September 1999

IRA Planning


By Edward A. Slott

On May 26, 1999, in announcement 99-57, the IRS gave the details of tax relief for certain ineligible Roth IRA converters. Apparently, many taxpayers were confused by the various Roth IRA tax rules. The IRS has reported that some people converted to Roth IRAs even though their income exceeded the $100,000 limit or they otherwise did not qualify for the Roth conversion.

Originally, a filing to recharacterize the election had to be made by the extended due date of the return. Taxpayers who filed for extensions still have time to recharacterize their ineligible Roth conversions. The problem exists for those who timely filed their 1998 tax returns. These taxpayers would be forced to withdraw their newly converted Roth IRA account, thus losing all future tax-deferred growth. They would also have to include the remaining 75% of the conversion as 1998 income if they opted to include the converted amount in income over a four-year period. Additionally, they would owe tax on any earnings on the converted amount, a 10% penalty on the entire current account value, (unless they had reached the age of 59 wQ ), and a 6% penalty on the conversion, which would be considered an excess contribution to the Roth IRA.

Due to lack of knowledge of the rules, taxpayers would lose their IRAs to the extent that they were converted and incurred sizeable penalties. The last thing that Congress, and especially Senator Roth, would want is for taxpayers to regret the day they ever heard of the Roth IRA.

The IRS to the Rescue

The IRS has solved the problem, so Congress no longer has to be concerned on election day. Usually it is the tax experts who look for loopholes, but this time the IRS found one that will allow taxpayers who filed their returns timely, by the April 15, 1999, due date, to have until October 15, 1999, to recharacterize their 1998 Roth conversions. The loophole was created by calling the decision to recharacterize a tax election and claiming relief under Regulations section 301.9100-2(b), which provides for an automatic extension of 6 months from the due date of the return for tax elections. The IRS concludes in their announcement that "consequently, calendar-year taxpayers who timely filed their 1998 returns may elect to recharacterize 1998 Roth IRA conversions ... on or before October 15, 1999."

How to Get Relief

In order to claim relief, as with all recharacterizations, the Roth IRA funds must be transferred back to a traditional IRA in a trustee-to-trustee transfer. The funds must go directly from the Roth account to the traditional IRA, or the Roth IRA can be redesignated as a traditional IRA within the same financial institution.

The IRS announcement states that the taxpayer must notify both the Roth IRA trustee (bank, broker or fund) and the trustee receiving the recharacterized funds (if different) with the information necessary to effect the recharacterization. The taxpayer must also file an amended tax return, Form 1040X, within 3 years of the original due date of the return. The recharacterization must be completed by October 15, 1999. The amended tax return would result in a refund of any conversion tax paid, so there is really no reason to delay filing. If applicable, an amended state return should be filed to recover tax paid as well as to avoid any state-imposed penalties on an ineligible Roth IRA.

It's back. Form 8606, Nondeductible IRAs, must also be filed with the amended return to report recharacterization. The gain or loss on the entire recharacterization should be reconcilable to the 1099 forms which the trustee bank, broker or mutual fund will issue to the IRS. The 1099 amount will not agree with the Form 8606 amount, so a schedule reconciling the two should be attached to the Form 8606.

Planning Opportunities: What the IRS Didn't Say

The IRS announcement did not say that the extension of time to recharacterize applies only to those who made a conversion improperly. Rather, this ruling applies to all taxpayers. This is true even if a taxpayer qualified for the Roth conversion but decided she wanted her tax money back.

Example 1. In 1998, Mary converted a $100,000 IRA to a Roth IRA. She filed her return without extension. Her income was under the limit, so she was eligible to convert. Mary's Roth IRA money was invested in and is now valued at $5,000. She paid the tax on one quarter of the $100,000. If not for the IRS's new position, Mary would be stuck paying the tax over the next three years with the hope that the stock rebounds. Now, Mary has until October 15, 1999 to watch Anything. Com and decide if she wants a do-over. Mary won't get her money back from the investment, but she can receive a tax refund for the conversion tax paid and eliminate the liability for the remaining installments. Furthermore, unless there is a dramatic change in the IRS's position, this break will apparently be available every year.

The 6-month extension will also help married couples who may have converted their traditional IRA to a Roth IRA and inappropriately filed separate returns. It will provide the same relief for anyone in this situation, granting them an opportunity to correct the problem and recharacterize until October 15, 1999. The IRS calls the procedure "appropriate corrective action."

Example 2. Recharacterizations can also be applied in the reverse order. Assume John made a tax deductible (or a nondeductible) contribution to a traditional IRA and filed his return by April 15, 1999. Now John realizes that he may have been better off contributing to a Roth IRA instead of a traditional IRA. John will be allowed to recharacterize as a Roth IRA even though he already filed his return. As an added bonus, the new Roth IRA will be treated as if it had originally been a Roth IRA and the 5-year Roth IRA clock will still begin as of January 1, 1998. This is true even though John's 1998 annual IRA contribution was not designated as a Roth IRA contribution until up to 21 Qw months later.

Example 3. Here's another possibility: Let's say Suzie's income exceeded the limits. She filed her 1998 tax return timely, without an extension. The phase-out income limits for contributing to a Roth IRA are $95,000­$110,000 (single) and $150,000­$160,000 (married-joint). Previously, Suzie would have an ineligible Roth IRA and no relief. Now, she has up to October 15, 1999, to recharacterize her contribution as a traditional IRA.

Example 4. In 1998, Max contributed to a Roth IRA and filed his return by April 15, 1999. Now he wants to have a tax-deductible IRA instead. Max has until October 15, 1999 to recharacterize his 1998 Roth IRA contribution back to a traditional IRA, assuming he otherwise qualifies for the tax deduction. There are no extensions allowed for IRA contributions (Roth or traditional), so they must be made by the original due date of the return. But when recharacterizing, the IRA contribution is treated as if it had originally been made to the recharacterized IRA account. In this example, the traditional deductible IRA contribution will be treated as if it were timely made, even though the original return was already filed and the actual money was not in the traditional IRA until October 15, 1999.

Thanks, IRS

The IRS is to be commended for the proactive position it has taken to benefit many taxpayers who either did not know the rules or were so perplexed by the many tax law changes that they committed costly errors. If not for the IRS's taxpayer-friendly position, the Roth IRA would go down in tax history as another Congressional foul-up, leaving confused and angry taxpayers licking their wounds and thinking twice about any future tax "breaks." *

Edward A. Slott, CPA, E. Slott & Co., is the editor of Ed Slott's IRA Advisor, from which this article was adapted.


By Edward A. Slott

Since there have been so many recent changes in position, including the IRS announcement 99-57 described in the accompanying article, a brief review is needed to clear up any remaining confusion regarding conversions, recharacterizations, and reconversions.

1998 Rules

January 1­October 31, 1998: No rules. Unlimited conversions, recharacterizations, and reconversions.

November 1­December 31, 1998: Only one "round trip" allowed. A round trip is a conversion, a recharacterization, a reconversion, and a recharacterization of the reconversion if desired or necessary. A second reconversion is not allowed during this time period.

1999 Rules

Same as the 1998 rules. Only one round trip allowed for 1999.

2000 Rules

Beginning in 2000, a second conversion (a reconversion) of the same money in the same calendar year is not permitted. Rather, once converted, and then recharacterized, a taxpayer must wait to reconvert until the later of the next calendar year or 30 days after the recharacterization. For example, if a taxpayer converted in 2000 and recharacterized that conversion on December 20, 2000, she would have to wait 30 days to reconvert; reconversions as of January 1, 2001, would not be permitted.

Example: Oscar converted a traditional IRA to a Roth in 1999 and then recharacterized (undid the Roth conversion) sometime later in 1999. He then reconverts the same IRA money to a Roth in 2000. Is this really a reconversion? If so, it is not permitted in 2000. The answer is that this is not a reconversion, even though it's the same IRA money being contributed back to the Roth IRA. This will be a 2000 conversion, which can be recharacterized in 2000, but cannot be reconverted until the later of 2001 or 30 days after the 2000 recharacterization. *

Edward A. Slott, CPA
E. Slott & Company

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