ESTATE AND FINANCIAL PLANNING
Retirement Benefits Planning

By Harvey B. Wallace II

This article provides information on developments in the field of retirement benefits.

Refocus on Roth IRS conversions. Three legislative changes since 2006 should be noted. First, Internal Revenue Code (IRC) § 408A(c)(3)(B) was repealed for taxable years beginning after 2009. As a result, for future years the requirements that a traditional individual retirement account (IRA) owner or plan participant (1) have modified adjusted gross income (MAGI) of $100,000 or less for the taxable year of a Roth IRA conversion and (2) not file a separate income tax return, if married, no longer apply. Second, section 824 of the Pension Protection Act amended the IRC § 408A(c)(3)(B) definition of a qualified rollover distribution to permit a trustee-to-trustee rollover from a non–Roth qualified plan account to a Roth IRA to have the same effect as a distribution to a traditional IRA followed by a conversion. The mandatory withholding requirements do not apply to this direct rollover even though the rolled-over amount is included income. Finally, paragraph (iii) of IRC § 408A(d)(3)(A) was amended to provide that, unless a taxpayer elects otherwise, any amount required to be included in gross income as a result of the conversion of a traditional IRA to a Roth IRA that occurs in 2010 shall be included in income ratably over the two-taxable-year period of 2011 and 2012.

Qualified distributions. Because the amounts contributed to a Roth IRA are not deductible, distributions of the amounts contributed to the account owner will not be includable in the distributee’s gross income. Earnings of the Roth IRA, however, may be subject to income tax unless the distribution from the Roth IRA is a qualified distribution. A qualified distribution is one that is made after any Roth IRA of the account owner has existed for five years and that is made after the account owner attains age 591/2, on account of death or disability, or as a distribution to a first-time home buyer. For 2010 and future years, a strategy for establishing a Roth IRA to start the five-year nonexclusion period running is available to an individual whose MAGI exceeds the limits for contributions to a traditional IRA under IRC § 408(o). The individual may make nondeductible contributions to a traditional IRA up to the maximum limits if the individual has compensation at least equal to the contribution amount. The traditional IRA may then be converted to a Roth IRA.

Conversion tax and post- conversion tripwires. Because the conversion of all or part of a traditional IRA to a Roth IRA is treated as a distribution from the traditional IRA to the converting account owner, the rules for allocating tax basis when distributions are made from a traditional IRA apply so that all traditional IRAs maintained by an account owner are aggregated. The tax basis component of any distribution from one of the aggregated IRAs is computed based on the percentage that the aggregate tax basis of all the IRAs represents aggregate value of all the IRAs.

An account owner who receives distributions from a Roth IRA following a conversion contribution may have two tripwires to step over. First, if the contribution conversion is made when the account owner is under age 591/2, the 10 percent penalty tax for a premature distribution does not apply to the deemed distribution from the traditional IRA to the account owner that is considered to occur in connection with the conversion transfer to the Roth IRA. But, if a distribution is made within the five-year period after the conversion to an account owner under age 591/2 and any portion of the distribution is attributable under the ordering rules to the conversion contribution, the 10 percent penalty tax applies to the distribution allocable to the conversion contribution unless an exception to the penalty tax applies.

Individuals who elect to make a conversion transfer to a Roth IRA in 2010 need to be aware of a second tripwire that treats distributions from the Roth IRA in 2010 and 2011 as premature distributions, accelerating income inclusion that is otherwise deferred until the 2011 and 2012 extended period for the payment of tax on a 2010 conversion. Any distribution made in 2010 will be included in income for 2010 to the extent the distribution is allocable to the conversion transfer under the ordering rules. Any amount distributed in 2011 will similarly be includible in the taxpayer’s income for 2011 in addition to the one-half of the total conversion amount, provided that the total amount included in income after taking into account the 2010 distribution does not exceed the total conversion amount.

Recharacterization and reconversion. The success of a Roth conversion may well depend on facts that cannot be predicted at the time the conversion transfer is made. For example, the income tax payable on a conversion contribution made in mid-2009 would seem a high cost to pay if the resulting Roth account had a year-end value equal to 60 percent of the conversion transfer amount. The Roth IRA conversion may be reversed at any time up to the due date of the account owner’s tax return for the year of the conversion transfer by treating the conversion contribution as if it had never been made and transferring the contributed amount by a trustee-to-trustee transfer back to the traditional IRA from which it was transferred. To make the election to recharacterize, the account owner must notify the trustee of the Roth IRA to which the contribution transfer was made and the trustee of the IRA to which the contribution is being moved (the second IRA) that the account owner is electing to treat the contribution as having been made to the second IRA.

Estate planning benefits. The unique characteristics of a Roth IRA make it a preferred vehicle for a high-net-worth account owner to transmit wealth to lower generations. First, if a traditional IRA or qualified plan account is converted to a Roth IRA by an account owner who can fund the payment of income tax from nonplan and non-IRA assets, the entire Roth IRA account can grow because no minimum required distributions are necessary for the remainder of the account owner’s lifetime. Second, the payment of income tax on the Roth conversion removes the income tax dollars from the account owner’s taxable estate. If the pre– income tax value of the unconverted traditional IRA or plan account is instead included in the account owner’s taxable estate, the deduction under IRC § 691(c) for estate tax caused by income in respect of a decedent provides no offset for state death taxes and, as an itemized deduction, may not be fully deductible by the recipient. Finally, if the account owner (or surviving spouse) names children or grandchildren or qualified look-through trusts for them as designated beneficiaries, the Roth account is likely to continue to increase in value during the initial post-death years for which minimum required distributions are made.


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