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Retirement Benefits Planning Update provides information on developments in the field of retirement benefits law. The editors of Probate & Property welcome information and suggestions from readers.
Refocus on Roth IRA Conversions
The January/February 2006 "Retirement Benefits Planning Update" described two developments that occurred in 2005 and 2006 that provided an increased opportunity for wealthy individuals to take advantage of the benefits of a Roth IRA. One change was the 2005 introduction of the designated Roth accounts under IRC § 402A that permitted plan participants in plans adopting this option to allocate all or a part of their annual elective deferrals to these accounts on an after-tax basis. The second development was a 2006 change in the computation of an individual's modified adjusted gross income (MAGI) for the purposes of determining whether the IRC § 408A(c)(3)(B) limit of $100,000 or less required for the conversion of a traditional IRA to a Roth IRA was met. MAGI is the amount of adjusted gross income under IRC § 62, computed with the adjustments made in IRC § 219(g)(3). IRC § 408A(c)(3)(C)(i)(II) permitted the amount of minimum required distributions (MRDs) received from a traditional IRA in the year of a Roth conversion to be disregarded. Despite these two changes, the 2006 update noted that a "catch-22" still existed because the MAGI limit generally prevented those account owners who had sufficient net worth to finance a Roth IRA conversion from converting.
Two legislative changes that have occurred since the 2006 update have eliminated the catch-22 and will cause a new focus on the opportunity for high-income traditional IRA account owners and qualified plan participants to complete Roth IRA conversions. First, less than five months after the 2006 update was published, section 512(a)(1) of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) repealed IRC § 408A(c)(3)(B) for taxable years beginning after 2009. Pub. L. No. 109-222, 120 Stat. 345. As a result, for 2010 and future years, the requirements that a traditional IRA account owner or plan participant (1) have 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. An account owner may convert all or any part of a traditional IRA to a Roth IRA (1) by distributing funds from a traditional IRA and rolling them over to a Roth IRA within 60 days of distribution, (2) by a trustee-to-trustee transfer, or (3) by redesignating a traditional IRA as a Roth IRA, all of which conversion methods of transfer are considered to be rollovers. IRC § 408(d)(3)(A). A Roth IRA conversion is treated as a distribution of the converted amount from the traditional IRA or plan account to the account owner for income tax purposes and the conversion amount is included in the account owner's gross income for the year of transfer except to the extent that the account owner has a basis in the traditional IRA. IRC § 408A(d)(3)(A), (B), and (C). In the case of a 60-day rollover that spans two years, the year in which the distribution is made from the traditional IRA or plan is the year of transfer. Treas. Reg. § 1.408A-4, A-2(a).
As discussed in the 2006 update, for years after 2005, sponsors of IRC § 401(k) or § 403(b) plans could adopt plan provisions permitting participants to allocate all or a portion of their elective deferrals that would otherwise be made to the plan on a pre-tax basis to designated Roth accounts. Before 2008, a participant in IRC § 401(k), § 403(b), or § 457(b) plan could transfer all or a portion of a non-Roth plan account to a Roth IRA only by means of receiving an eligible rollover distribution from the plan, rolling the distribution over to a traditional IRA, and then converting the traditional IRA to a Roth IRA. Under IRC § 3405(c), a qualified plan is required to withhold 20% of any distribution amount, leaving only 80% of the distribution available for transfer to the traditional IRA. The second significant legislative change since the 2006 update was the enactment of section 824 of the Pension Protection Act of 2006 (PPA 2006), Pub. L. No. 109-280, 120 Stat. 780, which 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 such a direct rollover even though the rolled over amount is included income. Notice 2009-75, 2009-39 I.R.B. 436, amplifying and clarifying Notice 2008-30, 2008-12 I.R.B. 638. Notice 2009-75 states that the amount that would be includible in gross income were it not part of a qualified rollover contribution is included in the distributee's gross income for the year of distribution and that the amount included in gross income is equal to the amount rolled over, reduced by the amount of any after-tax contributions that are included in the amount rolled over, in the same manner as if the distribution had been rolled over to a non-Roth IRA . . . and that non-Roth IRA had then been immediately converted to a Roth IRA.
Finally, section 512(b)(1) of TIPRA caused an immediate 2010 focus on Roth IRA conversions by amending paragraph (iii) of IRC § 408A(d)(3)(A) 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. This "one time" offer to defer payment of income tax on a Roth conversion and to spread the income over two taxable years will prompt many taxpayers who are now newly eligible to convert to a Roth IRA to seek advice regarding the pros and cons of converting some or all of their retirement benefits to a Roth account and the flexible mechanics of making a conversion transfer, recharacterizing that conversion transfer with 20/20 hindsight, and making a second conversion transfer under more optimal conditions.
Roth IRA Characteristics
A Roth IRA provides an income tax free investment fund for the life of the account owner (and, potentially, the joint lives of the account owner and the account owner's spouse) because the lifetime portion of the minimum required distribution (MRD) rules of IRC § 401(a)(9) do not apply to a Roth IRA. IRC § 408A(c)(5). The post-death MRD rules do apply beginning in the distribution calendar year following the account owner's death (or, if a surviving spouse designated beneficiary elects to treat the Roth IRA as the spouse's own, in the year following the surviving spouse's death) as if the account owner (or surviving spouse) had died before the required beginning date. Accordingly, if there is a designated beneficiary of the account owner (or of the surviving spouse), MRD payments may be made over the life expectancy of the designated beneficiary. IRC § 401(a)(9)(B)(iii). The younger the beneficiary, the longer the period for tax free growth of the account. Note that because the Roth IRA account owner has no required beginning date (RBD) for MRDs, the on-death MRD rules that apply are those that apply to a pre-RBD death even if the account owner dies after age 70½. If the account owner has not designated a beneficiary or if there is no designated beneficiary because of a failure to qualify a trust named as beneficiary as a look-through trust, the five-year rule applies and all of the Roth IRA benefits must be distributed no later than the end of the calendar year in which the fifth anniversary of the account owner's (or surviving spouse's) death occurs. IRC § 401(a)(9)(B)(ii); Treas. Reg. § 1.401(a)(9)-3, A-4.
Because the amounts contributed to a Roth IRA (whether by regular contributions or by conversion) are not deductible, distributions of the amounts contributed to the account owner (or a designated beneficiary) will not be includible 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 a distribution that is (1) made after any Roth IRA established by the account owner has been in existence for five years and (2) made after the account owner attains age 59½, on account of the account owner's disability, following the account owner's death, or as a distribution to a first time home buyer under IRC § 72(t)(8). IRC § 408A(d)(2)(A)(iv). The five-year period (the "nonexclusion period") begins on the first day of the account owner's taxable year for which the account owner made a regular contribution to any Roth IRA or, if earlier, on the first day of the taxable year in which a conversion transfer is transferred to (or distributed from a traditional IRA for transfer to) any Roth IRA. IRC § 408A(d)(2)(B); Treas. Reg. § 1.408A-6, A-2. If the account owner's death occurs within the five-year period, the nonexclusion period continues until the five years are up. IRC § 408A(d)(2)(B).
Because all Roth IRAs maintained by an account owner are aggregated to determine the five-year nonexclusion period, an account owner expecting to make a conversion contribution at a future time might want to establish a modest Roth IRA to start the five-year nonexclusion period running. As described in the 2006 update, contributions to traditional IRAs by an individual who is an active participant in a qualified retirement plan (or whose spouse is an active plan participant) may be prohibited or limited if the individual's MAGI exceeds certain levels. For 2010, an active participant who files a joint return may deduct the maximum amount of $5,000 ($6,000 if age 50 or older) only if the individual's MAGI is under $89,000 and may deduct a lesser amount until the deduction phases out at $109,000. For single individuals, the 2010 phase-out range is from $56,000 to $66,000. Whether an individual fits within the required MAGI profile, or if neither the individual nor the individual's spouse is an active participant so that the MAGI limitations do not apply, the deduction is limited to the amount of compensation included in gross income for the year of the contribution. Individuals may make nondeductible contributions to a Roth IRA subject to the same limitations that apply to deductible contributions to traditional IRAs except that the maximum annual contribution that can be made is similarly phased out (though at higher levels of income) if the individual's MAGI is between $167,000 and $177,000 for an individual filing a joint return in 2010 (and between $105,000 and $120,000 for a single account owner). Note that contributions (including conversion contributions) may be made to a Roth IRA by an account owner over age 70½. In the case of a post age 70½ conversion of an entire traditional IRA or plan account, any MRD required for the year of conversion should be distributed before the conversion transfer. Otherwise, the MRD amount will be treated as a taxable distribution followed by a regular contribution to the Roth IRA that may result in a 6% penalty tax if the contributing account owner does not fall under the MAGI contribution limits. Treas. Reg. § 1.408A-3, A-6.
If an individual is unable to make an initial regular contribution to a Roth IRA because of the MAGI limits but is a participant in a IRC § 401(k), § 403(b), or § 457(b) qualified plan, a portion of the annual elective deferral may be made on a post-tax basis to a designated Roth account if the plan agreement permits. If the individual is entitled to receive a distribution from the plan, all or part of the designated Roth account may be rolled over to a Roth IRA. Note that, even if the rollover contribution is a qualified distribution from the designated Roth account (it was held in the account for the five-year nonexclusion period and distributed after age 59½), there is no aggregation of the plan's five-year nonexclusion period with the recipient Roth IRA's five-year nonexclusion period. The Roth IRA (or Roth IRAs) must satisfy the five-year nonexclusion rule independently. If the rollover distribution is a qualified distribution from the designated Roth account, the entire amount of the contribution (including any earnings) is treated as a regular contribution to the Roth IRA and thus may be distributed from the Roth IRA free of income tax even if the Roth IRA five-year nonexclusion period has not been met. Treas. Reg. § 1.408A-10, A-3. If the rollover distribution from the designated Roth account is a nonqualified distribution (either because the plan five-year nonexclusion period has not been met by the distributing designated Roth account or the distribution purpose test is not met), any earnings transferred as part of the rollover transfer will remain potentially subject to income tax on distribution until the five-year nonexclusion period is independently satisfied by the recipient Roth IRA account. Treas. Reg. § 1.408A-10(b), ex. 3.
For 2010 and future years, a second strategy for establishing a Roth IRA to start the five-year nonexclusion period running is available. In fact, the elimination of the $100,000 MAGI cap on conversions of traditional IRAs to Roth IRAs has, in a sense, rendered the MAGI limits on regular Roth contributions irrelevant. Under IRC § 408(o), an individual whose MAGI exceeds the limits for contributions to a traditional IRA 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 at little or no income tax cost.
Although it may be prudent to establish a Roth IRA in order to meet the five-year nonexclusion requirement before a substantial conversion contribution in case there is an unforeseen need to liquidate the account shortly after the conversion, even substantial distributions from the converted Roth IRA (for example, a withdrawal to pay the income tax caused by the conversion) are unlikely to result in taxable income to the withdrawing account owner. This is the case because nonqualifying distributions from a Roth IRA, whether made to the account owner or to a beneficiary who must begin to receive MRDs in the year following the year of an account owner's death that occurs during the nonexclusion period, are protected by ordering rules that treat nonqualifying distributions as being made first from regular contributions to the Roth IRA and then from already taxed conversion contributions (each of which represents the nontaxable return of basis) and finally from Roth IRA earnings includible in gross income. IRC § 408A(d)(4)(A).
Conversion Tax and Post-Conversion Tripwires
Because the conversion of all or any 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 and 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 of the IRAs represents aggregate value of all of the IRAs. IRC § 408A(d)(2). Although the amount of nondeductible contributions may not be large enough to justify the effort, an account owner who is a participant in a qualified plan that will accept rollovers from a participant's traditional IRAs could roll over the portion of the traditional IRA or IRAs equal to the amount of deductible contributions made and earnings received on those contributions (as well as earnings received on nondeductible contributions to the qualified plan). The rollover of the components of the IRA that are subject to income tax is made possible because, under IRC § 408(d)(3)(H)(ii), a distribution from an IRA to a qualified plan is deemed to be made first from the taxable portion of the IRA. After such a rollover, the IRA or IRAs will hold only the amount of the nondeductible contributions and can be converted to a Roth IRA free of income tax.
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 59½, the 10% 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. IRC § 408A(d)(3)(A)(ii). But, if a distribution is made to an under age 59½ account owner within the five-year period (beginning with the first day of the account owner's taxable year in which the conversion transfer occurred) and any portion of the distribution is attributable under the ordering rules to the conversion contribution, the 10% penalty tax applies to the distribution (or the portion of the distribution) allocable to the conversion contribution unless an exception to the 10% penalty tax applies. IRC § 408A(d)(3)(F); Treas. Reg. § 1.408A-6, A-5(b). This restriction (which is separate from the application of the five-year nonexclusion period of the recipient IRA) effectively prevents an account owner from indirectly receiving pre age 59½ distributions from a traditional IRA. The 10% penalty tax will not apply to a beneficiary that taps the Roth IRA account following the account owner's death because distributions following the death of an account owner are an exception to the IRC § 72(t) tax. IRC § 72(t)(2)(A)(ii).
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. TIPRA § 512(b)(2)(A), amending clause (i) of IRC § 408A(d)(3)(E). In the case of such an accelerated inclusion of the conversion amount in income, the one-half otherwise includible in income for 2012 is reduced to equal the unincluded balance of the conversion amount. Finally, if the five-year rule that applies to pre age 59½ conversions also applies, distributions during the two-year extended inclusion period will be subject to the 10% premature distributions tax as well, unless an exception applies. Finally, if an account owner who has elected to have the income on a 2010 conversion transfer included in 2011 and 2012 dies in 2010 or 2011, the income is instead included on the account owner's final return unless the account owner's surviving spouse is the sole beneficiary of the Roth IRA and elects to report the income over the two-year period. IRC § 408A(d)(3)(E)(ii).
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% of the conversion transfer amount. A conversion contribution made in early 2010, with respect to which the account owner plans to elect to have the income included in 2010 (rather than ratably in 2011 and 2012) in anticipation that income tax rates will increase in 2011 because of the sunset of the EGTRRA income tax rate reductions, may become more expensive if income tax rates are increased by new legislation enacted before the December 31, 2010, EGTRRA sunset date. An account owner may decide to make a deathbed conversion to a Roth IRA based on projections that show that the pre-death payment of income tax will reduce estate tax payable. The deceased account owner's executor may discover that, because of a decline in the value of estate taxable assets or a legislative increase in estate tax exemptions, there will be no estate tax to pay.
In each of these instances, the Roth IRA conversion may be reversed at any time up to the due date (plus extensions) 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 (increased by any post-transfer earnings and decreased by any post-transfer losses) by a trustee-to-trustee transfer back to the traditional IRA from which it was transferred. IRC § 408A(d)(6) and (7); Treas. Reg. § 1.408A-5, A-1(a). A recharacterization accomplished before the extended due date of the account owner's tax return (typically, October 15 of the year following the conversion transfer) unwinds the transaction so that no income is reportable for the original conversion transfer and the transfer is reported as a transfer to a traditional IRA on the account owner's tax return. Treas. Reg. § 1.408A-5, A-10.
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. The notification must contain information about the conversion contribution (the amount, the date made, and the year for which it was made), a direction to the trustee of the first IRA to transfer the contribution (plus or minus net income or loss) to the trustee of the second IRA, and the names of the trustees of each IRA. IRS Publication 590—Individual Retirement Arrangements (2008). If a recharacterization is contemplated to be elected after April 15 of the year following the conversion, it is advisable to obtain the automatic six-month extension by filing Form 4868 by April 15. Treas. Reg. § 1.6081-4T. Although the failure to actually extend the due date will not prevent a recharacterization from being made by October 15, an amended return would need to be filed reflecting the recharacterization. Treas. Reg. § 301.9100-2(b).
It would seem (but does not appear to have yet been formally addressed by the IRS) that a conversion contribution made from a qualified plan account by a direct rollover could be recharacterized even though the Treasury Regulations describing recharacterization transactions have yet to be updated to reflect the direct rollover option introduced by PPA 2006. Otherwise, a plan participant who took advantage of the direct rollover to a Roth IRA introduced by PPA 2006 rather than by using the only pre-PPA 2006 alternative of rolling the plan account over to a traditional IRA and converting that traditional IRA to a Roth IRA would be penalized. The transferring participant would be electing to recharacterize the transfer as made to a traditional IRA instead of being treated as a transfer to a Roth IRA. Because a rollover from a Roth IRA to a qualified plan is not permitted, the account owner would presumably need to designate a traditional IRA to receive the transfer from the Roth IRA. Treas. Reg. § 1.408A-10, A-5.
Once the recharacterization has been made reversing the Roth IRA conversion, the account owner may wish to initiate a reconversion if the market conditions or applicable income tax is more favorable. To prevent short-term game playing, an account owner cannot reconvert an amount that has been transferred back to a traditional IRA by a recharacterization before the later of (1) the tax year following the tax year in which the amount was converted to a Roth IRA or (2) the end of the 30-day period beginning on the date on which the amount was transferred back to the traditional IRA from the Roth IRA. Treas. Reg. § 1.408A-5, A-9.
Lifetime Roth Benefits
If a taxpayer's retirement prospects are such that a substantial portion of the Roth IRA funded by converting a traditional IRA or qualified plan benefits is expected to be distributed to the taxpayer (or the taxpayer's surviving spouse) during the retirement period, the benefits of the conversion, if any, depend on the current and post-retirement income tax rates. If the federal and state (if applicable) income tax rate paid in the year of conversion is the same or higher than the income tax rates that would otherwise apply to the retirement income withdrawn from the unconverted traditional IRA or qualified plan account, the conversion will be of no benefit. If a portion of the conversion amount is not subject to tax because the taxpayer has made nondeductible contributions to the traditional IRA or plan account being converted or if the taxpayer has extraordinary deductions (such as a carryover charitable deduction) that would reduce the applicable tax rate for the year of conversion, the tax conversion may be reduced sufficiently to make the conversion beneficial. The payment of benefits from a Roth IRA may also serve to reduce the account owner's adjusted gross income following retirement, which may, inter alia, reduce income tax on Social Security benefits.
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 ("outside assets"), the entire Roth IRA account can grow because no MRDs are required for the remainder of the account owner's lifetime. If the account owner's surviving spouse is named as beneficiary and elects to make the account the spouse's own, the Roth IRA may continue to grow through the spouse'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. Under the single life table below that applies to a grandchild or child as designated beneficiary, the following percentage of the Roth IRA account is required to be distributed, depending on the age attained in the year after the account owner's or surviving spouse's death, for the indicated age attained during the MRD payout period.
To the extent that the Roth IRA's investments appreciate at a rate greater than the percentage required to be distributed as an MRD each year, the investment fund will continue to grow. Although not all designated beneficiaries will limit annual distributions to the MRD amount, the potential wealth generated within the Roth IRA and from the investment of all or a portion of the MRDs received without reduction by income tax will be difficult to match using any other vehicle.
Age Year After Death
Age Attained During MRD Period