funds can be invested, reinvested, and allowed to compound completely tax-free for as long as you choose to do so. Given the fact that it is possible for an IRA to earn enormous profits, this is an important advantage. Even more important, the profits are completely tax-free when the money is taken out—provided the owner is at least 59½ years old and the account has been established for five years or more. Contributions to a Roth IRA can be taken out at any time without tax or penalty.

It is interesting to note that, over any given period of time and at any given rate of return, the final value and the after-tax yield for most investors will be 40% to 50% greater when the money is allowed to compound tax-free.

4. As with other entities, a Roth IRA can increase its yield through the use of leverage. For example, it could borrow some of the money needed to purchase a larger mortgage at a discount. When a Roth IRA uses leverage (financing), some of the profits will be taxed. If, for example, the IRA uses financing for 75% of the cost, 75% of the gain will be taxed—unless the borrowed funds have been repaid.

However, any tax should be a one-time occurrence. Both the contributions and the earnings can remain in the IRA and allowed to compound, tax-free, thereafter. Caution: Any IRA financing will need to “stand on its own.” That is, only the asset being acquired and/or other IRA assets should secure the debt. If the owner of the IRA, or members of his or her family, were to personally guarantee financing obtained by the IRA, it could be a prohibited transaction involving self-dealing.

5. A Roth IRA can serve as a “safe haven.” In most states, retirement assets are protected from those who would use the law to take from others. For minimum liability exposure, it is recommended that you hold only intangible assets in a Roth IRA. These include cash, notes and mortgages, beneficial interests in real estate trusts, and real estate options.

6. The Roth IRA can be a valuable tool for transferring wealth to children and other members of the family, thereby reducing estate taxes and probate costs.

7. A surviving spouse who inherits a Roth IRA is allowed to treat the IRA as his or her own IRA. The surviving spouse can withdraw the funds or keep them invested and can designate other beneficiaries. Your beneficiaries can be your estate, dependents, and anyone you choose to receive the benefits from the IRA after you die.

8. Starting a self-directed Roth IRA is as easy as opening a checking account at a bank. (Our account is with Mid-Ohio Securities Corp. They can be reached by telephone at (440) 323-5491 or on the internet at www.MidOH.com.

Roth IRA Rules

It is important that we become familiar with the rules that apply to the Roth IRA. In order to maximize our benefits, it is equally important that we consider what the rules don’t say and explore creative ways to profit without violating the rules.

Who Can Qualify For A Roth IRA

A Roth IRA can be established for almost any individual—even a small child. The owner of a Roth IRA must have “earned” income, all of which could be contributed to the IRA as long as the contribution doesn’t exceed $3,000 a year. (Starting in 2005, this increases to $4,000 and starting in 2008, it increases to $5,000.)

Even a small child can earn $2,000 to $3,000 a year. One enterprising businessman paid each of his small children (ages one and two) $2,000 to model for photographs. The professionally made photographs were later used to advertise his business. The father then set up a Roth IRA for each child, using the $2,000 of “earned” income to fund it.

If either husband or wife is working, each can establish a Roth IRA and contribute up to $3,000 per year for a total of $6,000, as long as they have at least $6,000 in earned income. The adjusted gross income (AGI) for married couples that file jointly must be under $160,000. If their AGI is between $150,000 and $160,000, they will only be allowed to make partial contributions.

Single individuals having an adjusted gross income is $95,000 or less can contribute up to 100% of their first $3,000 of earned income each year (increasing to $4,000 in the year 2005). For incomes between $95,000 and $110,000 the amount of contribution that can be made is reduced.

The AGI-based contribution limits for Roth IRAs apply whether or not the taxpayer is a participant in a qualified retirement plan.

We have until April 15th each year to make the contribution for the previous year. For example, contributions for the year 2001 can be made at any time prior to April 15th in the year 2,002.

There is no requirement that a contribution be made each year and you don’t have to make a contribution at the time you open the account. You can fund a Roth IRA with as little as $200 and then contribute from $0 to $3,000 each year. It is, of course, to your advantage to contribute the maximum amount. The sooner you make your contributions, the longer the money can work for you.

Requirements

Your IRA is a trust or custodial account, set up in the U.S. for your exclusive benefit or for the benefit of your beneficiaries. An account is created by a written document that must show that the account meets all of the following requirements:

1. The trustee or custodian must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee or custodian.

2. The trustee or custodian generally cannot accept contributions of more than $3,000 a year. However, funds held in one retirement plan can be rolled over to a traditional IRA and funds held in a traditional IRA can be rolled over to a Roth IRA. However, to rollover a traditional IRA to a Roth IRA, the owner’s taxable income must be less $100,000 in the year the IRA is rolled over.

3. Your contributions must be in cash, except that rollover contributions can be property other than cash.

4. The amount in your account must be fully vested at all times, meaning that you must have a non-forfeitable right to the amount.

5. Money in your account cannot be used to buy a life insurance policy.

6. Assets in your account cannot be combined with other property, except in a common trust fund or common investment fund.

Withdrawals

Unlike the traditional IRA, you can always withdraw the capital contributions that you have made to a Roth IRA without paying a tax or penalty—regardless of your age or the number of years in the Roth IRA. For income tax purposes, the withdrawal of contributions is treated as a return of capital and, therefore, not taxable.

Generally, funds that are transferred from a traditional IRA to a Roth IRA cannot be withdrawn prior to age 59 ½ or within five years from the date of rollover without incurring a 10% penalty.

With a few exceptions, you will be required to pay income taxes and a 10% penalty if your IRA profits are withdrawn prior to reaching the age 59 ½ or within five years from the date the IRA was established.

However, the profits or earnings in your Roth IRA can be distributed tax-free and penalty-free if you and your Roth IRA meet any one of the following conditions:

1. You have attained the age of 59½ and your Roth IRA has been established for at least five years.

2.It has been at least five years since the Roth IRA was established and the first contribution was made and . . .

a. You become disabled; or

b. You withdraw money to use toward the purchase of your first home, or a first home for certain members of your family, including your spouse, child, grandchild, or ancestor. (There is a lifetime limit of $10,000); or

c. At or after your death, the Roth IRA makes a payment to a beneficiary or estate.

If you are under the age 59½, a distribution of profits or earnings for any of the following reasons will be subject to ordinary income tax, but not the 10% premature distribution penalty:

1. Medical expenses in excess of 7.5% of adjusted gross income.

2. The purchase of medical insurance after receiving more than 12 weeks of unemployment compensation.

3. To pay college tuition and related expenses for yourself or a member of your family.

Prohibited Transactions

A prohibited transaction is any improper use of an IRA account by the owner or any other disqualified person. A disqualified person would include one's fiduciary and certain family members. A disqualified family member would include a spouse, ancestor, or lineal descendants (mother, father, son, daughter, grandchildren, and in-laws). Although I don’t recommended it, an IRA can do business with a brother, sister, uncle, or cousin.

Any form of self-dealing which involves your IRA is prohibited. You and members of your family (as described above) should not borrow money from nor lend money to your IRA. Your IRA assets should not be used as security for loans acquired by you or members of your family. You, and members of your family, should not sell assets to or buy assets from your IRA; nor, should your IRA purchase assets for personal use by you or any member of your family.

Only cash may be contributed to an IRA. All purchases must be done inside your plan. You cannot purchase an asset and then contribute it to your IRA.

To engage in a prohibited transaction could result in the value of all profits in your IRA being taxed in the current year and a penalty imposed by the IRS. Moreover, your IRA could no longer earn tax-free profits. Needless to say, it is important that we carefully document all transactions and avoid any form of self-dealing. Indeed, the benefits of a Roth IRA are too important to take a chance on having it disqualified.

It may be helpful to remember that your retirement plan is intended to benefit you when you retire, and not before. If you are planning any transaction that clearly appears to confer direct benefits to you prior to retirement, you should carefully examine the legality of such a transaction.

You may direct the custodian for your IRA to invest your IRA funds in any prudent asset of your choice, provided the investment doesn’t involve self-dealing. Also, you should be careful to avoid operating your IRA as a business. Otherwise, the earnings will be subject to an unrelated business income tax (UBIT). All transactions within your IRA should be treated as investments.

There are a few exemptions. For example, you may direct your custodian to purchase notes and mortgages and then service the accounts. Or, you may direct your custodian to purchase rental property and then manage the property. However, you cannot direct your custodian to acquire a property and then lease it back or lease it to any disqualified person or entity under your control. Moreover, your Roth IRA cannot compensate you or any disqualified person for rehab work performed on an asset in your plan.

The actions which cannot be performed by you or any other disqualified person may, however, be accomplished through some unrelated party. In summary, prohibited transactions are those that violate the basic intent of the IRA.

Creative Investments For Your Roth IRA

It is permissible for both an individual and his or her Roth IRA to do business with the same unrelated person or entity. Here is one of the ways a Roth IRA can earn enormous profits—completely tax-free.

Suppose, for example, that you find a rental property that can be acquired at a low price. The property is in need of repair, has several vacancies, and the owner is highly motivated to be free of the responsibilities. You convince the owner to enter into a net lease with an option to buy. (When an owner isn’t willing to lease with an option to buy, get another unrelated person to buy it on your behalf and then lease it to you with an option—or right to buy.)

To reduce the risks of dealing with the public, you decide to use a limited-liability company to lease the property. At the same time, you set up a Roth IRA and make the current maximum contribution of $3,000. You direct the custodian of your IRA to pay the property owner $2,000 for the option, leaving a reserve for other opportunities.

The net lease allows you to take possession of the property and operate it as if you were the sole owner. You are responsible for paying operating expenses and the agreed amount of rent. Any income remaining should be distributed to you each month by the LLC.

Although the option gives your IRA the right to purchase the property, there is usually no reason to do so. When you decide to sell the property and an agreement is reached, you arrange for the buyer to purchase the option from your Roth IRA and then exercise it. If, for example, the agreed price for the property is $400,000 and the option price is $300,000, the Roth IRA could receive $100,000.

The profits (and the taxable income) in the LLC were limited to any net income remaining after making payments on the lease and paying operating expenses, including deferred maintenance and perhaps some capital improvements. (Any net income in the LLC should be distributed to the LLC members on a regular basis.)

The Roth IRA, however, realized a windfall profit of $100,000 on its $2,000 investment—completely tax-free.

Investors who want to share future profits or transfer more wealth to their children (or anyone else), could arrange for the option to be owned jointly by members of the family—or preferably, their Roth IRA. We prefer to set up a separate “Option Trust” (with an unrelated individual serving as Trustee) to hold the option on behalf of the Roth IRA beneficiaries. Then, when the option is sold, the profits will be earned by the Roth IRAs. In that way, the profits will not be taxed, included in the investor’s estate, or subject to loss through litigation.

Why not take a few minutes of your time to sit back and ponder the ways you can enrich your future through the creative use of a Roth IRA? If you discover other benefits, please let me hear from you.

How A Roth IRA Compares With A Traditional IRA

Traditional IRA	Roth IRA
Who Can Qualify: Any individual under the age of 70 1/2 who has "earned" income.	Who Can Qualify: There is no age limit, but the income must be earned. Married individuals with adjusted gross income of not more than $160,000 in the year it is established. Single individuals with not more than $110,000 gross income in the year it is established.
Allowed Contributions: Up to $3,000 each year. Husband and wife can each have their own IRA for a total of up to $6,000 per year.	Allowed Contributions: Up to $3,000 each year. Husband and wife can each have their own IRA for a total of up to $6,000 per year.
Contributions Can Be Made: Prior to attaining age 70 ½.	Contributions Can Be Made: At any age.
Tax Deductible Contributions: Contributions to a traditional IRA are tax deductible.	Tax Deductible Contributions: Contributions to a Roth IRA are not tax deductible.
Withdrawing Contributions: Contributions withdrawn at any time will be taxed. (No taxes were paid when the money was earned.) Withdrawing contributions prior to attaining age 59 1/2 will result in a 10% penalty. (See exceptions discussed in Withdrawal paragraph.)	Withdrawing Contributions: There is no tax when contributions are withdrawn. (Taxes were paid when the money was earned.) Contributions can be withdrawn at any time without penalty.
Withdrawing Profits or Earnings: All profits or earnings are fully taxed when withdrawn, regardless of age.	Withdrawing Profits or Earnings: All profits are tax-free after the Roth IRA has been established for 5 years and attaining age 59 1/2. Profits withdrawn prior to age 59 1/2 will be taxed. (See exceptions in Withdrawals paragraph)
Mandatory Distributions: During the year you become age 70 ½, you must decide to: (1) cash in and pay the taxes; (2) buy an annuity; or (3) establish a payout plan. There is a 50% penalty tax on amounts not withdrawn properly.	Mandatory Distributions: Even after attaining age 70 ½, money in a Roth IRA can be justify in the account and continue to compound tax-free. Or, the owner could withdraw all or part.

Bio:

Ernest Tew is the author of two popular books. "How To Get Rich Helping Others," which explains in simple terms how one can become wealthy by investing in manufactured homes and manufactured home communities and "How To Protect Your Assets" from lawsuits, excessive taxes, probate, and government seizure.