Volume 18, Number 2
IRS Issues New Guidance on Roth IRAs
By Dianne Bennett
Congress has passed legislation making changes to the Roth IRA, and has issued proposed regulations and a notice answering questions about Roth IRAs.
The notice attempts to curtail reconversion back to a traditional IRA or what has been called a "round-trip switch," inspired by current market conditions. For example, taxpayer A converted her traditional IRA to a Roth IRA in February 1998, when her IRA was valued at $200,000. Assume the entire amount is taxable. Under the Roth IRA conversion rules, $200,000 will be included in A’s 1998 income or, if A elects four-year averaging, $50,000 per year will be included in her taxable income in 1998, 1999, 2000, and 2001. Assume also that in September, with the market decline, A’s Roth IRA was valued at $150,000. Without doing more, A still would face the tax on $200,000. However, A corrected her error in judgment by reconverting her Roth IRA back to a traditional IRA, and thereby avoided the income tax hit on $200,000. Now she can reconvert her "new" traditional IRA back to a Roth IRA. Let’s say the IRA still is worth $150,000 in December 1998. If A then reconverts to the Roth IRA, her taxable income would be $150,000, instead of the previous $200,000. In fact, A could have waited until the due date of her 1998 federal tax return before making that last conversion.
The IRS addressed this decision in Notice 98-50. The IRS Notice is designed to handle the reconversion device on a temporary basis in 1998 and 1999 while the IRS examines other ways of dealing with reconversions. The notice permits a reconversion from a traditional IRA (which started out as a traditional IRA converted to a Roth IRA in 1998) once after October 31, 1998, and once in 1999. A taxpayer who first converted in 1999 could reconvert once in 1999 as well.
The IRS technique for dealing with the reconversion device is to term any reconversion in addition to the one permitted after October 31, 1998, an "excess reconversion." A "failed recharacterization," however, is the situation in which the taxpayer recharacterizes his or her traditional IRA as a Roth IRA at a time when he or she is not eligible to do so because the taxpayer exceeds the AGI limit of $100,000, described below. The failed recharacterization is not a conversion at all. The excess reconversion has no tax effect. As a result, the tax effect from the prior (nonexcess) reconversion holds, even though the amount may have been recontributed to a traditional IRA and then again reconverted to a second, third, or additional Roth IRA.
In essence, the notice blesses the transaction of a recharacterization of a traditional IRA (IRA1) to a Roth IRA (Roth IRA1) to a traditional IRA2 to Roth IRA2, the last after October 31, 1998, or in 1999. Any recharacterization or transfer must meet the requirements that otherwise apply, such as the $100,000 AGI limit related to the tax year in which the amount is converted out of, or distributed out of, the traditional IRA. The due date for recharacterizations continues to be the federal income tax return due date with extensions.
The three methods specified in the regulations are the indirect rollover, the trustee-to-trustee transfer, and the transfer by the same trustee. The indirect rollover is accomplished when an amount in a traditional IRA is distributed to the IRA holder and then within 60 days is contributed, or rolled over, to a Roth IRA. Note that the rollover cannot be from other than a traditional IRA. The trustee-to-trustee transfer is accomplished by asking the first trustee to transfer directly to a second trustee. As a practical matter, taxpayers often incur delays by the outgoing trustees in such transfers. The same trustee technique simply involves the trustee redesignating the IRA as a Roth IRA at the same institution. Trustees designate new account numbers and show the funds as transferring from one account (the traditional IRA) to another (the Roth IRA).
The proposed regulations also make both recharacterization and the timing of any recharacterization easy and favorable to the taxpayer. The proposed regulations state that the taxpayer can transfer from one IRA to another, as long as it is accomplished before the due date of the individual’s federal income tax return for the tax year for which the contribution was made to the first IRA. The net income from the first IRA also must be transferred to the second IRA. If no distributions or additional contributions have been made from or to the first IRA, then the entire account balance is transferred to the second IRA. In the case of a decrease in value, the amount transferred is the net of the decrease, rather than a net increase.
Aggressive tax planners had suggested earlier that one could transfer a Roth IRA by gift, without paying gift tax. The regulations foreclose such a transfer by characterizing it as an assignment of the Roth IRA. The assignment of the Roth IRA results in a deemed total distribution of the Roth IRA to the IRA owner, and the amount is treated as no longer held in a Roth IRA.
Older taxpayers had complained that the modified AGI limit of $100,000 prevented them from converting their traditional IRAs if at the same time they were receiving required minimum distributions that put them over the $100,000 limit. Required minimum distributions cannot be converted. Note, however, that required minimum distributions are excepted from modified AGI only for years beginning after 2004. For years before 2005, any required minimum distribution is included in the determination of modified AGI. Note also that the exception is only for distributions from IRAs, not for required minimum distributions from plans.
Older taxpayers may contribute to Roth IRAs if they otherwise meet the contribution requirements. A taxpayer who has reached age 70 1/2 before the end of a tax year cannot make a contribution to a traditional IRA for that year or any year after. There is no comparable provision in the Roth IRA provisions, as the IRS noted in its explanation of the proposed regulations. Although the conversion recharacterization relating to a tax year can occur as late as the due date of the federal income tax return for the applicable tax year, contributions to a Roth IRA for a tax year must be made by the taxpayer’s due date, without extensions, generally April 15 of the subsequent tax year.
The IRS clarified other uncertainties. The $100,000 modified AGI limit for eligibility for conversions applies to the joint modified AGI of a married couple, and a married taxpayer filing a separate return is not allowed to convert at all. In the case of a conversion by indirect rollover, described above, the $100,000 modified AGI limit applies to the year in which the distribution from the traditional IRA is made, not the year in which the contribution (rollover) is made to the Roth IRA, if that occurs in a later year.
Another clarification is that conversion to a Roth IRA does not trigger the additional income tax on early distributions in the case of payments made pursuant to the exception to that tax for substantially equal distributions. The conversion amount is not subject to the early distribution tax, and if the series of payments continues, there is no modification of the distributions schedule and thus no recapture tax.
The proposed regulations also clarify that the minimum distribution rules that apply after the Roth IRA owner’s death are those that would apply if the owner died before his or her required beginning date. The surviving spouse who is the sole beneficiary may delay distributions until the decedent would have been age 70 1/2 or may treat the Roth IRA as his or her own. In addition, the minimum distribution rules are determined separately for traditional IRAs and Roth IRAs. Therefore, minimum distributions required for a traditional IRA cannot be taken during the Roth IRA holder’s lifetime from the Roth IRA.
Dianne Bennett, president of Hodgson Russ LLP, concentrates her practice in corporate and individual taxation, employee benefits, and cross-border executive estate planning.
- This article is an abridged and edited version of one that originally appeared on page 8 of The ABA Section of Taxation Newsletter, Winter 1999 (18:2).