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ROTH IRAs
Including Technical Corrections in the IRS Restructuring and Reform Act of 1998.

1998 by Noel C. Ice, Cantey & Hanger, Fort Worth, Texas

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CONTENTS

WHAT IS A ROTH IRA?
CONTRIBUTIONS TO REGULAR (Non-Roth) IRAs
ANNUAL (NON ROLLOVER) CONTRIBUTIONS TO A ROTH IRA
TAXATION OF DISTRIBUTIONS FROM A ROTH IRA
ROLLOVERS TO A ROTH IRA
ISSUES NOT EXPRESSLY COVERED BY THE STATUTE
MISCELLANEOUS MATTERS
THE ECONOMICS OF A ROTH IRA CONVERSION

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WHAT IS A ROTH IRA?

What is the Basic Approach Used in this Outline For Explaining the Roth IRA Rules?

The approach I will take in this memorandum is to parse 408A, piece by piece, not necessarily in the order in which the statute was drafted, explicating the statute by means of questions which the statute answers (we hope).

 

By the end of this memo, the statute will have been quoted in its entirety. This approach has the advantage of at least being thorough, and the conclusions subject to some sort of empirical check, which in this case is particularly apropos, because the statute is new, there are no regulations, and even the commentators differ on its precise meaning in some cases. I will, of course, add comments as appropriate, and at the end of the memo will devote a series of questions and answers to issues that are outside of the statutory language, and hence, not amenable to the parsing method.

 

This memo was written just days after the Roth Technical Corrections were enacted (the IRS Restructuring and Reform Act of 1998, PL 105-206, was signed into law 7/23/98), and so I have had little time to fully digest its implications. Please take this into account. The next version of this memo will be more polished.

What is a Roth IRA?

(a) General rule. Except as provided in this section [408A], a Roth IRA shall be treated for purposes of this title [Title 26 of the US Code, i.e., the Internal Revenue Code] in the same manner as an individual retirement plan.

Further, "the term "Roth IRA" means an individual retirement plan (as defined in section 7701(a)(37)) which is . . ."

So, except as otherwise provided in 408A, a Roth IRA is just like an ordinary IRA (Individual Retirement Account/Annuity). The "except" part is where the sizzle is, because there are some very important differences.

What Are the Most Important Differences Between a Roth IRA and a Regular IRA?

Each of the differences will be discussed in detail below. However, here is a preview:

(1) Contributions to a Roth IRA are not deductible.

(2) Distributions from a Roth IRA (if qualified) are income tax free.

(3) And, finally, there are no minimum required lifetime distributions.

Where is the Roth IRA Statute Found?

An ordinary IRA is created and described by IRC 408. The Roth IRA is described in 408A.

What Are the Primary Tax Benefits of a Roth IRA?

If certain conditions are met, distributions from a Roth IRA are tax free. Further, the mandatory minimum distributions rules of IRC 401(a)(9) and 408(a)(6) & (b)(3) do not apply during the life of the Roth IRA owner.

(A) Exclusions from gross income. Any qualified distribution from a Roth IRA shall not be includible in gross income.

* * * *

 

(5) Mandatory distribution rules not to apply before death. Notwithstanding subsections (a)(6) and (b)(3) of section 408 (relating to required distributions), the following provisions shall not apply to any Roth IRA:

(A) Section 401(a)(9)(A) [i.e., the minimum required distribution rules applicable during the lifetime of the participant, after age 70&1/2].

(B) The incidental death benefit requirements of section 401(a) [a rule that benefits are primarily for the benefit of the participant and not fort the benefit of the participant’s beneficiaries].

Is a Roth IRA an IRA?

The statute is explicit that a Roth IRA is a type of IRA and is to be treated the same as an ordinary IRA, except as otherwise provided.

(a) General rule. Except as provided in this section, a Roth IRA shall be treated for purposes of this title in the same manner as an individual retirement plan.

(b) Roth IRA. For purposes of this title, the term "Roth IRA" means an individual retirement plan (as defined in section 7701(a)(37)) which is designated (in such manner as the Secretary may prescribe) at the time of the establishment of the plan as a Roth IRA. Such designation shall be made in such manner as the Secretary may prescribe.

When 408A Refers to an Individual Retirement Plan, What Does it Mean?

As indicated in IRC 408A(b) quoted above, an individual retirement plan has the definition used in 7701(a)(37). 7701(a)(37) reads as follows:

(37) Individual retirement plan. The term "individual retirement plan" means --

 

(A) an individual retirement account described in section 408(a), and

(B) an individual retirement annuity described in section 408(b).

 

408(a) describes a conventional IRA. Is a SEP IRA an individual account described in 408(a)? Well, yes; but SEPs appear to be excluded under 408A(f).

CONTRIBUTIONS TO REGULAR (Non-Roth) IRAs

Is It Necessary to Know the Rules Applicable to Regular IRAs In Order to Understand Roth IRAs?

To a certain extent it is necessary to understand the rules applicable to regular IRAs in order to understand the rules applicable to Roth IRAs, if for no other reason than that the Roth IRA rules make reference to and in many cases incorporate the normal IRA rules. Therefore, without turning this memo into a full explication of the normal IRA rules, those rules will be discussed briefly so far as necessary.

The limit on Roth IRA contributions is defined by reference to the limit on regular IRA contributions: "The aggregate amount of contributions for any taxable year to all Roth IRAs maintained for the benefit of an individual shall not exceed the excess (if any) of — (A) the maximum amount allowable as a deduction under section 219."

What Statute Governs Regular IRAs?

Normal or regular IRAs are governed by IRC 408, for the most part. This statute is too long to quote in its entirety here, though I am sorely tempted to, to make a point.

The regular IRA limits are not particularly easy to describe, and to describe them in detail here would be a significant digression. Nevertheless, a summary will be attempted.

What Statute Governs Contributions to Regular IRA?

IRC 219 governs contributions to regular IRAs. A complete copy of this statute 219, including the special rules that apply only to volunteer firefighters, dog catchers and certified paleo-ornithologists, is contained in the following footnote which represents tax simplification at its worst. I quote this statute in its entirety, in part for your ready reference, and in part to make the point I wanted to make when I did not quote 408 in full.

Where Can One Find A Good Summary of the Regular IRA Rules?

A very good (free) source of information is the IRS’ own publication on the subject, Pub. 590. Dave Foltz, an attorney with Comerica Bank, recently called my attention to the fact that this publication was 8 pages in 1978, 48 pages in 1992 and 72 pages in 1996! The regulations explaining the minimum required distribution rules are only slightly longer, but then they are single spaced using small type.

 

When you consider that tens of millions of Americans have IRAs, it is somewhat of an insult to the electorate that their own representatives would pass a law this important and universal in its application that at its simplest level takes 78 pages to explain in layperson language.

  Publication 78 can be found on the world wide web in a number of places, including—
http://www.benefitslink.com/index.cgi/forms/pub590.html

It can also be accessed, as a link, from David Baker’s employee benefits web site: http://www.benefitslink.com/index.shtml.

How Much Can an Individual Contribute to a Regular IRA?

The basic deduction limit under the regular IRA rules is $2000 per year, if neither the taxpayer nor the taxpayer’s spouse is an active participant in a qualified plan. If either the taxpayer or the taxpayer’s spouse is an active participant in a qualified plan —including being eligible to contribute to a 401(k) plan even if the taxpayer or spouse elects not to contribute—, the amount deductible depends on the taxpayer’s adjusted gross income (AGI). Here is an executive summary of the regular IRA deduction limits.

Executive Summary of Deduction Limits Applicable to Regular IRAs.

If the taxpayer is unmarried and is an active participant in a qualified plan, then the taxpayer cannot make a deductible IRA contribution if the taxpayer has $40,000 in AGI (adjusted for inflation after 1998). Between $30,000 and $40,000 the $2000 deduction limit is phased out pro rata.

 

If the taxpayer is married filing separately, then unless the spouses are not living together, no contribution can be made to a regular IRA if either spouse is an active participant in a qualified plan.

 

If the taxpayer is married filing jointly and is an active participant in a qualified plan, the taxpayer cannot make a deductible regular IRA contribution if the taxpayer has AGI over $60,000 (adjusted for inflation after 1998). Between $50,000 and $60,000 the $2000 deduction limit is phased out pro rata. (The $10,000 difference rises to $20,000 in the case of a joint return for a taxable year beginning after December 31, 2006).

 

If the taxpayer is married filing jointly and is not an active participant in a qualified plan, but the taxpayer’s spouse is an active participant in a qualified plan, then the applicable dollar amount is $150,000 and the phase-out amount is $10,000. Such a taxpayer can deduct $2000 if AGI is $150,000 or less, can deduct $1000 if AGI is $155,000, and can deduct nothing if AGI is $160,000 or more.

What Changes to 219 Were Wrought By the IRS Restructuring and Reform Act?

Until 1998, the AGI limits applied without modification to both a husband and wife if either was an active participant in a qualified plan. The IRS Restructuring and Reform Act of 1998 eased this rule in those cases where the taxpayer is not an active participant in a qualified plan, but the taxpayer’s spouse is. In that case, under the new rules described above, the applicable dollar amount is $150,000 and the phase-out amount is $10,000. Part of the fun of being a tax lawyer is that the rules change every Monday.

How Does the Statute Describe the Phase-Out Rule?

The phase out of the deduction, which I simply described as pro-rata, is described in the statute more precisely as follows:

(A) In general. The amount determined under this paragraph with respect to any dollar limitation shall be the amount which bears the same ratio to such limitation as —

(i) the excess of —

(I) the taxpayer's adjusted gross income for such taxable year, over

(II) the applicable dollar amount, bears to

(ii) $10,000 ($20,000 in the case of a joint return for a taxable year beginning after December 31, 2006).

Can a Taxpayer Make a Nondeductible Contribution to a Regular IRA?

A taxpayer can make a nondeductible contribution to a regular IRA, but with the advent of the Roth IRA, no one should ever do this if the Roth IRA is available as an alternative. Unfortunately, the AGI limits may make the Roth IRA unavailable as an alternative.

 

The rules on nondeductible regular IRA contributions are found in 408(o).

The advantage of making a nondeductible contribution to a regular IRA is that the growth while in the IRA is tax free. Unlike a Roth IRA, however, the earnings are taxable when withdrawn.

Do the AGI Limits Apply to a Nondeductible Regular IRA Contribution?

The amount that can be contributed to a nondeductible regular IRA is the same as that which can be contributed to a regular deductible IRA ($2000), except that there are no AGI limitations. Of course, the AGI limits apply to a regular IRA only if the taxpayer or spouse is an active participant in a qualified plan; but then, if the taxpayer or spouse is not an active participant in a qualified plan, the taxpayer would certainly prefer a deductible regular IRA contribution to a nondeductible regular IRA contribution.

 

The concept of an AGI limit is common to both Roth IRAs and regular IRAs; unfortunately, the limits do not correspond exactly.

ANNUAL (NON ROLLOVER) CONTRIBUTIONS TO A ROTH IRA

Can Anyone Contribute to a Roth IRA?

A major problem with the Roth IRA is that not everyone is eligible to contribute to one. A Taxpayer whose adjusted gross income (AGI) exceeds the "applicable dollar amount" are either limited or prevented from making a contribution to a Roth IRA.

(ii) the applicable dollar amount is —

(I) in the case of a taxpayer filing a joint return, $150,000,

(II) in the case of any other taxpayer (other than a married individual filing a separate return), $95,000, and

(III) in the case of a married individual filing a separate return, zero.

 

Note that there are different limits applicable to Roth IRA rollovers. These will be discussed later.

 

Taxpayers whose adjusted gross income exceeds the "applicable dollar amount" may still contribute to a Roth IRA if the excess is within 10 to 15 thousand dollars. In the inimitable style of the IRC, the pro rata phase out is described as follows:

 

(A) Dollar limit. The amount determined under paragraph (2) for any taxable year shall not exceed an amount equal to the amount determined under paragraph (2)(A) for such taxable year, reduced (but not below zero) by the amount which bears the same ratio to such amount as —

(i) the excess of —

(I) the taxpayer's adjusted gross income for such taxable year, over

(II) the applicable dollar amount, bears to

 

(ii) $15,000 ($10,000 in the case of a joint return or a married individual filing a separate return).

The rules of subparagraphs (B) and (C) of section 219(g)(2) shall apply to any reduction under this subparagraph.

 

219(g)(2)(B)&(C), in turn, provide:

(B) No reduction below $200 until complete phaseout. No dollar limitation shall be reduced below $200 under paragraph (1) unless (without regard to this subparagraph) such limitation is reduced to zero.

(C) Rounding. Any amount determined under this paragraph which is not a multiple of $10 shall be rounded to the next lowest $10.

What Does "Adjusted Gross Income" Mean Under the Statute?

Until 2005, "adjusted gross income shall be determined in the same manner as under section 219(g)(3), except that any amount included in gross income under subsection (d)(3) shall not be taken into account."

 

Income included under (d)(3) means income recognized as a result of the rollover from a regular IRA to the Roth IRA. Not taking the conversion from the regular to the Roth IRA into account can indirectly effect such things as the amount of passive losses that the taxpayer can theoretically recognize in determining AGI. For example, under the statute, as amended, the taxpayer can compute AGI as if passive losses would be available, when in fact they will be lost as a result of the recognition of the conversion income.

 

However, effective for tax years beginning after 12/31/2004:

(i) adjusted gross income shall be determined in the same manner as under section 219(g)(3), except that —

(I) any amount included in gross income under subsection (d)(3) [i.e., recognized because of the rollover] shall not be taken into account, and

(II) any amount included in gross income by reason of a required distribution under a provision described in paragraph (5) [i.e., the minimum required distributions applicable to regular IRAs after age 70&1/2, which by the way, cannot be rolled over to a Roth or any other IRA] shall not be taken into account for purposes of subparagraph (B)(i) [i.e., for purposes of the $100,000 AGI rollover limit!].

 

Under IRC 219(g)(3)(A),

(A) Adjusted gross income. Adjusted gross income of any taxpayer shall be determined —

(i) after application of sections 86 and 469, and

(ii) without regard to sections 135 [sic], 137, and 911 or the deduction allowable under this section.

 

The difference between the current rule and the rule in 2005 is that in and after the later date, amounts required to be distributed under the minimum distribution rules during the lifetime of the IRA owner will not be included in determining whether the taxpayer’s adjusted gross income exceeds the rollover Roth IRA AGI limits. Note that this change does not apply to the Roth IRA contribution (non rollover) limits.

 

This change is important, and it is too bad this rule is not in effect now. It means that a client interested in qualifying to make a Roth IRA rollover might need to make the rollover before his or her required beginning date (RBD, April 1 of the year following the year the taxpayer reaches age 70&1/2), if the minimum required distributions after the RBD would cause the taxpayer’s AGI to exceed the $100,000 limit discussed below.

Can a Minimum Required Distribution From a Regular IRA Be Rolled Over to a Roth IRA?

Whether or not a minimum required distribution (MRD) is required to be taken into account in applying the AGI limits, in no event can the MRD be rolled over to a Roth IRA or to any other IRA.

 

Treas. Reg. 1.402(c)-2 Q&A 7(a) provides in part:

A-7. (a) General rule. Except as provided in paragraphs (b) and (c) of this Q&A, if a minimum distribution is required for a calendar year, the amounts distributed during that calendar year are treated as required minimum distributions under section 401(a)(9), to the extent that the total required minimum distribution under section 401(a)(9) for the calendar year has not been satisfied. Accordingly, these amounts are not eligible rollover distributions. . . . [Emphasis added.]

Is an Income Tax Deduction Allowed For a Contribution to a Roth IRA?

"No deduction shall be allowed under section 219 [or under any other section, for that matter] for a contribution to a Roth IRA."

How Much Can an Individual Contribute Each Year to a Roth IRA?

(2) Contribution limit. The aggregate amount of contributions for any taxable year to all Roth IRAs maintained for the benefit of an individual shall not exceed the excess (if any) of —

(A) the maximum amount allowable as a deduction under section 219 with respect to such individual for such taxable year (computed without regard to subsection (d)(1) or (g) of such section), over

(B) the aggregate amount of contributions for such taxable year to all other individual retirement plans (other than Roth IRAs) maintained for the benefit of the individual.

 

The reference to 219(d)(1)&(g) above are important. IRC 219(d)(1) provides, in the case of a regular IRA:

(1) Beneficiary must be under age 701/2. No deduction shall be allowed under this section with respect to any qualified retirement contribution for the benefit of an individual if such individual has attained age 701/2 before the close of such individual's taxable year for which the contribution was made.

 

And IRC 219(g)(1) provides, in the case of a regular IRA:

(g) Limitation on deduction for active participants in certain pension plans. (1) In general. If (for any part of any plan year ending with or within a taxable year) an individual or the individual's spouse is an active participant, each of the dollar limitations contained in subsections (b)(1)(A) and (c)(1)(A) for such taxable year shall be reduced (but not below zero) by the amount determined under paragraph (2).

 

What all this means is that an individual cannot contribute any more to a Roth IRA than he or she can to an ordinary IRA, and that any contribution to an ordinary IRA will reduce the amount available for contribution to a Roth IRA; except that the limitation on contributions after age 70&1/2, and the AGI and active participation limitations applicable to regular IRAs, do not apply to Roth IRAs. Of course Roth IRAs have their own AGI limits. The fact that the limits are not the same contributes some confusion to the area.

Unlike a regular IRA, a Roth IRA can receive contributions from a 71 year old who is an active participant in a qualified plan, if the special Roth AGI limits can be met.

Does a Contribution to a SEP-IRA or Simple IRA Reduce the Amount that a Taxpayer Can Contribute to a Roth IRA?

Technical Corrections in the IRS Restructuring and Reform Act of 1998 make it clear that contributions to a SEP-IRA or Simple IRA do not reduce the amount otherwise available for contribution to a Roth IRA.

(2) contributions to any such pension or account [i.e., "a simplified employee pension or a simple retirement account"] shall not be taken into account for purposes of subsection (c)(2)(B).

 

Subsection (c)(2)(B) provides that "the aggregate amount of contributions for any taxable year to all Roth IRAs maintained for the benefit of an individual shall not exceed the excess (if any) of . . . the aggregate amount of contributions for such taxable year to all other individual retirement plans (other than Roth IRAs) maintained for the benefit of the individual."

Do The Regular IRA Contribution Limits Apply to Roth IRA Contributions?

It is important to note that the regular IRA contribution limitations under discussion do not apply to Roth IRA rollovers, a subject that will be discussed in detail later.

May Contributions to a Roth IRA Be Made After Age 70&1/2?

"Contributions to a Roth IRA may be made even after the individual for whom the account is maintained has attained age 701/2."

Can Contributions to a Roth IRA Made After the End of the Year be Treated as Having Been Made on the Last Day of the Preceding Year?

(7) Time when contributions made. For purposes of this section, the rule of section 219(f)(3) shall apply.

219(f)(3), in turn, provides:

(3) Time when contributions deemed made. For purposes of this section, a taxpayer shall be deemed to have made a contribution to an individual retirement plan on the last day of the preceding taxable year if the contribution is made on account of such taxable year and is made not later than the time prescribed by law for filing the return for such taxable year (not including extensions thereof). [Emphasis added.]

 

Since no deduction is allowed for a contribution to a Roth IRA, the main significance of fixing the contribution year is for purposes of computing the 5-year time period required for tax free distributions, discussed below, and for computing the annual deduction limitations for regular Roth IRA contributions.

 

Interestingly, for purposes of the distribution rules of subsection (d), the due dates would include extensions.

(7) Due date. For purposes of this subsection, the due date for any taxable year is the date prescribed by law (including extensions of time) for filing the taxpayer's return for such taxable year.

 

408A(d) covers the definition of a "qualified distribution" (including the 5-year rule), rollovers from non Roth IRAs to Roth IRAs, etc.

Is There a Special Rule For Married Taxpayers Filing Separately And Living Apart Applicable In Applying the Contribution Limits and the Rollover Limits?

"(D) Marital status. Section 219(g)(4) shall apply for purposes of this paragraph." [Emphasis added.]

The paragraph referred to is 408A(c)(3), which contains the limitation on contributions in 408A(c)(3)(A)&(C) by reference to the "applicable dollar amount" ($150,000/$90,000), and which also contains the $100,000 adjusted gross income limit on rollover eligibility described in 408A(c)(3)(B).

219(g)(4), in turn, provides:

 

(4) Special rule for married individuals filing separately and living apart. A husband and wife who —

(A) file separate returns for any taxable year, and

(B) live apart at all times during such taxable year, shall not be treated as married individuals for purposes of this subsection.

TAXATION OF DISTRIBUTIONS FROM A ROTH IRA

Are Distributions From a Roth IRA Tax Free?

If the distribution from a Roth IRA is a "qualified distribution," it is excluded from income for income tax purposes:

"Any qualified distribution from a Roth IRA shall not be includible in gross income."

What is a Qualified Distribution?

(2) Qualified distribution. For purposes of this subsection —

(A) In general. The term "qualified distribution" means any payment or distribution —

 

(i) made on or after the date on which the individual attains age 591/2,

(ii) made to a beneficiary (or to the estate of the individual) on or after the death of the individual,

 

(iii) attributable to the individual's being disabled (within the meaning of section 72(m)(7)), or

 

(iv) which is a qualified special purchase distribution. [Emphasis added.]

What is a Qualified Special Purchase Distribution?

(5) Qualified special purpose distribution. For purposes of this section, the term "qualified special purpose distribution" means any distribution to which subparagraph (F) of section 72(t)(2) applies.

In case you were wondering, IRC 72(t)(2)(F), in turn, provides:

(F) Distributions from certain plans for first home purchases. Distributions to an individual from an individual retirement plan which are qualified first-time homebuyer distributions (as defined in paragraph (8)). Distributions shall not be taken into account under the preceding sentence if such distributions are described in subparagraph (A), (C), (D), or (E) or to the extent paragraph (1) does not apply to such distributions by reason of subparagraph (B).

***Are There Any Important Exceptions to the Qualified Distribution Definition —Distributions Within 5 Years, For Example?

A very important exception to the qualified distribution definition is for distributions within 5 years of the initial contribution.

(B) Distributions within nonexclusion period. A payment or distribution from a Roth IRA shall not be treated as a qualified distribution under subparagraph (A) if such payment or distribution is made within the 5-taxable year period beginning with the 1st 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.

Can a Taxpayer Start the 5-year Period Running With a Token Contribution Now?

The statute, as amended, appears to say that if a Roth IRA was established more than five years prior to the distribution, it makes no difference that contributions to the already established Roth IRA were made within five years of the distribution! This reading is supported by the Senate Committee Reports to the IRS Restructuring and Reform Act of 1998. Query, what happens if you set up a Roth IRA today, with a $1 contribution, withdraw it tomorrow, and make a "real" Roth IRA contribution or rollover 5 years from now? Is the 5 year distribution rule a concern any longer?

 

Prior to its amendment, IRC 408A(d)(2(B)(ii) applied a separate five year waiting period for Roth rollover IRAs. Prior to its amendment, IRC 408A(d)(2(B) read:

 

(B) Certain distributions within 5 years. A payment or distribution shall not be treated as a qualified distribution under subparagraph (A) if —

(i) it is made within the 5-taxable year period beginning with the 1st 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, or

(ii) in the case of a payment or distribution properly allocable (as determined in the manner prescribed by the Secretary) to a qualified rollover contribution from an individual retirement plan other than a Roth IRA (or income allocable thereto), it is made within the 5-taxable year period beginning with the taxable year in which the rollover contribution was made.

 

While the provision just quoted was still in effect, the IRS indicated that it was important to keep rollover Roth IRAs and annual contribution Roth IRAs separate, but the IRS Restructuring and Reform Act of 1998 would appear to make this no longer necessary. My reading of the recent amendments is that the five year period begins, not when a particular contribution is made, but when the first contribution is made, and that the rule is the same for rollovers as for other contributions. We will have to see if this reading is correct.

In Order to Avoid Recapture Under the 5-Year Rule, Does the Taxpayer Look to the Anniversary Date of the Initial Establishment of the Roth IRA?

Note that the statute does not require that the distribution be on the 5th anniversary of the establishment of the Roth IRA. Rather, the distribution must be made after the end of the 5 taxable year period in order to entirely avoid income taxation. So, if a contribution were made on April 14 of 2002 which was attributed to taxable year 2001, the first tax free distribution of earnings could be made January 1, 2006, taxable year 6, a total of 3 years, 8 months and 16 days.

Can the Distribution of An Excess IRA Contribution Be Treated as a Qualified Distribution?

(C) Distributions of excess contributions and earnings. The term "qualified distribution" shall not include any distribution of any contribution described in section 408(d)(4) and any net income allocable to the contribution.

408(d)(4) overrides the general rule of 408(d)(1) that causes inclusion of IRA distributions in gross income under 72. 408(d)(4) provides that 408(d)(1) "does not apply to the distribution of any contribution paid during a taxable year to an individual retirement account or for an individual retirement annuity to the extent that such contribution exceeds the amount allowable as a deduction under section 219 if (1) the contribution is returned before the due date of the individual’s tax return (including extensions if applicable), (2) no deduction is allowed under 219, and the income attributable to the excess contribution is returned as well.

 

I think that this provision is in the statute simply to assure that the income on the returned contribution will be taxed.

How is a Distribution Taxed If It Is Not a Qualified Distribution?

If a distribution is not a qualified distribution, it is not necessarily exempt from income. If the taxpayer has already paid tax on the amount distributed, then it would be tax exempt, even if not part of a qualified distribution. If (or rather, since) the account has earnings and appreciation, it is necessary to determine whether it is the earnings and appreciation that is being distributed as a part of the nonqualified distribution, or whether it is after-tax contributions are being returned. The IRS Restructuring and Reform Act of 1998 gives us ordering rules with which to make this determination.

Are Nonqualified Distributions Subject to the 10% Premature Distribution Tax?

Recall 408A(a):

(a) General rule. Except as provided in this section, a Roth IRA shall be treated for purposes of this title in the same manner as an individual retirement plan.

 

As in the case of a regular IRA, a nonqualified distribution from a Roth IRA, if includable in income, will now be subject to the 10% premature distribution tax of 72(t), if the taxpayer is under age 59&1/2, for example. In addition, even previously taxed distributions (which are therefore not includable in income when distributed) will be subject to 72(t) if a rollover contribution is withdrawn before the end of the 5-year period. This is a matter that will be discussed later in this outline.

Does the Owner Have a Basis in Contributions to the Roth IRA?

It is a fundamental (though not in all cases universal) concept of income taxation that income is only taxed once and that the cost or other basis of an asset is recaptured tax free if the asset is sold or exchanged. Now tax has already been paid on amounts contributed to a Roth IRA. Therefore, even if a distribution is not a qualified distribution, all or a portion of the amount distributed will have already been taxed; and, consequently, the taxpayer will have a basis in it.

If Amounts Are Withdrawn From a Roth IRA, How Are Those Amounts Allocated or Attributed? In Other Words, Are There Any Ordering Rules?

Both before and after the IRS Restructuring and Reform Act, withdrawals from Roth IRAs received very favorable treatment. Originally, the statute simply provided that if a distribution was made, the taxpayer’s contributions (basis) would be treated as distributed first. While retaining this original approach, the IRS Restructuring and Reform Act of 1998 replaced this broadly favorable rule with a more precise set of ordering rules.

 

The Senate Committee Reports to the IRS Restructuring and Reform Act of 1998 describes the new rules this way:

 

Ordering rules. Ordering rules will apply to determine what amounts are withdrawn in the event a Roth IRA contains both conversion amounts (possibly from different years) and other contributions. Under these rules, regular Roth IRA contributions will be deemed to be withdrawn first, then converted amounts (starting with the amounts first converted). Withdrawals of converted amounts will be treated as coming first from converted amounts that were includible in income. As under present law, earnings will be treated as withdrawn after contributions. For purposes of these rules, all Roth IRAs, whether or not maintained in separate accounts, will be considered a single Roth IRA.

How is Basis Recaptured in the Case of a Distribution that is Not a Qualifying Distribution?

I would describe the ordering rules as treating distributions as coming from non-rollover contributions first, from taxable rollover contributions second, and from nontaxable rollover contributions next.

The new statute, 408A(d)(4)(B), is somewhat imposing, but the essential import is that after-tax contributions to a Roth IRA (including rollovers) will come out first, and it is only after all previously taxed contributions are recovered that distributions will be taxable, and then only if the distribution is a not a qualified distribution. The statute, as amended, provides:

Are Contributions Made to all Roth IRAs Considered First?

The ordering rules, as set forth in IRC 408A(d)(4)(B), read as follows:

(B) Ordering rules. For purposes of applying this section and section 72 [the section that imposes a tax on IRA distributions] to any distribution from a Roth IRA, such distribution shall be treated as made —

(i) from contributions to the extent that the amount of such distribution, when added to all previous distributions from the Roth IRA, does not exceed the aggregate contributions to the Roth IRA, and

Within the Class of Contributions, Are Rollover Contributions Considered Last on a FIFO Basis?

(ii) from such contributions in the following order:

(I) Contributions other than qualified rollover contributions to which paragraph (3) applies.

(II) Qualified rollover contributions to which paragraph (3) applies on a first-in, first-out basis.

Are Rollover Contributions (Considered on a FIFO Basis) Allocated First to Amounts Previously Included in Income?

Any distribution allocated to a qualified rollover contribution under clause (ii)(II) shall be allocated first to the portion of such contribution required to be included in gross income.[Emphasis added.]

I assume that the phrase "required to be includable in gross income" is a reference to previously taxed regular and rollover contributions, which means it would be tax-free at this point. A hasty reading (to which I do not subscribe) might give the opposite impression: that the allocation is made to distributions now required to be taxed.

 

In sum, if a nonqualifying distribution is made, the distribution will be treated as having been made out of non rollover contributions first, which means the distribution proceeds will be tax free to that extent. After all non rollover contributions have been deemed distributed, nonqualifying distributions will be treated as coming out of rollover contributions on a FIFO basis, and within the distributions attributable to rollover contributions, the previously taxed contributions will be deemed to be distributed first, which means these distribution proceeds will be tax free. Any remaining amounts will be allocated to income and appreciation, and therefore taxed.

 

Except for 1998 Rollovers from a regular IRA to a Roth IRA on which 4-year income averaging is elected (which are a special case), the ordering rules go a long way towards mitigating the downside risk of establishing a Roth IRA. The worst that can happen is that income on the account will be recaptured, but then only if the distribution is nonqualifying (e.g., made within five years of establishment) and then only after the amounts on which tax has already been paid have been distributed tax-free.

 

Example: Suppose a taxpayer contributes $2000 per year to a Roth IRA for three years, and in year three also makes a $1 million Roth Rollover contribution. In year four the taxpayer withdraws $5000 and in year five withdraws $50,000. The $5000 withdrawal in year three is tax free, representing a recapture of $5000 of the $6000 non rollover contributions. Another $1000 would be recaptured in year four tax free. Of the remaining $49,000 nonqualifying distribution made in year four, it too would be nontaxable because it would be attributed to the portion that has already been taxed when rolled over. (I think.)

 

The rule would be different if the rollover were made in 1998 and the taxpayer elected to spread income recognition attributable to the rollover over four years, as permitted for 1998 rollovers only. The technical corrections require that income deferred under this special provision be recaptured if distributions are made within the four year period. This is discussed in detail later in this outline.

Are all Roth IRAs to Be Aggregated For Purposes of the Ordering Rules?

The statute is somewhat ambiguous with respect to whether all Roth IRAs are to be aggregated for purposes of applying the ordering rules, but it is implied that this is the case. Immediately prior to 408A(d)(4)(B), the ordering rules quoted above, there is an aggregation rule:

 

(A) Aggregation rules. Section 408(d)(2) shall be applied separately with respect to Roth IRAs and other individual retirement plans.

 

In this regard I note that 408(d)(2)(A) requires that "all individual retirement plans shall be treated as 1 contract."

 

On the other hand Subparagraph (B) begins: For purposes of applying this section and section 72 to any distribution from a Roth IRA, such distribution shall be treated as made . . . " [Emphasis added.]

ROLLOVERS TO A ROTH IRA

Can an Individual Rollover a Regular IRA to a Roth IRA?

One of the most attractive features of the Roth IRA is the ability of some persons to rollover a regular IRA or a qualified plan distribution to a Roth IRA, so that the minimum required distribution rules will not apply during life and so that distributions from the Roth IRA in the future will not be subject to income tax.

Can Anyone Make a Roth IRA Rollover?

Unfortunately, not everyone is eligible to make a Roth IRA rollover.

(B) Rollover from IRA. A taxpayer shall not be allowed to make a qualified rollover contribution to a Roth IRA from an individual retirement plan other than a Roth IRA during any taxable year if, for the taxable year of the distribution to which such contribution relates —

(i) the taxpayer's adjusted gross income for such taxable year exceeds $100,000, or

(ii) the taxpayer is a married individual filing a separate return.

Must a Roth IRA Rollover Be a "Qualified Rollover Distribution"?

(6) Rollover contributions.

(A) In general. No rollover contribution may be made to a Roth IRA unless it is a qualified rollover contribution.

What is a "Qualified Rollover Contribution"?

In order to make a Roth IRA rollover, the rollover must be a "qualified rollover contribution."

(e) Qualified rollover contribution. For purposes of this section, the term "qualified rollover contribution" means a rollover contribution to a Roth IRA from another such account, or from an individual retirement plan, but only if such rollover contribution meets the requirements of section 408(d)(3). For purposes of section 408(d)(3)(B), there shall be disregarded any qualified rollover contribution from an individual retirement plan (other than a Roth IRA) to a Roth IRA.

 

Disregarding 408(d)(3)(B) means disregarding the rule that only one rollover per year is permitted.

 

Many people think that the rollover rules are very simple. In fact, they are very simple compared to the rules prior to the Small Business Job Protection Act. Now the rules can be described in one subsection that can be squeezed into only two pages. 408(d)(3) is set forth in a footnote below.

Can a Roth IRA Rollover be Made From a Qualified Plan?

IRC 408A, by its terms, applies only to rollovers from other Roth IRAs and from regular IRAs. For some reason, qualified plans are not mentioned. A rollover from a qualified plan to a Roth IRA could easily be accomplished, however, by first rolling over (or making a direct transfer) to a regular IRA, and from there to a Roth IRA.

Can a Rollover Be Effected By Simply "Converting" a Regular IRA to a Roth IRA?

(C) Conversions. The conversion of an individual retirement plan (other than a Roth IRA) to a Roth IRA shall be treated for purposes of this paragraph as a distribution to which this paragraph applies.

Can a SEP-IRA be Designated as a Roth IRA?

For reasons that escape me, 408A was amended to provide that neither an SRA (a Simple Retirement Account described in 408(p)) or an SEP (a Simplified Retirement Account described in 408(k)) can be converted into a Roth IRA:

(f) Individual retirement plan. For purposes of this section —

(1) a simplified employee pension or a simple retirement account may not be designated as a Roth IRA . . .

 

However, in most cases it would appear that a rollover from the SRA or SEP to a regular IRA, followed by a rollover or conversion to a Roth IRA, would be possible.

In Order to Make a Rollover to a Roth IRA, Must Income Tax Be Paid on the Amount Rolled Over?

The primary disadvantage in making a Roth IRA rollover is that income tax must first be paid on the amount rolled over. Unlike a regular rollover, no deduction is allowed for a rollover to a Roth IRA. The statute is explicit on the question of income inclusion:

 

(3) Rollovers from an IRA other than a Roth IRA.

(A) In general. Notwithstanding section 408(d)(3), in the case of any distribution to which this paragraph applies —

(i) there shall be included in gross income any amount which would be includible were it not part of a qualified rollover contribution, . . . .

Are There Any Special Income Tax Breaks For Roth IRA Rollovers Made Before January 1, 1999?

(iii) unless the taxpayer elects not to have this clause apply for any taxable year, any amount required to be included in gross income for such taxable year by reason of this paragraph [(d)(3)] for any distribution before January 1, 1999, shall be so included ratably over the 4-taxable year period beginning with such taxable year.

 

Any election under clause (iii) for any distributions during a taxable year may not be changed after the due date for such taxable year.

Roth IRAs established before 1999 means Roth IRAs established in 1998, because prior to 1998 there was no such thing as a Roth IRA. This is a one-shot tax break only applicable in 1999.

 

Note that the election is all or nothing: a partial election procedure is not described in the statute.

What Happens if a Roth IRA Rollover Made In 1998 is Withdrawn Early?

As indicated above, if a taxpayer does not elect out of 408A(d)(3)(A)(iii), the taxpayer will recognize any income attributable to a rollover made in 1998 from a regular IRA to a Roth IRA ratably over four years, 1998-2001. In order to prevent taxpayers from using this provision simply as a loophole to spread the income, followed by an immediate withdrawal from the Roth IRA, the IRS Restructuring and Reform Act of 1998 amended 408A by adding elaborate provisions designed to accelerate income if withdrawals are made the first three years of the 4-year averaging period (i.e., before 2001).

 

(E) Special rules for contributions to which 4-year averaging applies. In the case of a qualified rollover contribution to a Roth IRA of a distribution to which subparagraph (A)(iii) applied, the following rules shall apply:

(i) Acceleration of inclusion.

 

(I) In general. The amount required to be included in gross income for each of the first 3 taxable years in the 4-year period under subparagraph (A)(iii) shall be increased by the aggregate distributions from Roth IRAs for such taxable year which are allocable under paragraph (4) to the portion of such qualified rollover contribution required to be included in gross income under subparagraph (A)(i)[i.e., any amount "included in gross income any amount which would be includible were it not part of a qualified rollover contribution"].

 

(II) Limitation on aggregate amount included. The amount required to be included in gross income for any taxable year under subparagraph (A)(iii) shall not exceed the aggregate amount required to be included in gross income under subparagraph (A)(iii) for all taxable years in the 4-year period (without regard to subclause (I)) reduced by amounts included for all preceding taxable years.

 

Under the statute, income tax would be owed on any distributions made in 1998, 1999 or 2000 made out of amounts rolled over to a Roth IRA in 1998, until the total that was originally deferred has been recognized. For example, if $100,000 were rolled over in 1998, and no withdrawals and no election to accelerate were made, $25,000 would be recognized in each of 1998, 1999, 2000 and 2001. If, however, $15,000 were withdrawn in 1999, we presume that $40,000 would be recognized in that year ($25,000 + $15,000).

Does the Original 4-Year Payment Schedule Change to Reflect a Prior Acceleration in the Tax Paid?

At this point (1999) $65,000 in tax has been paid, with $35,000 and two years left to go. If $50,000 were withdrawn in 2001, $35,000 is all that could be taxed under this portion of the statute (unless contributions were exhausted under the ordering rules) because only $35,000 remains. However, what if nothing were withdrawn?

 

(a) Does the taxpayer still recognize $25,000 as if still under the original schedule? Or (b), is the $35,000 that is left paid ratably over two years ($17,500 per remaining year)? Or, (c) since the taxpayer was to have paid a total of $75,000 over the first three years, and since the taxpayer has already paid $65,000 due to the withdrawal, maybe all that is owed in year three is $10,000. In this case a $25,000 payment in year four would round out the deficit.

 

My money is on (a): that the taxpayer must pay $25,000 each year, plus whatever has been withdrawn that year, not to exceed a total of $100,000 (except to the extent that the withdrawal is not a qualifying distribution and all contributions have been recaptured).

 

Contrary to the usual Roth distribution rule, basis is recovered last if the 4-year averaging recapture provisions apply.

What Happens if the Taxpayer Dies Before the 4-Years is Up?

Acceleration on account of death will not apply if the taxpayer’s spouse inherits the Roth IRA and makes an appropriate election.

(ii) Death of distributee.

(I) In general. If the individual required to include amounts in gross income under such subparagraph dies before all of such amounts are included, all remaining amounts shall be included in gross income for the taxable year which includes the date of death.

Is There An Exception to the Income Inclusion Rule in the Case of Death of the Taxpayer Within 5-Years if the Taxpayer’s Spouse is the Beneficiary of the Roth IRA?

(II) Special rule for surviving spouse. If the spouse of the individual described in subclause (I) acquires the individual's entire interest in any Roth IRA to which such qualified rollover contribution is properly allocable, the spouse may elect to treat the remaining amounts described in subclause (I) as includible in the spouse's gross income in the taxable years of the spouse ending with or within the taxable years of such individual in which such amounts would otherwise have been includible. Any such election may not be made or changed after the due date for the spouse's taxable year which includes the date of death. [Emphasis added.]

Does the Spouse Have to Be the Beneficiary of All Roth IRAs or Just the 1998 Rollover IRA, for the Exception to Apply?

The statute accelerates the tax due if a taxpayer dies within 4-years of making a 1998 rollover that was being averaged. However, the exception in cases where the taxpayer’s spouse is the beneficiary applies if the spouse acquires the interest in "any Roth IRA to which such qualified rollover contribution is properly allocable." This certainly suggests that if there is more than one 1998 Roth rollover IRA, only one of which names the spouse as the beneficiary, then the one of which the spouse was the beneficiary should qualify for the exception.

 

Note that unless the spouse is also a beneficiary of the taxpayer’s estate, the spouse may not be inclined to make the election to defer the tax, since the obligation to pay the tax would be on the estate if the exception does not apply. If the spouse makes the election anyway, is the payment of the tax a gift to the beneficiaries of the estate? Hopefully not.

What Happens If a Roth IRA Rollover is Made, But It Later Turns Out that the Taxpayer’s Adjusted Gross Income Exceeded the Rollover Limits?

If a person makes a Roth IRA rollover, but later finds out that he or she had more than $100,000 of adjusted gross income during the year, what can the taxpayer do about it? An amendment to the statute appears to offer a way out, by allowing the taxpayer to transfer the Roth IRA contribution made during the year, plus earnings, to a regular IRA on before his or her income tax return is due.

(6) Taxpayer may make adjustments before due date.

 

(A) In general. Except as provided by the Secretary, if, on or before the due date for any taxable year, a taxpayer transfers in a trustee-to-trustee transfer any contribution to an individual retirement plan made during such taxable year from such plan to any other individual retirement plan, then, for purposes of this chapter, such contribution shall be treated as having been made to the transferee plan (and not the transferor plan).

 

(B) Special rules.

(i) Transfer of earnings. Subparagraph (A) shall not apply to the transfer of any contribution unless such transfer is accompanied by any net income allocable to such contribution.

(ii) No deduction. Subparagraph (A) shall apply to the transfer of any contribution only to the extent no deduction was allowed with respect to the contribution to the transferor plan.

When is the Latest that the Corrective Transfer Can Be Made?

(7) Due date. For purposes of this subsection, the due date for any taxable year is the date prescribed by law (including extensions of time) for filing the taxpayer's return for such taxable year.

 

Interestingly, the corrective transfer can be made by the extended tax return due date, though the original contribution would have had to have been made by April 15 to be considered as having been made on account of the preceding year.

 

This provision allows a Roth Rollover to be undone under certain circumstances. Note that the undoing could work both ways. Apparently, the transfer could be to or from a regular IRA and to or from a Roth IRA. So, a contribution to a regular IRA could be transferred to a Roth IRA by the tax return due date, as well as the other way around.

It might even be the case that a market crash following a Roth IRA conversion causes the taxpayer to wish he had waited until the next year to effect the rollover. This new provision of the law would appear to allow the taxpayer to do just that.

 

A partial transfer might also be desirable, particularly if the taxpayer’s AGI is within the phase-out range.

Note that a rollover will not work. It has to be a "trustee-to-trustee transfer." According to the Senate report, a trustee-to-trustee transfer can include transfers between IRA trustees, transfers between IRA custodians, transfers from and to IRA accounts and annuities, and transfers between IRA accounts and annuities with the same trustee or custodian.

What Distributions Are Covered By the Special Taxation Rules Governing Roth Rollover IRAs?

(B) Distributions to which paragraph applies. This paragraph [i.e., 408A(d)(3) dealing with rollovers from a regular IRA to a Roth IRA] shall apply to a distribution from an individual retirement plan (other than a Roth IRA) maintained for the benefit of an individual which is contributed to a Roth IRA maintained for the benefit of such individual in a qualified rollover contribution..

Does the 72(t) Premature Distribution 10% Penalty Tax For Distributions Prior to Age 59&1/2 Apply on Roth IRA Rollovers Required to be Included in Ordinary Income?

As a general rule, the premature distribution tax (imposed by 72(t)) does not apply on the income required to be recognized as a result of a Roth IRA rollover.

(A) In general. Notwithstanding section 408(d)(3), in the case of any distribution to which this paragraph applies —

* * * *

(ii) section 72(t) shall not apply, . . .

 

However, the IRS Restructuring and Reform Act of 1998 makes an exception to this rule in the case of nonqualifying distributions attributable to rollovers that are withdrawn within 5 years, thereby closing a loophole allowed under the original statute. See below.

Are There Any Exceptions to the Inapplicability of the Premature Distribution Tax to Roth IRA Rollovers?

Distributions from a Roth IRA, if not included in income, would, under prior law, not be subject to the premature distribution tax, because that tax only applies to distributions included in income. Hence a technique was suggested of making a Roth IRA rollover (on which income tax would have to be paid), relying on the exception from 72(t) provided in IRC 408A(d)(3)(A)(ii), quoted immediately above, and then taking a nontaxable distribution from the Roth IRA which would be exempt from 72(t), not because of an exception, but because it was nontaxable.

408A(d)(3)(F) was added to address this loophole:

 

(F) Special rule for applying section 72.

(i) In general. If —

(I) any portion of a distribution from a Roth IRA is properly allocable to a qualified rollover contribution described in this paragraph, and

(II) such distribution is made within the 5-taxable year period beginning with the taxable year in which such contribution was made,

 

then section 72(t) shall be applied as if such portion were includible in gross income.

(ii) Limitation. Clause (i) shall apply only to the extent of the amount of the qualified rollover contribution includible in gross income under subparagraph (A)(i). [Emphasis added.]

Are Non Rollover Roth IRA Contributions Immune From the Premature Distribution Tax No Matter What?

The combination of the 408A(F)(i)(I) phraseology, the 408A(F)(ii) limitation, and the ordering rules of 408A(d)(4)(B) all lead to the conclusion that the premature distribution tax can apply only to previously taxed rollover contributions, not to income and not to nonqualifying distributions attributable to non-rollover Roth IRA contributions. Distributions of these amounts are still immune from the 10% premature distribution tax, no matter when withdrawn.

The ordering rules treat distributions as coming from non-rollover contributions first, from taxable rollover contributions second, and from nontaxable rollover contributions next.

Can the Premature Distribution Tax Apply to a Nontaxable Qualifying Distribution?

Note that even if a distribution is a qualifying distribution —meaning that a Roth IRA has been established for at least 5 years— then a nontaxable premature distribution tax could still apply, if the taxpayer is under age 59&1/2 at the time, because the 5-year period referred to in 408A(d)(3)(F)(i)(II) begins "with the taxable year in which such contribution was made" rather than "within the 5-taxable year period beginning with the 1st taxable year for which the individual made a contribution to a Roth IRA" and because the statute makes the tax applicable "as if such portion were includible in gross income"

Are Roth and Regular IRA Trustees and Custodians Required to Report Amounts Included in Gross Income as a Result of a Roth IRA Rollover?

(D) Additional reporting requirements. Trustees of Roth IRAs, trustees of individual retirement plans, or both, whichever is appropriate, shall include such additional information in reports required under section 408(i) as the Secretary may require to ensure that amounts required to be included in gross income under subparagraph (A) are so included.

How Are the Regular IRA Distribution Taxation Rules Found in 408(d)(2) Coordinated With Roth IRAs?

IRC 408(d) is a fairly comprehensive section which specifies the income tax treatment of distributions from IRAs. The first two paragraphs of 408(d) read as follows:

(1) IN GENERAL. -- Except as otherwise provided in this subsection, any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under section 72.

 

(2) SPECIAL RULES FOR APPLYING SECTION 72. -- For purposes of applying section 72 to any amount described in paragraph (1) --

 

(A) all individual retirement plans shall be treated as 1 contract,

(B) all distributions during any taxable year shall be treated as 1 distribution, and

(C) the value of the contract, income on the contract, and investment in the contract shall be computed as of the close of the calendar year with or within which the taxable year ends.

 

For purposes of subparagraph (C), the value of the contract shall be increased by the amount of any distributions during the calendar year.

 

408A(d)(4)(A), provides:

(A) Aggregation rules. Section 408(d)(2) shall be applied separately with respect to Roth IRAs and other individual retirement plans.

Is a Qualified Rollover Contribution Taken Into Account In Determining the Roth IRA Contribution Limits on Adjusted Gross Income?

Since a taxpayer cannot make a Roth IRA rollover if the individual has adjusted gross income (AGI) over $100,000, then, unless there were a special rule excluding the rollover income, no rollover could exceed $100,000. Fortunately, the amount taken into income as a result of the rollover is excluded from the $100,000 AGI limitation.

(B) Coordination with limit. A qualified rollover contribution shall not be taken into account for purposes of paragraph (2) [limiting contributions by persons with adjusted gross income that exceeds the $150,000/$95,000 applicable dollar amount].

ISSUES NOT EXPRESSLY COVERED BY THE STATUTE

Are Roth IRAs Exempt From Creditor Claims?

IRAs are generally not covered by ERISA, and therefore cannot rely on the ERISA legislation giving creditor protection to certain pension plans. However, many states have "shield laws" which classify IRAs as exempt assets. Now, a Roth IRA is an IRA; so in many cases a state’s IRA shield law will protect a Roth IRA as well as a regular IRA. But each state’s statute will have to be carefully read, because the wording could make a difference. For example, in Texas, the statute does not extend to IRAs that are not tax deductible. Whether the statute covers a Roth rollover IRA on which tax was paid is not clear. Arguably it doesn’t. Many states, including Texas, are expected to pass legislation shortly to make sure that Roth IRAs are treated the same as regular IRAs for purposes of creditor protection.

Can an Irrevocable Roth IRA Be Established Under Which the Taxpayer Retains No Rights that Would Put the Roth IRA in the Taxpayer’s Estate?

This is an idea that has been popularized by Merv Wilf, and, in my opinion, it has some merit, as well as some risk.

The idea is that the Roth IRA is established in the form of a trust in which the owner has given up all benefits and rights. Because the minimum distribution rules do not apply to a Roth IRA during life, the owner is not required to take distributions. At death, the IRA continues for the benefit of the owner’s beneficiaries, who are irrevocably designated when the IRA is established. The owner has made a taxable gift at the time the IRA is established. But since the IRA will compound tax free during the owner’s life and thereafter for the life expectancy of the beneficiary, the size of the gift and the size of the benefit ultimately enjoyed will be very disproportionate. For example, a $1 million gift could easily generate $30 million in benefits over thirty to forty years. Further, that $30 million would be income and estate tax free. Not bad, if it works.

Do the AGI Limits Apply Separately to a Husband and Wife Filing Jointly?

The IRS has indicated informally that it intends to apply the AGI limits to a husband and wife jointly, but it is not at all clear that the statute requires this. There is nothing in the technical corrections that address this issue.

 

The rollover AGI limit for a married taxpayer filing jointly as well as for a single person is $100,000. It would stand to reason that each spouse (each taxpayer) can effect a Roth IRA rollover if that spouse has AGI that does not exceed $100,000, particularly since this is the limit for a single person. Moreover, it would have been easy enough for the statute to have referred to combined AGIs if that had been intended.

 

In the case of the AGI contribution limit applicable only to a taxpayer [sic] filing a joint return, the literal wording of the statute is extremely important, in my opinion. The statute reads:

 

(I) in the case of a taxpayer filing a joint return, $150,000 [Emphasis added.]

 

Now, this provision (408A(c)(3)(C)(ii)(I)) applies only to joint returns. Therefore, if the word "taxpayers" (plural) had been substituted for "taxpayer" (singular) there would have been no ambiguity whatsoever, because a joint return is never filed by a single taxpayer. In other words there is not even a reason for claiming that the word taxpayer (singular) was used for convenience, in a generic sense. Because a joint return is always filed by more than one taxpayer, the use of the word taxpayer (singular) can only refer to the taxpayer who is making the Roth IRA contribution; since, otherwise, there would have been no imaginable reason not to have used the plural.

Can an Inherited IRA Be Converted to a Roth IRA by a Surviving Spouse?

I see no reason why an inherited IRA could not be converted to a Roth IRA by a surviving spouse, especially if the IRA were either rolled over by the spouse to a regular IRA first, or if the spouse elected to treat the IRA as his or her own under 408(d)(3)(C). However, this is not explicitly addressed in 408A.

 

I do not think that a beneficiary of an IRA who is not a spouse can make a Roth IRA conversion, because only a spouse can rollover an inherited IRA. Further, I think it would be imprudent for a spouse-beneficiary to make a Roth IRA rollover without first becoming the owner (rather than the beneficiary) of the IRA.

MISCELLANEOUS MATTERS

Are There Any Roth Web Sites on the World Wide Web?

There are dozens of Roth IRA web sites on the internet. Check these out:

http://www.rothira.com/

http://www.fool.com/School/Taxes/1998/taxes980115.htm

http://www.benefitslink.com/index.shtml

 

The first site (www.rothira.com) is the mother of all Roth web sites. It contains links to hundreds of other Roth websites and articles and Roth calculators.

The second site is maintained as a part of the "Motley Fool" web page (http://www.fool.com/index.htm). The site is devoted to more than just Roth IRAs. You will find a free Roth IRA calculator there.

The last cited site is maintained by David Rhett Baker, an attorney in Orlando. This is the mother of all pension web sites and the mother of all pension links. I am telling you, this is a "must" for the professional pension advisor.

Has the IRS Issued Any Special Guidance or Forms For Use With Roth IRAs?

The IRA issued an Announcement —issued before enactment of the IRS Restructuring and Reform Act of 1998—, which offered the following guidance.

Model forms. – New Form 5305-R, Roth Individual Retirement Trust Account, and Form 5305-RA, Roth Individual Retirement Custodial Account, will serve as Service-approved model forms for use by financial institutions to offer Roth IRAs to their customers. These forms can be downloaded from the IRS homepage at www.irs.ustreas.gov.

 

• Separate trusts. – Contributions to a Roth IRA must be maintained as a separate trust, custodial account or annuity from contributions to a Traditional IRA. Separate accounting within a single trust, custodial account or annuity is not permitted.

 

• Opinion letters. – The Service is not presently accepting submissions for opinion letters on prototype Roth IRAs, but will issue procedures in the future for requesting such opinion letters.

 

• Combined documents. – The Service will permit a prototype sponsor to combine a Roth IRA and a Traditional IRA in the same document provided that (1) the separate trust requirement, above, is satisfied and (2) the document, as completed by the owner, clearly indicates whether it is to be used as a Traditional IRA or as a Roth IRA. This must be done in a way that makes clear that designation as one type of IRA precludes its designation as the other type of IRA.

Has the IRS Issued a Form Roth IRA Trust or Custodial Agreement?

As indicated in Announcements 97-122 and 98-14, the IRS has promulgated Forms 5305-R (trust account IRA) and 5305-RA (custodial account IRA), similar to the 5305 IRA prototype forms. These forms leave much to the imagination. For example, it is implied (perhaps), but not stated, that the IRA beneficiary (or, for that matter, the owner) can withdraw funds from the IRA without the permission of the IRA trustee.

Blue Book

On Dec. 17, the staff of the Joint Committee on Taxation released the 1997 Blue Book (General Explanation of Tax Legislation Enacted in 1997, JCS-23-97). The "Blue Book" contains useful information on Roth IRAs.

Senate Report

The Senate Committee Reports to the IRS Restructuring and Reform Act of 1998 contains very helpful information explaining the reasoning behind the Roth IRA amendments found in that act.

   

THE ECONOMICS OF A ROTH IRA CONVERSION

Does it Make Economic Sense to Convert a Regular IRA to a Roth IRA?

Whether it makes sense to convert a regular IRA to a Roth IRA of course depends on the circumstances of the taxpayer. Much has already been written on this subject. There are by now dozens of Roth IRA calculators available on the internet to help taxpayers make this decision.

 

I would pose a simple thought experiment to illustrate the point: Suppose, that a taxpayer has $1 million in a regular IRA. In one case the IRA is converted to a Roth IRA; in the other it is not. If it is not converted, it doubles in value after x number of years, at which point the IRA is liquidated and income taxes are paid. Assume the income tax rate is 50%. At this point, the taxpayer or his or her beneficiaries have $1 million income tax free to utilize.

 

In the other example, the IRA is converted. This means that income tax must be paid. So now we only have $.5 million to put in our Roth IRA. At the end of the period of x years, the Roth IRA doubles in value and is liquidated. Assuming 5 years have passed, no income taxes are paid. At this point, the taxpayer or his or her beneficiaries have $1 million income tax free to utilize.

 

I hope you see the point. At the very worst, we have a push.

Now there are several facts that we can add to our example that give the Roth IRA a decided advantage.

 

For one thing, if the taxpayer were over age 70&1/2 the regular IRA would not be growing tax free because the premature distribution rules would require that at least a portion of the IRA be distributed (and taxes paid on it) each year. This alone tilts the scale in favor of conversion.

 

More significant, however, is that if the taxpayer had rolled over $1 million, and paid the $.5 million out of other funds, then, in effect, the $.5 million will grow tax free during our theoretical time period.

 

Income taxes will have to be paid in any event, so the taxpayer is not really out the .5 million by paying the tax early. As the example showed, the time-value use of the pre-paid tax is not the issue that it would first appear without doing the math. All that really happens is that the $.5 million now grows in the Roth IRA tax free instead of outside of the IRA in investments subject to annual income tax and capital gains.

 

Thus, at the end of the term, the period, the taxpayer or heirs would have $2 million tax free. The assumption is that the $.5 million can be double faster in the Roth IRA than outside of it. This is the primary advantage of the Roth IRA rollover —this and the fact that lifetime minimum distributions do not have to be made.

 

A further aid to the decision of whether or not to convert or contribute to a Roth IRA can be found in any of the dozen or more calculators and programs, most of them free, which can be found on the world wide web. See, for example, http://www.rothira.com/, mentioned earlier.

 

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Copyright 1998 by Glenn M. Karisch     Last Revised September 9, 1998