Retirement

Account

After TRA '97

By Richard A. Naegele and Mark P. Altieri

In Brief

Pulling It All Together

In the past year, The CPA Journal has published a number of articles relating to the many changes brought about by the Taxpayer Relief Act of 1997 (TRA). Included in those have been several dealing with specific uses for individual retirement accounts (IRAs). Last month it was about using IRAs for qualified educational expenses and whether to choose a Roth or a deductible IRA. This month's article summarizes the new provisions of TRA relating to all kinds of IRAs and integrates them with the prior, unchanged aspects of IRAs.

The discussion includes the changes caused by TRA on traditional deductible IRAs and a brief description of the new Roth and educational IRAs, including examples of the interaction between the new and old law. The article goes on to explain matters common to all IRAs, including contributions, limitations, rollovers from qualified plans, and distributions. The Taxpayer Relief Act of 1997 (TRA) brought many revisions to existing tax law relative to Individual Retirement Accounts ("IRAs") and additionally created a number of new IRA vehicles. Readers may find a summary of all the IRA rules, the old and the new, of value.

Modification of Prior Law

Eligibility for Establishing Individual Retirement Accounts. The TRA gradually increases the prior law adjusted gross income ("AGI") phaseout limits for deductible IRA contributions for individuals who are active participants in tax-qualified, employer-sponsored retirement plans. For 1998, the phaseout range is from $30,000 to $40,000 for single taxpayers and from $50,000 to $60,000 for married taxpayers filing jointly. Active participants who are below these thresholds may make deductible IRA contributions. The IRA contribution deduction available to an active participant is reduced proportionately over the phaseout range. Active participants with AGI above the phaseout range are not entitled to any deduction for a contribution to an IRA.

Active Participant Status Is Not Attributed to Spouse After 1997. For years commencing prior to 1998, an individual is considered to be an active participant in a plan if such individual's spouse is an active participant. For years commencing after 1997, however, an individual will not be considered to be an active participant in an employer-sponsored plan merely because the individual's spouse is an active participant during such year.

Significantly, the AGI phaseout limit for a spouse of an active participant has been set at a relatively high amount. The maximum deductible IRA contribution for an individual who is not an active participant, but whose spouse is, will be phased out for AGI between $150,000 and $160,000 for tax years commencing after 1997.

Another significant change to prior law, detailed at the end of this article, involves new permissible nonpenalty distributions from traditional IRAs.

Roth IRAs

The TRA establishes a new type of nondeductible IRA called a "Roth IRA." For Roth IRA rules to apply, an IRA must be designated as a Roth IRA at the time of its establishment. Roth IRAs are effective for tax years commencing after December 31, 1997.

Contribution Limits. The contribution limits on Roth IRAs and traditional deductible and nondeductible IRAs are coordinated and limited to $2,000 per taxpayer per year (not including rollovers) for all three types of IRAs. The maximum yearly contribution that may be made to a Roth IRA is phased out for single taxpayers with AGI between $95,000 and $110,000 and for joint filers with AGI between $150,000 and $160,000. Contributions may be made to a Roth IRA even after the individual for whom the account is maintained has attained age 70 wQ.

Contributions Are Nondeductible. Contributions to Roth IRAs are nondeductible. Rather than deducting the contribution "up front" as with a traditional deductible IRA, the tax benefits are backloaded. Qualified distributions (including earnings) from Roth IRAs are tax-free. Thus, unlike deductible IRAs and tax-qualified plans that provide tax-deferral, Roth IRAs provide true tax-free buildup of investment earnings within the IRA.

Rollover to a Roth IRA. An existing traditional IRA can be rolled over (or converted) into a Roth IRA by a taxpayer with AGI of less than $100,000 (not counting the rollover conversion amount) for the taxable year of the rollover.

Traditional tax-deferred IRAs rolled over into a Roth IRA are includable in the income of the taxpayer for the year of the rollover or conversion to a Roth IRA. However, if the rollover or conversion is made prior to January 1, 1999, the amounts required to be includable in income by reason of the rollover will be included ratably over the four taxable year period beginning with the taxable year in which the payment or distribution is made. This window will provide possible mitigation to progressive taxation and a time value of money benefit to the taxpayer on the tax liability deferral. The 10% early distribution tax under IRC section 72(t) does not apply to rollovers to Roth IRAs.

Distributions from Roth IRA. Qualified distributions from a Roth IRA are not included in the taxpayer's gross income and are not subject to the 10% tax on early withdrawals. Qualified distributions must satisfy a five-year holding period and must meet one of four criteria for a distribution. The five-year holding period begins with the first taxable year for which the individual made a contribution to a Roth IRA (or such individual's spouse made a contribution to a Roth IRA) established for such individual. In the case of a rollover, the five-year period begins with the taxable year in which the rollover contribution was made.

Distributions that have satisfied the five-year holding period will be qualified if the distribution is additionally--

* made on or after the date on which the individual attains age 59 1/2;

* made to a beneficiary (or the individual's estate) on or after the individual's death;

* attributable to the disability of the individual; or

* a distribution made for qualified first-time homebuyer expenses (up to $10,000 over the taxpayer's lifetime).

Nonqualified Distributions. In applying the taxation rules of IRC section 72 to a distribution from a Roth IRA that is not a qualified distribution, such distribution shall first be treated as made from after-tax contributions to the Roth IRA (and thus constitute a tax-free recovery of capital). This taxpayer-favored FIFO methodology is applicable to the extent that such distribution, when added to all previous distributions from the Roth IRA, does not exceed the aggregate amount of contributions to it.

Mandatory Distribution Rules Do Not Apply Before Death. The pre-death required distribution rules of IRC section 401(a)(9), requiring distributions from traditional IRAs to commence at age 70 1/2, do not apply to Roth IRAs.

Education Individual Retirement Accounts

The TRA creates a new type of IRA to assist taxpayers in saving for education expenses. Joint filers with AGI of less than $150,000 ($95,000 for single filers) may contribute up to $500 per beneficiary per year to an education IRA. Contributions to an education IRA are nondeductible but distributions to (or for the benefit of) the beneficiary of such IRA are tax-free (including earnings) if used to pay for "qualified higher education expenses." Education IRAs are effective for taxable years beginning after December 31, 1997.

Trust Requirements. The trust instrument used as the funding vehicle for an education IRA must provide that--

* no contribution may be accepted after the date on which the beneficiary attains age 18;

* all contributions must be made in cash;

* except in the case of a rollover contribution, annual contributions [from any source(s)] to a beneficiary's education IRA cannot exceed $500;

* no portion of the trust's assets may be invested in life insurance contracts;

* the trustee must be a bank or other person who demonstrates ability to properly administer the trust;

* the assets must not be commingled with other property, except in a common trust or investment fund; and

* upon the death of the designated beneficiary, any balance to the credit of the beneficiary must be distributed within 30 days after the date of death to the estate of such beneficiary.

Additional Tax on Distributions Not Used for Educational Expenses. The tax imposed for any taxable year on any taxpayer who receives a noneducation distribution from an education IRA is includable in gross income and shall be increased by 10% of the amount that is includable.

Rollover Contributions. Amounts held in an education IRA may be distributed and rolled over into an education IRA for another member of the beneficiary's family not later than the 60th day after the date of such payment or distribution and avoid the additional tax described in the prior paragraph.

Examples of Interaction of Old and New Law

Example 1. Over the years, Mr. Grasshopper has not been a regular saver. Part of the reason for this savings deficiency is the fact that Mr. and Mrs. Grasshopper are the parents of six minor children. Mrs. Grasshopper stays at home with the children. Mr. Grasshopper works hard at supporting his family and, in the process, generates an adjusted gross income of $115,000 in 1997 and 1998. Mr. Grasshopper is an active participant in his company's qualified retirement plan. The Grasshoppers, having passed 40 years of age, are now desirous of maximizing their tax-favored retirement savings. Due to Mr. Grasshopper's status as an active participant in his company's retirement plan, in 1997 the Grasshoppers are precluded from making any tax-deductible contribution to an IRA.

In 1998, the picture will change significantly. Mrs. Grasshopper will not be deemed an active participant in her husband's qualified plan. Therefore, she will be eligible to make a Roth or a tax-deductible $2,000 contribution to an IRA. Mr. Grasshopper will be able to contribute $2,000 to a Roth IRA. Additionally, the Grasshoppers may establish an education IRA for each of their six children and contribute a total of $3,000 ($500 x 6) to the childrens' education IRAs.

Example 2. Mr. Ant, age 55, has worked for his employer for 10 years and has accumulated an account balance in 1998 of $200,000 in his employer's profit-sharing plan. He additionally has investments in taxable accounts outside of the retirement plan amounting to $100,000. He is single and his AGI is approximately $50,000. Mr. Ant's employer's profit-sharing plan allows in-service distributions at age 55.

In 1998, Mr. Ant elects to receive a distribution of his account balance from the profit-sharing plan and have the entire amount rolled over directly to an IRA. Mr. Ant next elects to convert the rollover IRA into a Roth IRA in 1998. Since the conversion to the Roth IRA occurs in 1998, Mr. Ant includes the $200,000 account balance in income ratably over the four-year period commencing in 1998 (i.e., Mr. Ant picks up $50,000 in income for each year from 1998 until 2001). The additional 10% tax on distributions prior to age 59 wQ does not apply to rollovers or conversions to Roth IRAs. Mr. Ant uses funds from his taxable investments to pay the taxes on the additional income resulting from the Roth IRA conversion for the years from 1998 until 2001 and keeps the entire $200,000 rollover amount invested in the Roth IRA.

If Mr. Ant can achieve a 12% return on his investments in the Roth IRA, he will double his money every six years and have a balance in his Roth IRA of $400,000 at age 61, $800,000 at age 67, and $1,600,000 at age 73. Thus, Mr. Ant will have accumulated $1,400,000 on a tax-free basis in the 18-year period following his rollover to the Roth IRA. Furthermore, since the rules requiring the distribution of benefits commencing at age 70 wQ do not apply to Roth IRAs, distributions from the Roth IRA are completely at Mr. Ant's discretion.

Contributions to an IRA

The general rule is that the maximum contribution to a Roth IRA or a traditional deductible or nondeductible IRA (but not to an education IRA) is coordinated and limited to the lesser of $2,000 or 100% of compensation.

Spousal IRA of Nonworking Spouse. Subject to AGI eligibility limitations, effective for tax years beginning after December 31, 1997, even if a working spouse is an active participant in an employer-sponsored plan, the nonworking spouse may make a deductible contribution of up to $2,000 per year to a traditional IRA. Also starting in 1998, subject to the AGI limitations noted under the discussion of Roth IRAs, the nonworking spouse may alternatively make a contribution of up to $2,000 per year to a Roth IRA.

Nondeductible Contributions to a Traditional IRA. An individual ineligible for a full deductible contribution to an IRA because of the AGI phaseout may make nondeductible contributions. Again, total Roth and nondeductible and deductible IRA contributions for any one taxpayer cannot exceed $2,000 for any year. Nondeductible contributions are reported on Form 8606.

Timing and Calculation of Contribution. Contributions must be made by the due date for an individual's tax return, without taking extensions into consideration. Thus, the contribution must be made by April 15. The IRS has ruled that a contribution postmarked on April 15 will be considered to have been made on that date.

No deduction to a traditional IRA is allowed for an individual who has attained age 70 1/2. However, if the participant's spouse is not 70 1/2, deductible contributions can still be made on the spouse's behalf. Additionally, a rollover may be made by an individual after age 70 wQ.

Limitations of an IRA

Penalty for Excess Contributions. An IRA contribution must either be to a Roth IRA, a deductible contribution, a nondeductible contribution, or a rollover contribution. A nonrollover contribution greater than $2,000 is an excess contribution. If an excess contribution is not corrected, it is subject to a six percent annual penalty until it is corrected.

Applicability of Prohibited Transaction Rules. Since an IRA is not an ERISA pension plan, the prohibited transaction rules of IRC section 4975, as opposed to ERISA, apply. If the owner or beneficiary of an IRA engages in a prohibited transaction with the IRA, the entire IRA is disqualified, not just the amount involved in the prohibited transaction. A loan cannot be secured by an IRA. An assignment or pledging of any amount will be considered a distribution. The IRA cannot be used to purchase life insurance. Consequently, rollover contributions from a qualified plan may not include life insurance.

An IRA Cannot Invest in Collectibles. This includes coins, stamps, art, antiques, wine, etc. Any amount invested in a collectable will be considered a distribution. However, an IRA may invest in gold, silver, or platinum coins issued by the United States or any coin issued under the laws of any state. An IRA may also invest in gold, silver, platinum, or palladium bullion acquired after December 31, 1997 if such bullion is in the physical possession of the IRA trustee or custodian.

Rollovers from Qualified Plans

Eligible Rollover Distributions. Only a qualified plan participant can make an "eligible rollover" of a distribution to another qualified plan or to an IRA.

An eligible rollover distribution means any distribution to a participant of any portion of the balance to the credit of the participant in a tax-qualified retirement plan [or IRC section 403(b) tax sheltered annuity], with the exception of--

* a distribution that is one of a series of substantially equal periodic payments (not less frequently than annually) made i) for the life (or life expectancy) of the employee or the joint lives [or joint life expectancies] of the employee and the employee's designated beneficiary, or ii) for a specified period of 10 years or more, and

* any distribution to the extent such distribution is required to be made under IRC section 401(a)(9) (e.g., minimum required distributions at age 70 wQ).

An individual who has attained age 70 1/2 is permitted to roll over all of an eligible rollover distribution except the minimum distribution amount required under IRC section 401(a)(9).

Nonemployee Distributions. An alternate payee spouse or former spouse receiving a qualified plan distribution pursuant to a qualified domestic relations order (a "QDRO") and a surviving spouse can receive an eligible rollover distribution but may only roll over to an IRA. Distributions to a distributee other than spouse, surviving spouse, or former spouse are not eligible rollover distributions.

Timing the Rollover. Rollover treatment must be elected within 60 days after the distribution. Previously, the IRS allowed a taxpayer to revoke his or her rollover and select 10-year averaging as long as this was accomplished by the due date of the taxpayer's return. However, the IRS has altered its prior position. Thus, taxpayers must make a choice between rollover treatment or 10-year averaging prior to the time of the rollover.

There are virtually no exceptions to the 60-day period for rollovers. In Kane v. Commissioner, T.C. Memo 1992-218, an individual who failed to roll over a distribution due to severe medical problems was taxed on the distribution. His medical condition was no excuse for his failure to comply with the 60-day deadline.

Noncash Property. Noncash property may be rolled over to an IRA as long as an IRA is permitted to hold that type of property. Alternatively, the cash proceeds from the sale of such noncash property may be rolled over in lieu of the actual property sold. Cash equal to the fair market value of the property may not be rolled over unless the property is actually sold (i.e., an individual may not keep the property and roll over an equivalent amount of cash).

Nondeductible Employee Contributions. Nondeductible employee contributions may not be rolled over to an IRA. A participant can, however, determine which assets from the plan constitute the nondeductible contributions. A mistaken rollover to an IRA of a participant's after-tax contributions may be subject to the six percent excise tax on excess contributions under IRC section 4973. Additionally, when such amounts are distributed from the IRA, they may be treated like any other IRA distributions and be subject to income tax and the 10% excise tax under IRC section 72(t) if the recipient has not attained age 59 1/2.

Rollover to Same IRA. The withdrawal and redeposit of funds into the same IRA within a 60-day period constitutes a tax free rollover. An individual is only permitted to have one IRA rollover within any 12-month period.

Conduit IRA. If an eligible rollover from a qualified plan is rolled over to a rollover IRA, amounts from that IRA may be rolled over into another qualified plan at a future date. A new IRA should be established to receive the rollover distribution. If a distribution from a qualified plan is rolled over to an existing IRA and/or commingled with nonrollover assets, the funds cannot be rolled back into a qualified plan.

Distributions from an IRA

Disability. No penalties pertain to a distribution made on account of disability. A person is disabled if he cannot "engage in any substantial gainful activity by reason of a readily determinable physical or mental impairment which can be expected to result in death or to be of a long-continued and indefinite duration."

Age 70 1/2 Distributions. Distributions (except from a Roth IRA) must begin by the April 1 following the year in which the participant attains age 70 wQ. Distribution may be made over the life of the participant, the joint lives of the participant and his or her designated beneficiary, or sooner. If the minimum distribution requirements are not complied with, the IRS can impose a 50% penalty on the amount that should have been distributed. The IRS can waive the penalty tax if reasonable steps are taken to correct this matter.

If the owner of the IRA dies after distributions have begun, the remaining balance must be distributed at least as rapidly as the method in effect before the participant's death. If the owner died before a distribution began and did not name a beneficiary, the entire interest must be distributed within five years. If a beneficiary is named, distributions that begin within one year of the owner's death may be made over the life, or life expectancy, of the beneficiary. If the surviving spouse is the beneficiary and distributions have not begun, the spouse can defer distributions until such time as the owner would have attained age 70 1/2. Alternatively, the surviving spouse can roll over to the spouse's own IRA and delay distributions until the spouse attains age 70 1/2.

10% Additional Tax on Early Distributions from IRA. An additional 10% tax is imposed on distributions from an IRA prior to age 59 1/2. The additional 10% tax does not apply to distributions that are--

* made on or after the date on which the individual attains age 59 1/2;

* made to a beneficiary (or to the estate of an individual) on or after the death of the individual;

* attributable to the individual being
disabled;

* part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the individual or the joint lives (or joint life expectancies) of such individual and his or her designated beneficiary;

* used to pay deductible medical expenses;

* made to alternate payees receiving distributions from an IRA under a QDRO;

* made to unemployed individuals to pay health insurance premiums under certain circumstances.

* made after December 31, 1997, and used for qualified higher education expenses furnished to the taxpayer, the taxpayer's spouse, or a child or grandchild of the taxpayer; or

* made after December 31, 1997, for qualified first-time homebuyers. This exemption is subject to a $10,000 lifetime limitation. *

Richard A. Naegele, JD, is a shareholder in the law firm of Wichens, Herzer & Panza, and Mark P. Altieri, JD, LLM, CPA, is an assistant professor of accounting at Kent State University.