By Thomas C. Foster
On February 4, 1999, the IRS issued final regulations pertaining to Roth IRAs, Treas. Reg. §§ 1.408A-0 - 9 (Regulations). The Regulations are in a question and answer format and provide comprehensive coverage of the Roth IRA rules that may differ from those applicable to other individual retirement accounts (traditional IRAs). With very minor exceptions, because they are explanatory of current law, the Regulations are effective at the same date as Roth IRAs are effective--tax years beginning after December 31, 1997. On most issues, the Regulations track unambiguous provisions of the Code. The Regulations, however, take positions on some issues that observers might find surprising or not clearly based on the underlying Code provisions. This article generally describes the Regulations, with a particular focus on the surprising or extending provisions.
Roth IRA Basics
The Taxpayer Relief Act of 1997, Pub. L. 105-34, § 302(a), 111 Stat. 788 (1997) (Act), created the Roth IRA. The Roth IRA piggybacks on the rules previously established for traditional IRAs. Except to the extent that the Act established different rules for Roth IRAs, the familiar rules for traditional IRAs apply to Roth IRAs. This piggybacking helps to deal with administrative and investment issues raised by IRAs, such as prohibited transactions, trustee qualification, pledging prohibitions, trust tax exemptions and unrelated business taxable income rules.
The tax consequences of contributions to and distributions from Roth IRAs, however, differ greatly from those for traditional IRAs. A few of the major differences are:
* Not everyone with compensation is eligible to make Roth IRA contributions. Eligibility phases out with modified adjusted gross income (MAGI) between $140,000 and $150,000 for married individuals filing jointly, $95,000 and $110,000 for single filers and $0 and $10,000 for married individuals filing separately. A married individual filing separately who lives apart from his or her spouse for the entire year is treated as single for this purpose.
* An individual cannot deduct a contribution to a Roth IRA.
* Distributions from Roth IRAs to individuals who have had such accounts for at least five years and who meet certain other criteria (e.g., being over age 59 1/ 2 or disabled) are not taxable.
* The Code does not require a Roth IRA owner to begin to take distributions from a Roth IRA when he or she reaches age 70 1/ 2. Rather, the distributions may be deferred until the owner's death.
* Rollovers or transfers from a traditional IRA to a Roth IRA cause the taxable portion of the traditional IRA to be included in the owner's gross income and are only available to certain individuals.
Establishing a Roth IRA
Under the Regulations, the instrument establishing a Roth IRA must clearly designate it as such. Further, a document designated as a Roth IRA cannot be changed at a later date to a traditional IRA, or vice versa. Treas. Reg. § 1.408A-2, A-2. It is not clear, however, whether this "cannot later be changed" position of the Regulations is modified by the conversion provisions, discussed below, that allow a taxpayer to convert a traditional IRA to a Roth IRA, i.e., by redesignating the traditional IRA as a Roth IRA. Does "redesignating" require execution of a new document that meets the "clearly designated" and "cannot be changed" criteria? As discussed below, a "separate document" requirement does appear to be an important consideration for successfully recharacterizing a contribution.
The Regulations provide a generous coordination between the contribution phaseout based on the individual's single or joint MAGI and the combined Roth/traditional IRA lesser of $2,000 per year or compensation limit. In particular, the $2,000 combined limit continues to apply even though a reduced amount is allowable as a contribution to the Roth IRA. For example, if, based on his or her MAGI, an individual with compensation exceeding $2,000 is subject to a phased out Roth IRA contribution limit of $1,340, he or she may make total IRA contributions of $2,000. Of that, the individual may contribute up to $1,340 to his or her Roth IRA. Treas. Reg. § 1.408A-3, A-3(c).
The Regulations use the word "conversion" for a distribution from a traditional IRA that the owner rolls over to a Roth IRA. The Regulations specify three methods by which such a conversion can occur:
(1) A distribution from a traditional IRA that is rolled over to a Roth IRA within 60 days;
(2) A trustee-to-trustee transfer from a traditional IRA to a Roth IRA maintained by a different trustee; or
(3) A trustee-to-trustee transfer from a traditional IRA to a Roth IRA maintained by the same trustee, which may be accomplished by "redesignating" a traditional IRA as a Roth IRA.
Treas. Reg. § 1.408A-4, A-1(b).
As discussed below, conversion treatment will not apply to a direct transfer that qualifies as a "recharacterization."
The Regulations specify that the MAGI limitation of $100,000, above which a married individual filing jointly is not eligible to convert a traditional IRA to a Roth IRA, is the married couple's combined MAGI from the individuals' joint return. Id. at A-2(b). As Roth IRA aficionados will recognize, this is a restrictive position. Some commentators had previously opined that this $100,000 limit should apply to the separate income of the spouse making the conversion.
The Regulations confirm that the recharacterization rules discussed below may be used to correct a failed conversion, such as one attempted by an individual whose MAGI exceeds the $100,000 limitation. Id. at A-3(a). The Regulations also provide that a failed conversion, if not recharacterized, will be treated as a regular annual Roth IRA contribution. Id. at A-3(b). To the extent that the individual's annual Roth IRA contribution exceeds his or her allowable annual contribution, the amount of the failed conversion will be an "excess contribution." Unless the individual withdraws the excess contribution and the applicable investment earnings by the date for filing his or her income tax return for the year of the contribution, the excess contribution will be subject to a 6% per year excise tax until corrected.
The Regulations clarify an ambiguous point in the statute, namely that an owner may convert a SIMPLE or SEP IRA to a Roth IRA. Consistent with other provisions relating to SIMPLEs, the conversion of a SIMPLE must await the expiration of the two year period after which the individual first participated in any SIMPLE maintained by his or her employer. Id. at A-4. Of course, current year employer contributions under a SEP or SIMPLE may not be made to a Roth IRA.
The Regulations provide that, for an individual who has attained age 70 1/ 2 by the end of a calendar year, a conversion during that year may not include that year's required minimum distribution from the traditional IRA. Id. at A-6. The IRS' reasoning in arriving at this conclusion might shed some light on the longstanding controversy about whether a year's required minimum distribution must be made before a rollover between traditional IRAs. One can interpret the Regulations as requiring such distributions.
The Regulations clarify that a conversion made by any of the three methods is a "distribution" subject to the IRA withholding rules. Treas. Reg. § 1.408A-6, A-13. The Code generally requires withholding on distributions from IRAs unless the distributee elects not to have withholding apply. Most individuals making a conversion to a Roth IRA will probably make a "no withholding" election to facilitate the conversion of the entire value of the traditional IRA. In that case, the individual will need another source of cash for paying income taxes on the conversion and may find it necessary to make estimated tax deposits to avoid penalties.
Under the Regulations, if an individual has been receiving substantially equal periodic payments from a traditional IRA, for the purpose of coming within that exception to the premature distribution penalty tax, the individual may, if he or she is otherwise eligible, convert the traditional IRA to a Roth IRA. In that case, the substantially equal periodic payments must continue from the Roth IRA, or prior distributions from the traditional IRA will be subject to recapture of the penalty tax. Such substantially equal periodic payments from the Roth IRA will be nonqualified distributions subject to inclusion in gross income during the first five years, and in many cases thereafter, but will be exempt from the penalty tax. Treas. Reg. § 1.408A-4, A-12.
Conversions in 1998
For an election to include the full taxable conversion amount in income in 1998, instead of using the normal four year spread, made available by the IRS Restructuring and Reform Act of 1998, Pub. L. 105-206, § 6005(b)(4)(A)-(B), 112 Stat. 685 (1998) (1998 Act), the taxpayer must make the election on Form 8606 that is filed with the individual's 1998 federal income tax return.
The Regulations specify that a traditional IRA distribution in 1997 may not be contributed to a Roth IRA in 1998, even if the general rollover requirements are fulfilled (e.g., it was deposited within 60 days of the date of distribution). Such a transaction is a "failed conversion" that may be recharacterized or be treated as a
Roth IRA excess contribution in the manner described above. Treas. Reg. § 1.408A-4, A-13.
If a Roth IRA account owner dies with his or her surviving spouse as his or her sole beneficiary, under the Regulations, the surviving spouse may make the election to continue the four year spread on either Form 8606 or Form 1040 in accordance with instructions on the forms.
The Regulations substantially flesh out the provision added by § 6005(b)(6)(A) of the 1998 Act that allows recharacterization of contributions made during a year as to the type of IRA to which they are contributed, if the contributions are transferred directly from trustee to trustee no later than the due date for filing the taxpayer's return for that year. The IRS quite clearly has Congress' approval to provide such substantive rules. The statutory provision explicitly states that such recharacterizations shall be made "except as provided by the Secretary." Code § 408A(d)(6)(A). The Regulations allow such recharacterizations in most, but not all, of the cases for which commentators had hoped.
On the permissive side of the ledger, the Regulations clarify that, when an IRA account holder has died, his or her executor, administrator or the person otherwise responsible for filing his or her tax return may make a recharacterization under the same terms as could a living account holder. Treas. Reg. § 1.408A-5, A-6(c). Further, the Regulations clarify that recharacterizing transfers are not treated as rollovers for purposes of the one rollover per year limitation.
The most important limitation that the Regulations impose for potential recharacterizations is a timing rule. If an individual receives a distribution from a traditional IRA in one tax year, then makes a contribution to a Roth IRA in the following tax year but within the 60 day rollover time limit, for recharacterization purposes, the IRS will treat the contribution as having occurred in the tax year of the distribution. Id. at A-1(b). This definitional provision will limit an affected taxpayer's ability to extend the recharacterization period into an additional year. For example, a traditional IRA distribution on December 15, 1998--contributed to a Roth IRA on January 15, 1999 by a calendar year taxpayer who does not extend the time for filing his or her income tax returns--could have been transferred to a traditional IRA and recharacterized no later than April 15, 1999.
The second most important regulatory limitation is also a timing issue. The Regulations base the time period for transfer and recharacterization on the taxable year "for which" the contribution was made, whereas the statute bases the recharacterization period on the contributions made "during such taxable year." Code § 408A(d)(6); Treas. Reg. § 1.408A-5, A-1(b). Like the roll-overs discussed above, this provision will, in certain cases, eliminate a full year from the recharacterization period that might otherwise be available. For example, an annual Roth IRA contribution for the 1998 tax year that was deposited on April 13, 1999--by an individual who extended his or her 1998 federal income tax return filing date until August 15, 1999--may be recharacterized as a traditional IRA contribution no later than August 15, 1999.
The Regulations explicitly prohibit a recharacterization of a "tax-free transfer" that was made during the year by treating such transfers as not being "contributions" capable of recharacterization. Treas. Reg. § 1.408A-5, A-4. For this purpose, the Regulations broadly define the term "tax-free transfer" to include rollovers to traditional IRAs from qualified retirement plans, tax sheltered annuities and other traditional IRAs, as well as rollovers between Roth IRAs and trustee-to-trustee (one can substitute "custodian" for either or both references to "trustee") transfers between traditional IRAs or between Roth IRAs. Treas. Reg. § 1.408A-8, A-1(a)(9). For purposes of determining whether an amount was contributed to an IRA for a taxable year, however, the IRS will disregard any subsequent tax-free transfers of that amount. Accordingly, if a contribution was eligible for recharacterization, it may still be recharacterized even though transferred in the interim to a different IRA of the same type.
The Regulations also clarify that employer contributions to a SIMPLE or a SEP may not be recharacterized as contributions to another type of IRA. A conversion of a SEP or a SIMPLE to a Roth IRA, however, may be characterized as a SEP or SIMPLE rollover contribution. Treas. Reg. § 1.408A-5, A-5.
The Regulations specify the mechanics for making a recharacterization. The individual electing to make the recharacterization must:
* notify the trustee/custodian of both the transfer or IRA and the transferee IRA of the type and amount of contribution to be recharacterized, the amount of the net income allocable to the contribution that is to be transferred, the date on which the contribution was originally made and the year for which it was made; and
* provide a direction to the trustee/custodian of the first IRA to transfer the contribution and net income from the first trustee/custodian to the second (which may be the same financial institution).
If the contribution to be transferred is the only amount that was contributed to the transfer or IRA, the entire balance must be transferred. The individual must report the transfer on his or her federal individual income tax return for the year for which the recharacterization is effective and the transfer is irrevocable following the date for filing the tax return for that year. Id. at A-6(b).
The Regulations impose limits on the frequency with which conversion/ recharacterization/reconversion transactions may be effected. In general, following a conversion and recharacterization, the owner must wait until the later of the next taxable year or 30 days after the recharacterization to again convert. A more liberal rule is in effect for 1998 and 1999, generally allowing unlimited reconversions before November 1, 1998, one reconversion between November and December 31, 1998 and one during 1999.
Taxation of Roth IRA Distributions
The Regulations add specificity to the ordering rules that apply to Roth IRA distributions under Code § 408A(d)(4). In particular, the Regulations clarify that the taxation of distributions from Roth IRAs involves disregarding the individual's traditional IRAs and aggregating all of the individual's Roth IRAs. Second, all distributions from that individual's Roth IRAs during a taxable year are treated as a single distribution. Finally, in determining the character of the amounts distributed, the IRS will attribute such amounts first to regular contributions, second to conversion contributions on a first-in, first-out basis and finally to earnings. To the extent a distribution is attributed to a particular conversion contribution, it is treated as being made first from the portion of the conversion that was includable in gross income, i.e., the portion that was not composed of nondeductible contributions. Finally, the Regulations clarify that the various amounts comprising a Roth IRA are calculated as of the end of the distribution year. Treas. Reg. § 1.408A-6, A-8 & A-9.
If a Roth IRA owner dies before the end of the five taxable year period for determining whether distributions are qualified distributions and the individual has multiple beneficiaries, the various categories of contributions and earnings that comprise his or her Roth IRA will be allocated pro rata among the multiple beneficiaries, based on the amounts of their respective entitlements. Therefore, if one of the beneficiaries should receive a distribution soon after the account owner's death while benefits of the other individuals remain in the Roth IRA, the beneficiary who received a distribution will be treated as receiving a pro rata portion of the regular contributions, each conversion contribution previously included in income, each conversion contribution previously not included in income (i.e., the nondeductible contributions) and investment earnings, with the total amount of each category determined as of the end of the distribution year. The amount of all of the components that are deemed distributed will equal the amount of cash or fair market value of assets distributed.
The Regulations state the not surprising conclusion that a distributee's basis in property distributed from a Roth IRA is its fair market value as of the date of distribution, whether or not the distribution was a qualified distribution. Id. at A-16.
The Regulations clearly provide that minimum distribution rules apply to Roth IRAs only after the death of the IRA owner and are computed using the rules for an owner who dies before his required beginning date. Most commentators expected this rule. Id. at A-14.
The Regulations specify that an individual beneficiary required to receive minimum distributions from a traditional IRA or SIMPLE IRA may not choose to take such minimum distributions from a Roth IRA, nor may an individual beneficiary take Roth IRA minimum distributions from a traditional IRA or SIMPLE IRA. Id. at A-15. There is an obvious tax policy reason for this position. The different types of IRAs have substantially different tax treatments on distribution, as well as differing minimum distribution requirements. Further, a beneficiary may elect to satisfy the minimum distribution requirements for a Roth IRA from another Roth IRA only if he or she inherited both Roth IRAs from the same decedent. Id.
Rolling Over Distributions
The Regulations state that a taxpayer may not contribute Roth IRA distributions to another type of retirement plan, such as a traditional IRA or a qualified retirement plan. Of course, this restriction does not apply to a recharacterization of a contribution that is effected through a direct transfer to a traditional IRA. Id. at A-17. Consequently, if an individual attempts such a rollover from a Roth IRA to a traditional IRA, the IRS will treat the amount in question as a distribution from the Roth IRA and a regular contribution to the traditional IRA. Some or all of the Roth IRA distribution may be subject to inclusion in the individual's gross income and may be subject to penalty taxes. The traditional IRA contribution may be an excess contribution, depending on the individual's eligibility to make such a regular annual traditional IRA contribution and the amount involved. The Regulations also provide that a person may not transfer any amounts from an education IRA to a Roth IRA. Id. at A-18. One might consider this statement unnecessary because an education IRA is not a retirement plan. Similarly, any amount transferred from a Roth IRA to an education IRA would be treated as a Roth IRA distribution and an education IRA contribution, which in many cases, would be an excess contribution.
The Regulations address the hotly debated proposed estate planning technique in which a Roth IRA owner irrevocably renounces his or her right to receive distributions during his or her lifetime accompanied by an irrevocable beneficiary designation. The idea behind this technique was that it would be a current gift, thereby freezing the account value and removing future appreciation in the account from transfer taxation. The Regulations discourage this technique by providing that a gift of a Roth IRA constitutes an "assignment" and that at the time of the gift, the assets of the Roth IRA are deemed to be distributed to the owner. Id. at A-19. At the time of the renunciation, therefore, the assets are no longer held in a Roth IRA. If the deemed distribution occurs before the account owner becomes eligible to receive a qualified distribution, he or she will include some or all of that amount in his or her gross income. Thereafter, such assets would not have the benefit of the tax-free internal buildup that is a primary benefit of having an IRA.
Although the public policy basis of this Regulation provision is clearly that the benefits of the technique seem too good to be true, the IRS' legal reasoning is strained. In particular, there is no specific statutory prohibition on an assignment of an IRA. The statutory prohibitions against pledging an IRA as security for a loan or borrowing from an IRA and the requirement that an IRA be a trust established for the exclusive benefit of an individual or his or her beneficiaries do not seem to clearly support the IRS' conclusion. One line of reasoning supporting this conclusion may be that no one can be a beneficiary of an individual's Roth IRA (or any IRA) before the death of the individual. The Treasury seems to allude to this position in longstanding traditional IRA proposed regulations that should also apply to Roth IRAs.
The Regulations provide a special correction rule. If an account holder made a gift of a Roth IRA before October 1, 1998, but the donee reconveyed the account to the donor before the end of 1998, the IRS will treat the transaction as never having occurred for federal income, estate and gift tax purposes. Id. An individual in need of making such a correction will want to determine whether and how the reconveyance should have been accomplished under applicable state property law. Impediments to making the correction may exist if the beneficiaries did not consent to the reconveyance or if they lacked the legal capacity to do so (e.g., if they are minors).
The Regulations impose the same reporting requirements--i.e., Forms 1099-R ("Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.") and 5498 ("IRA Contribution Information")--on Roth IRAs as apply to traditional IRAs. In addition, the Regulations specify that a trustee/custodian of a Roth IRA may rely on reasonable representations of a Roth IRA contributor or distributee for purposes of fulfilling reporting obligations. Treas. Reg. § 1.408A-7.
The Roth IRA Regulations that the IRS recently issued provide many of the substantive, definitional and procedural rules that will allow individuals who are eligible for Roth IRA conversions and contributions and their advisors to carefully plot their courses for dealing with this new tax-free savings vehicle and for making the corrections that, in certain cases, will be needed.
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