ROTH IRAS: TECHNICAL CORRECTIONS
By Barry C. Picker, CFP, CPA/PFS
he Taxpayer Relief Act of 1997 added IRC section 408A, creating the now very popular individual retirement account known as the Roth IRA. The basic premise of the Roth IRA is that there is no tax deduction for money going in, and no tax due on money coming out, as long as the following conditions of the section are met: The Roth IRA has been in existence for five years and the distribution occurs after the account holder attains age 59wQ , after the death of the individual, on account of disability, or for the purpose of a defined first-time home purchase.
Immediately after the passage of the new tax law, questions arose and loopholes were discovered in the Roth IRA rules. For example, an individual is permitted under certain circumstances to convert an existing traditional IRA into a new Roth IRA. The amount so converted will be included in taxable income in the year of conversion, except that, for conversions made in 1998, the resulting income will be spread ratably over four years. Since the additional 10% penalty tax on early withdrawals would not be applicable to these conversions, there appeared to be nothing to stop a taxpayer from converting their traditional IRA to a Roth and immediately withdrawing the money, thus getting the benefit of a four-year spread on the tax while avoiding the early withdrawal penalty. Also, the law was silent as to what would happen if the taxpayer died before the Roth IRA reached the five-year mark.
These issues, and more, are now addressed in the technical corrections aspects of the Internal Revenue Service Restructuring and Reform Act of 1998. The following is a discussion of the changes.
Two Thousand Dollars is Always Available. The rule for annual contributions states that an individual can contribute to a traditional IRA, a Roth IRA, or both, in any year, as long as the total amount contributed does not exceed $2,000. A drafting error in the original law would have limited certain taxpayers to a total contribution of less than $2,000, if their adjusted gross income (AGI) was such that their Roth IRA contribution was limited, but not eliminated. The technical correction clarifies this and the result is as follows: If a single taxpayer has an AGI between $95,000 and $110,000 or if married taxpayers filing a joint return have an AGI between $150,000 and $160,000, they can make a Roth contribution to the extent permitted and contribute the difference to a traditional IRA.
AGI Limitation Clarified. Individuals who wish to convert their traditional IRA to a new Roth IRA can do so only in a year in which their AGI does not exceed $100,000. The $100,000 AGI is computed, for this code section only, without including the income that results from the conversion. This has now been clarified to state that all components of AGI are computed, for this section only, with the conversion income excluded. For example, a taxpayer has a salary of $105,000 and an active participation rental loss of $6,000. If the taxpayer converts a traditional IRA to a Roth IRA, he or she will recognize $50,000 of conversion income. However when the conversion income is added into AGI, the rental loss will not be allowed. It is now clear that for purposes of determining AGI to see if the taxpayer is eligible to convert, the AGI in this example would be $99,000 ($105,000 salary less $6,000 rental loss), even though the actual tax return will not permit the rental loss.
Elect Not to Defer. Taxpayers who do a traditional to Roth conversion in 1998 will be permitted to make an election to include the entire conversion income in their 1998 taxable income, rather than taking it into account ratably over four years. This election cannot be changed after the (extended) due date of the tax return.
Death Before Four Years is Up. If a taxpayer converts his or her IRA in 1998 and then dies in either 1998, 1999, or 2000, the amount of conversion income not previously reported will be included in the decedent's final tax return. However, an exception is made if the Roth IRA is inherited by the spouse. The spouse can continue to report the conversion income on the same schedule as the decedent would have. This election cannot be made or rescinded after the due date of the spouse's tax return for the year of the decedent's death.
Convert and Run Blocked. The loophole whereby a taxpayer could convert their IRA to a Roth and then pull the money out has been closed by a combination of two new provisions. The first provision applies to the case of a 1998 conversion where the conversion income is being reported ratably over four years. Any withdrawal of the converted amount within the four years will mean an acceleration of the inclusion of the conversion income. The acceleration is accomplished by adding the withdrawal of the converted amount to income in the year of the withdrawal. However, the inclusion is limited to the remaining taxable amount of the conversion. For example, if the taxpayer converted $80,000 in 1998 (no amount attributable to nondeductible contributions) and then withdrew $10,000 in 1999, the taxpayer would have to report $30,000 of conversion income in 1999, instead of the $20,000 that would otherwise have to be included. In subsequent years, assuming no additional withdrawals, the taxpayer would report $20,000 conversion income in 2000 and $10,000 in 2001, bringing the total to the $80,000. If the taxpayer withdrew $50,000 in 1999, then $60,000 would be included in income in 1999 ($80,000 total less $20,000 included in income in 1998), and nothing would be reported in subsequent years. In no event would the total reported income exceed the taxable portion of the converted amount.
If the taxpayer has basis in a traditional IRA, the basis is deemed to come out after the taxable portion of the traditional IRA. So if the taxpayer converts a traditional IRA of $100,000 in 1998 which had a basis of $20,000, the timing of the inclusion of income would remain the same as in the preceding examples.
The second provision designed to close the loophole states that if a withdrawal is made of a converted IRA within the five-year period, IRC section 72(t) (the 10% early withdrawal penalty excise tax) will be applied to that withdrawal, as if the withdrawal were included in gross income, with the taxable portion of the IRA being deemed distributed first. If there was any IRA basis at the time of conversion due to non-deductible contributions, the portion of the subsequent withdrawal attributable to that basis will not be subject to section 72(t).
To illustrate, assume a taxpayer converts an IRA of $50,000 in 1999, and the taxpayer has a basis in the IRA of $10,000. The taxpayer will report income of $40,000 in 1999, due to the conversion. In 2003, the taxpayer withdraws $10,000 of the amount converted. The $10,000 is attributable to the income portion of the original IRA, and is therefore subject to an additional tax of $1,000, unless one of the exceptions of section 72(t) is met. Had all $50,000 been withdrawn within the five-year period, the additional tax would be limited to $4,000, since only $40,000 of the conversion was originally included in income.
Order of Distributions. In the original Roth IRA statute, it was stated that all contributions by participants would be deemed to be the first monies distributed. This had the effect of permitting tax- and penalty-free withdrawals from the Roth IRA to the extent of contributions, even if the withdrawal was made prior to age 59 wQ , or prior to the account having been in existence for five years. The technical corrections reaffirm this, but adds ordering rules to cover amounts converted from traditional IRAs. Under the revised rules, the first money coming out from a Roth IRA will be the annual contributions that have been made, followed by any converted amounts, on a first-in, first-out basis. However, as stated above, if the taxpayer had basis in the converted IRA, the basis comes out after the income portion of the conversion. The income earned or the appreciation of the assets in the account will be the last to come out. Except for the case of a withdrawal attributable to a conversion that will be subject to section 72(t) as discussed above, only the withdrawal of the income earned or asset appreciation will be subject to income tax and section 72(t), in the case of a nonqualifying withdrawal.
Comingling Allowed. At one time, it appeared that taxpayers would be required to keep their converted Roth IRAs separate from their contributory Roth IRAs. At the very least, the IRS was recommending this course of action. The technical corrections' aggregation rules eliminates the need to do this; in fact, there will be no difference whether the accounts are separate or not, since they will be treated as one for distribution rule purposes.
The distribution rules can be illustrated by the following example: A taxpayer contributes $2,000 to her Roth IRA each year for 1998, 1999 and 2000. In 2000, she converts her traditional IRA to her Roth IRA. The value at the time of the conversion is $60,000, of which $20,000 is her basis. She reports and pays tax on $40,000 on her tax return for 2000. In 2001, her Roth IRA has a value of $80,000, and she takes a withdrawal of $6,000. Since this $6,000 is attributable to her annual contributions, there is no tax consequence to this withdrawal. She then withdraws an additional $40,000. This $40,000 comes from the taxable portion of her converted IRA. It will not be subject to income tax, since income tax was paid in 2000. However it is subject to the 10% early withdrawal tax of section 72(t), unless an exception applies. At this point, the next $20,000 can be withdrawn free of income or penalty tax, since it will be attributable to the basis in the original IRA. Anything after that will be considered as coming from income, and will be subject to both income tax and penalty tax, until such time as the distribution would constitute a qualified distribution.
Mistakes Are Not Fatal. One very large question under the original statute was, what would happen if a taxpayer did a conversion, or made an annual Roth contribution, and then found that their AGI was too high? Theoretically, in the case of a conversion, the taxpayer would have emptied his entire IRA, being subject to income tax and section 72(t) tax (unless an exception was met) and losing the continued tax deferred compounding. The technical corrections address this issue by allowing taxpayers until the extended due date of their tax return to do a trustee-to-trustee transfer of any amount back to a traditional IRA as long as the transfer includes any income allocable to the amount being transferred. In fact, this ability to make a trustee-to-trustee transfer works both ways, so that a person can contribute to a traditional IRA and then transfer over to a Roth prior to the extended due date, if the taxpayer wishes to and is otherwise eligible. Keep in mind, however, that any conversion must be done by December 31st of any given year, and this provision in no way changes that. But it does remove the cloud hanging over taxpayers' heads, so that those who are unsure if their income will be over the $100,000 limit can go ahead and convert their IRAs. They will be able to revert to the IRA if it turns out that the conversion is not permitted.
There is an added advantage to this provision. Eligible taxpayers can now go ahead and convert their IRAs into Roth IRAs, and if the value of the IRA should then decrease due to market conditions, the taxpayer can then convert the account back to a traditional IRA and not have to pay tax on the loss in value. They can then subsequently reconvert the account back to a Roth, at the lower value.
Distributions After Required Beginning Date. Lastly, come 2005, if any individual past his or her required beginning date is taking a required distribution from a retirement plan, such required distribution will not count towards the $100,000 AGI limit for conversions. Thus, more people will be able to convert their IRAs to Roths. However, the required distribution will still be counted as taxable income, and such required distributions must be taken and cannot be converted to a Roth.
Hopefully, with all these corrections, Congress has now gotten it right. Taxpayers can go ahead with their Roth contributions and conversions, knowing exactly where they stand. *
Edward A. Slott, CPA
E. Slott & Co.
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