Tax planning for Roth IRAs.

Tax year 1998 was the first year a Roth IRA could be established. Approximately $21 billion poured into mutual funds via Roth IRAs at that time. However, taxpayers have made numerous errors with their Roth IRA investments. For example, taxpayers with modified adjusted gross income (MAGI) in excess of $100,000 and married per: sons who lived together but filed separate returns are ineligible for conversions of traditional IRAs to Roth IRAs. In addition, married taxpayers filing jointly with MAGI in excess of $160,000, married taxpayers with MAGI under $10,000 who file separate returns, and all other taxpayers with MAGI greater than $110,000 are ineligible to make Roth IRA contributions. As of Oct. 14, 1999, the IRS estimated that approximately 20,000 taxpayers who appeared to be ineligible for 1998 Roth IRA conversions still had not made the appropriate corrections. The Service sent notification to these taxpayers.

In response to the problems taxpayers have experienced in applying Roth IRA rules and limits, the IRS has issued numerous authoritative guidance over the past year. For example, the Service extended the due date until the end of 1999 to undo 1998 Roth IRA contributions or conversions. This extension was granted in recognition of the newness of the Roth IRA and taxpayer difficulties. However, taxpayer confusion continues, as evidenced in Ann. 99-104. In that notice, the IRS states "[i]t has come to the attention of the Internal Revenue Service and Treasury that taxpayers have experienced particular difficulty in properly applying the rules governing Roth IRA conversion contributions and recharacterizations"

A "conversion" refers to the transfer of an amount from a traditional IRA to a Roth IRA (Regs. Sec. 1.408A-4, A-1). A "recharacterization" refers to an amount or contribution treated as contributed to an IRA other than the one to which it was originally contributed (Regs. Sec. 1.408A-5, A-1). For example, a recharacterization allows a taxpayer to change his Roth IRA contributions or conversions back to a traditional IRA (Sec. 408A(d) and Regs. Sec. 1.408A-5). Taxpayers may choose to recharacterize if they have made ineligible Roth IRA contributions or simply changed their minds as to the type of IRA account they prefer.

Taxpayers must now be concerned with the complexities surrounding post-1999 Roth IRA conversions, the income tax effects of current Roth IRA investments and the tax planning surrounding 1998 Roth IRA conversions.

Post-1999 Conversions

Effective Jan. 1, 2000, recharacterization rules have changed for an IRA owner who converts a traditional IRA to a Roth IRA during any tax year and then transfers that amount back to a traditional IRA. In general, a taxpayer may not reconvert a traditional IRA to a Roth IRA until the later of 30 days after the recharacterization or the beginning of the next tax year (Regs. Sec. 1.408A-5, A-9). For example, an IRA owner whose tax year-end is December 31 and who converts an amount to a Roth IRA in 2000 and then transfers the amount back to a traditional IRA on Jan. 18, 2001, cannot reconvert that amount to a Roth IRA until Feb. 17, 2001 (the first day after the end of the 30-day period beginning on the day of the recharacterization transfer). However, if an IRA owner inadvertently attempts to reconvert that amount before Feb. 17, 2001, the attempted reconversion is not treated as a conversion for purposes of the reconversion rules. Therefore, the IRA owner could transfer the amount back to a traditional IRA in a recharacterization and reconvert it any time after Feb. 16, 2001. If the IRA owner does reconvert the amount after Feb. 16, 2001, the taxpayer cannot reconvert that amount again until 2002; see TD 8816.

Income Tax Effects

Taxpayers who convert amounts from traditional IRAs to Roth IRAs are required to include all of the taxable conversion in gross income in the conversion year; the four-year income-spreading provision available for 1998 is not available for tax years 1999 and beyond.

If an IRA participant is converting a traditional IRA to a Roth IRA and is age 7072 or older, the amount of the required minimum distribution (RMD) that the participant must receive from the traditional IRA cannot be converted. The RMD must be distributed and included in income in the year received. However, the remaining balance could be converted to a Roth IRA (Sec. 408A(d)(3)(E)).

To qualify as a tax-free Roth IRA distribution, no distributions can generally occur from the Roth IRA until a five-year holding period has passed. Therefore, tax-free distributions will not occur until tax years beginning in 2003. The five-year holding period begins on the first day of the tax year for which the first contribution (whether an actual Roth IRA contribution or a conversion) is made to a Roth IRA and ends on the last day of the owner's fifth consecutive tax year.

Continuing Tax Considerations on 1998 Conversions

Taxpayers who made 1998 Roth IRA conversions must consider the state tax consequences of the unamortized balance of the taxable portion of their conversions. For instance, if a taxpayer moves from one state to another between 1999 and 2001, the state income tax ramifications of his unamortized Roth IRA balances may be different. In addition, some states plan to tax individuals on the four years of state taxes due from 1998 Roth IRA conversions, even if they move out of state. (For a detailed discussion of the state tax consequences of Roth IRA conversions, see "Timing of Roth IRA Conversion," in the July 1999 issue of Journal of Accountancy.)

For 1998 Roth IRA conversion amounts subject to the four-year spread provisions, income inclusion is accelerated for any amount withdrawn from the Roth IRA before 2001 (Regs. Sec. 1.408A-6, A-6). if a Roth IRA owner who elected to use the four-year spread changes filing status or divorces before the end of the four-year period, he can include the remainder of the taxable conversion amount in gross income over the remaining amortization period, unless accelerated because of distribution or death. If a Roth IRA owner dies before the four-year period has ended, any amounts remaining to be included in income as a result of the 1998 conversion will be included on the decedent's final return (Regs. Sec. 1.408A-4, A-11).

Filing Requirements

For any corrections of 1998 Roth IRA conversions, a Form 1040X must be filed by April 15, 2002.

The IRS has provided a one-year extension of certain alternative methods of reporting IRA recharacterizations and reconversions; see Ann. 9911)6. A trustee will not fail to satisfy the otherwise applicable IRA reporting requirements for recharacterizations and reconversions occurring in 2000 using the same trustee, provided that the trustee complies with Ann. 99-5 (other than Ann. 99-5's requirement that the recharacterization or reconversion occur in 1998 or 1999). The Service will issue guidance in the future regarding the method of reporting recharacterizations and reconversions of IRA contributions made after 2000.

FROM CHRISTINE CZEKAI BAUMAN, ASSISTANT PROFESSOR. OF ACCOUNTING, UNIVERSITY OF WISCONSIN--MILWAUKEE, MILWAUKEE, WI, AND JO LYNNE KOEHN, ASSOCIATE PROFESSOR. OF ACCOUNTING, CENTRAL MISSOURI STATE UNIVERSITY, WARRENSBURG, MI (NEITHER ASSOCIATED WITH BDO SEIDMAN)