Roth IRA final regs. offer clarity and guidance.
* In addition to regular annual contributions to a Roth IRA, taxpayers may also make rollover (conversion) contributions from SEP, SIMPLE and traditional IRAs to a Roth IRA.
* If a decedent's spouse is the sole beneficiary of all of the decedent's Roth IRAs, he can elect to continue the decedent's four-year spread.
* A failed conversion is not eligible for the four-year income spread and is subject to the 6% Sec. 4973 tax on excess contributions and the 10% Sec. 72(t) tax on early distributions.
When introduced, Roth individual retirement accounts (IRAs) were complex, as taxpayers had to meet income limits to contribute regular IRAs to Roth IRAs. The final regulation make great progress in clarifying many confusing issues, such as recharacterization of conversions, treatment of the four-year spread at death or divorce and whether a penalty applies to distributions within five years.
To encourage individual saving, Congress created Sec. 408A, the Roth individual retirement account (IRA), in the Taxpayer Relief Act of 1997 (TRA '97), Section 302. Several Roth IRA provisions were then modified by Section 6005(b) of the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98). To clarify certain aspects of Roth IRAs, the Treasury issued proposed regulations(1) in 1998. In addition, Notices 98-49(2) and 98-50(3) provided interim guidance on Roth IRA reporting requirements and conversions. Treasury then issued final regulations in February 1999(4) that generally adopt the approach taken by the proposed regulations, but clarify and modify those rules. Exhibit 1 on p. 660 and Exhibit 2 on p. 662 summarize these changes. The final regulations continue to apply the interim guidance of Notice 98-50 for 1998 and 1999 reconversions, but adopt a new approach for post-1999 reconversions. The regulations were effective Feb. 3, 1999 and apply to tax years beginning after 1997.
Exhibit 1: Roth IRA final regs.' changes/clarifications
Regs. Sec./Topic Change/Clarification 1.408A-3, Q&A-7 Undistributed aggregate excess contribu- Contributions tions are reduced as deemed Roth IRA contributions in subsequent years. 1.408A-4, Q&A-1(b)(1) The rollover of a traditional IRA to a Conversions Roth IRA must occur within the 60-day period described in Sec. 408(d)(3)(A)(i). 1.408A-4, Q&A-1 (b)(3) Redesignating a traditional IRA as a Roth Conversions IRA is treated as a transfer of the traditional IRA to a Roth IRA. 1.408A-4, Q&A-1(d) Attempted reconversions before the Conversions permitted time period are not conversions. 1.408A-4, Q&A-3(b) Contributions not properly recharacterized Conversions may be subject to the Sec. 4973 excise tax, regardless of the conversion method used. 1.408A-4, Q&A-11(c) Taxpayers who use the four-year income Conversions spread and who file separately or divorce before including the entire taxable conversion amount in income must include the remaining taxable amount in gross in- come over the remaining four-year period. 1.408A-4, Q&A-12 Roth IRA distributions that are part of Conversions the substantially equal periodic payments converted from a traditional IRA are nonqualified Roth IRA distributions until they meet the qualified distribution requirements. The Sec. 72(t) tax does not apply, but the income acceleration rules apply if the four-year spread is used. 1.408A-5, Q&A-1(a) For recharacterizations, redesignating an Recharacterizations IRA is treated as a transfer of the IRA account balance. 1.408A-5, Q&A-1(b) A recharacterization via a rollover must Recharacterizations occur within 60 days after the distribution (as described in Sec. 408(d)(3)(A)(i)). 1.408A-5, Q&A-2(c) The income attributable to a recharacter- Recharacterizations ized contribution includes net losses on the recharacterized amount. 1.408A-5, Q&A-5 Amounts converted from SEP or SIMPLE IRAs Recharacterizations can be recharacterized as a contribution to a SEP or SIMPLE IRA. 1.408A-5, Q&A-6(c) The executor, administrator or other Recharacterizations person responsible for filing the decedent's final tax return can elect to recharacterize his IRA contribution. 1.408A-5, Q&A-9 Rules for reconversions. Also, Regs. Sec. Recharacterizations 1.408A-5, Q&A-9(a)(1),provides that post-1999 reconversions occurring before the permitted time are failed conversions. 1.408A-6, Q&A-1(d) Returned contributions (corrective Distributions distributions) are not includible in gross income, but net income is includible. 1.408A-6, Q&A-2 For purposes of the FTYP, corrective Distributions distributions are treated as if never contributed. 1.408A-6, Q&A-4 The amount of nonqualified distributions Distributions subject to tax is reduced by distributions previously included in income. 1.408A-6, Q&A-9(b) Regular contributions include Distributions contributions made by the return's unextended due date. 1.408A-6, Q&A-11 A beneficiary can aggregate all Roth IRAs Distributions inherited from the same beneficiary, subject to limits. 1.408A-8, Q&A-1(b)(4) A failed conversion is a conversion from a Definitions traditional or SIMPLE IRA to a Roth IRA in a transaction that does not meet the MAGI and rollover contribution requirements. Regs. Sec./Topic Prop. Regs. provision 1.408A-3, Q&A-7 None Contributions 1.408A-4, Q&A-1(b)(1) Rollover had to occur within Conversions 60 days after the distribution. 1.408A-4, Q&A-1 (b)(3) None Conversions 1.408A-4, Q&A-1(d) None Conversions 1.408A-4, Q&A-3(b) None Conversions 1.408A-4, Q&A-11(c) None Conversions 1.408A-4, Q&A-12 None Conversions 1.408A-5, Q&A-1(a) None Recharacterizations 1.408A-5, Q&A-1(b) Clarifies the distribution as one Recharacterizations described in Sec. 408(d)(3)(A)(i). 1.408A-5, Q&A-2(c) None Recharacterizations 1.408A-5, Q&A-5 None Recharacterizations 1.408A-5, Q&A-6(c) None Recharacterizations 1.408A-5, Q&A-9 None Recharacterizations 1.408A-6, Q&A-1(d) Contributions were referred to as Distributions "excess contributions." 1.408A-6, Q&A-2 None Distributions 1.408A-6, Q&A-4 None Distributions 1.408A-6, Q&A-9(b) None Distributions 1.408A-6, Q&A-11 None Distributions 1.408A-8, Q&A-1(b)(4) None Definitions
Exhibit 2: Roth IRA clarifications included in the preamble, but not in the final regs.
* Roth IRAs can be established for minor children meeting the compensation requirement.
* Sec. 408(d)(5) rules for tax-free distributions of excess IRA contributions after the tax return due date do not apply to Roth IRAs.
* Sec. 219(f)(6) rules allowing excess traditional IRA contributions to be deduded in subsequent years do not apply to Roth IRAs.
* Contributions to Education IRAs are disregarded in applying the Roth IRA contribution limits.
* A rationale for retaining the RMD rules is provided.
* The basis for Regs. Sec. 1.408A-4, Q&A-1 l(b), regarding surviving spouses, is provided in Sees. 408A(d)(3)(E)(ii)(11) and (d)(4).
* Excess contributions to a Roth IRA made in a prior year and applied against the contribution limits in the current year cannot be recharacterized, unless the recharacterization would be timely for the contribution itself.
* A conduit IRA converted to a Roth IRA and recharacterized as a traditional IRA retains its status as a conduit IRA.
* The final regulations continue the interim rules of Notice 98-50 (for 1998 and 1999).
* Recharacterization is not subject to withholding, but trustee- to-trustee Roth IRA conversions are distributions subject to withholding.
* The FTYP is not affected if the entire Roth IRA balance is distributed before the taxpayer makes any other Roth IRA contributions.
* The initial Roth contribution will not start the FTYP if it is recharacterized or revoked within seven days.
* Regs. Sec. 1.408A-6, Q&A-8(b), conversion contribution distributions, is based on Sec. 408A(d)(4)(B)(ii).
Roth IRA Accounts
Roth IRAs allow taxpayers who meet a modified adjusted gross income (MAGI) requirement an alternative type of individual retirement plan.(5) Under Sec. 408A, Roth IRA contributions are not deductible; the earnings thereon are not taxed. Distributions from a Roth IRA are tax-free if the account has existed for at least five years and the owner (1) is at least age 59 1/2; (2) is deceased; (3) is disabled when the withdrawal is made; or (4) uses the distribution for first-time homebuyer expenses.
Roth IRA Contributions
Regular contributions to a Roth IRA must be made by the due date (excluding extensions) of the taxpayer's return. The maximum allowable annual contribution to a Roth IRA is the lesser of (1) $2,000 or (2) the individual's compensation for the year. The preamble to the final regulations explains that Roth IRAs can be established for minor children who meet the compensation requirement. The maximum allowable Roth IRA contribution is phased out as a taxpayer's MAGI exceeds certain limits.
Although an individual can have both a traditional IRA and a Roth IRA, any current contribution to a traditional IRA reduces the maximum allowable Roth IRA contribution for that year. Regs. Sec. 1.408A-8, Q&A-1(a)(2), defines a traditional IRA to include a simple employer plan (SEP) IRA, but not a savings incentive match plan for employees (SIMPLE) IRA or a Roth IRA. According to the preamble, contributions to an Education IRA do not reduce the maximum allowable contribution that can be made to either a Roth or a traditional IRA, because the definition of an IRA does not include Sec. 530 Education IRAs.
Roth IRA contributions that exceed the contribution limits are Subject to the 6% Sec. 4973 excise tax. Contributions and earnings thereon distributed on or before the due date (including extensions) of the return for the tax year of the contribution are not subject to the excise tax; however, the earnings are included in the taxpayer's income. Regs. Sec. 1.408A-3, Q&A-7, clarifies that excess Roth IRA contributions not distributed by the return's extended due date are reduced as deemed Roth IRA contributions for each subsequent year, to the extent a taxpayer is eligible to make regular Roth IRA contributions in such years. The regulations do not explain the treatment of the earnings thereon, however.
Generally, absent conflicting provisions, traditional IRA law applies to Roth IRAs. However, the preamble explains that the Sec. 408(d) (5) rules, allowing the tax-free distribution of excess traditional IRA contributions after the return's due date, do not apply to Roth IRAs; Roth IRA distributions of regular contributions are always tax-free (except to the extent they accelerate income inclusion under the four-year spread). Similarly, the Sec. 219 (f)(6) rules permitting excess traditional IRA contributions to be deducted in subsequent years do not apply to Roth IRAs; Roth IRA contributions are never deductible.
Roth IRA Conversions
Regs. Sec. 1.408A-4 clarifies that, in addition to regular annual contributions to a Roth IRA, taxpayers may also make rollover (conversion) contributions from SEE SIMPLE and traditional IRAs to a Roth IRA. Amounts in other kinds of retirement plans (e.g., Secs. 401(a) and 403(a) and (b) plans and annuity contracts) cannot be converted to a Roth IRA. However, a rollover from a conduit IRA (i.e., a regular IRA that received a rollover from a qualified plan or annuity) is permitted.
Under Regs. Sec. 1.408A-4, Q&A-7(a), amounts converted to a Roth IRA (by actual rollover or by trustee-to-trustee transfer) are treated as an IRA distribution in the year the amount is transferred. The portion of the distribution attributable to nondeductible contributions is excluded from income; the portion attributable to earnings and deductible contributions is included in income. Regs. Sec. 1.408A-4, Q&A-7(b), states that the I0% Sec. 72(t) penalty tax on early distributions does not apply to any portion of the distribution on conversion. However, the tax may apply to subsequent distributions made from the Roth IRA within five tax years of conversion.
Regs. Sec. 1.408A-4, Q&A-2, provides that a taxpayer can convert a traditional IRA to a Roth IRA if:
* The taxpayer's MAGI does not exceed $100,000 in the year the funds are paid from an IRA (not the year they are contributed to the Roth IRA). Married taxpayers (1) must file a joint return for the year in which the funds are paid from an IRA and (2) are subject to the $100,000 MAGI limit on their combined income. Married couples who have lived apart for the entire year are not considered to be married, can file separate returns and are subject to the MAGI limit on their separate incomes.
* The Sec. 408(d)(3) requirements for a rollover contribution are satisfied. However, the one-rollover-per-year limit in Sec. 408 (d) (3) (B) does not apply.
Taxpayers may also convert SEP IRAs and SIMPLE IRAs to a Roth IRA, but additional restrictions apply.
Regs. Sec. 1.408A-4, Q&A-1(b), states that a conversion of a traditional IRA to a Roth IRA can be accomplished using one of the following methods:
1. Contributing (rolling over) an amount distributed from a traditional IRA within the 60-day period described in Sec. 408(d)(3)(A)(i) (i.e., no more than 60 days after the taxpayer's receipt of the distribution.)
2. Transferring an amount from a traditional IRA to a Roth IRA in a trustee-to-trustee transfer.
3. Transferring a traditional IRA to a Roth IRA maintained by the same trustee.
As is discussed below, attempted reconversions before the permitted time period are not considered conversions, under Regs. Sec. 1.408A-4, Q&A-1(d).
Regs. Sec. 1.408A-4, Q&A1 (b)(3), explains that a traditional IRA can be transferred to a Roth IRA simply by redesignating the account, if both IRAs are maintained by the same trustee; a new account or contract is not required. Because conversions are always treated as distributions from an IRA followed by a qualified rollover contribution to a Roth IRA, trustee-to-trustee transfers and account transfers by the same trustee to a Roth IRA are also treated as distributions followed by a rollover contribution.
According to the preamble, despite comments received on the proposed regulations about the conversion of required minimum distributions (RMDs) from traditional IRAs to Roth IRAs, these rules were retained. Thus, RMDs from a traditional IRA to a taxpayer who is at least 70/2 years old by the end of the distribution calendar year cannot be converted to a Roth IRA, even if the conversion is accomplished by a trustee-to-trustee transfer. Also, RMDs are considered the first dollars distributed from a traditional IRA. If the RMD is contributed to a Roth IRA, it is treated as a traditional IRA distribution, followed by a regular (not conversion) contribution to a Roth IRA.
Substantially Equal Periodic Payments
Regs. Sec. 1.408A-4, Q&A-12, permits taxpayers already receiving Sec. 72(t)(2)(A)(iv) substantially equal periodic payments from a traditional IRA to convert such an IRA to a Roth IRA. The conversion amount is not subject to the 10% Sec. 72(0 early withdrawal penalty and is not considered a distribution in determining whether a Sec. 72(t) (4) (A) modification has occurred. However, the periodic payments must continue from the Roth IRA. The payments will be treated as nonqualified distributions until they meet all the requirements and are subject to the Regs. Sec. 1.408A-6, Q&A-6, income acceleration rules that apply to 1998 conversions to which the four-year spread applies.
If, after conversion to a Roth IRA, substantially equal payments do not continue, the payments will be deemed modified and the taxpayer will be subject to the Sec. 72(t)(4)(A) recapture tax if the modification occurs (1) within five years of the first payment or (2) before the taxpayer reaches age 59 1/2 or becomes disabled.
Observation: The final regulations do not resolve questions about the continuation of periodic payments from a Roth IRA that received a conversion contribution of less than the traditional IRA's entire balance. Partial conversions of a portion of a traditional IRA may become popular after 1998 as the four-year averaging opportunity ends. The regulations specify, however, that the original series of periodic payments must continue from the Roth IRA after the conversion to avoid recapture tax. A literal interpretation of this requirement does not seem reasonable if assets remain in the traditional IRA. Satisfying the requirement for continued distributions should be partially permitted from the traditional IRA.
For conversion distributions before 1999, taxpayers can spread over four years the income required to be reported. Alternatively, Regs. Sec. 1.408A-4, Q&A-10, provides that taxpayers can elect on Form 8606, Nondeductible IRAs, to include the entire taxable amount in 1998 income. The election cannot be made or changed after the due date (including extensions) of the 1998 return.
Any deferred income attributable to distributions received in 1998, 1999 or 2000 to which the four-year spread applies must be included in income in the distribution year. Regs. Sec. 1.408A-4, Q&A-12, provides that Roth IRA distributions that are part of a series of substantially equal periodic payments begun under a traditional IRA (and before a Roth IRA conversion) to which the four-year spread applies are subject to the Regs. Sec. 1.408A-6, Q&A-6, income acceleration rule. However, the 10% Sec. 72(t) early withdrawal penalty will not apply
According to Regs. Sec. 1.408A-4, Q&A-11, if a taxpayer dies before all of the income from a four-year spread is reported, any unreported income is included in the decedent's gross income for the year of death. However, if a decedent's spouse is the sole beneficiary of all of the decedent's Roth IRAs, he can elect to continue the decedent's four-year spread. The preamble explains that the requirement that the decedent's spouse be the sole beneficiary of all of the decedent's Roth IRA accounts reflects (1) the Sec. 408A(d)(3)(E)(ii)(II) four-year spread requirement that the surviving spouse acquire the entire interest in a Roth IRA and (2) the Sec. 408A(d)(4) aggregation and ordering rules, which allocate a conversion contribution to all of the owner's Roth IRAs. The election is made on either Form 8606 or Form 1040 for the year of death and cannot be changed after the due date (including extensions) of that return. Any income to be reported for the year of death is included on the decedent's final income tax return.
Regs. Sec. 1.408A-4, Q&A-11 (c), states that a change in filing status or divorce does not affect the four-year spread. If a taxpayer fries separately or divorces before all of the income to be reported is included in income, the unreported income continues to be included in the taxpayer's gross income over the remaining four-year period, unless accelerated due to distribution or death.
Regs. Sec. 1.408A-8, Q&A-1(b)(4), defines "failed conversion" to include a transaction in which an individual contributes to a Roth IRA an amount distributed from a traditional or SIMPLE IRA (including a redesignation) that does not meet the requirements of Regs. Sec. 1.408A-4, Q&A-1. According to Regs. Sec. 1.408A-5, Q&A9(a)(1), the term also includes a post-1999 reconversion that occurs before the permitted time. A failed conversion is treated as a distribution from a traditional IRA followed by a regular Roth IRA contribution. Therefore, the failed conversion is not eligible for the four-year income spread and is subject to the 6% Sec. 4973 tax on excess contributions and the 10% Sec. 72(t) tax on early distributions. However, failed conversions can be cured if they are recharacterized.
To provide relief for taxpayers who erroneously convert an IRA to a Roth IRA or who want to change the nature of an IRA contribution, IRSRRA '98 Section 6005 (b) (6) (A) added Sec. 408A(d) (6), allowing taxpayers to treat the transfer of a contribution (or a portion of a contribution) from one type of IRA (the first IRA) to a different type of IRA (the second IRA), as though the original contribution had been made directly to the second IRA. In effect, the contribution is reversed (recharacterized) and it and any associated earnings or losses are transferred back to the original IRA. Regs. Sec. 1.408A-5, Q&A-1(a), clarifies that redesignating the first IRA as the second IRA is treated as a transfer of the entire account balance from the first IRA to the second IRA. Regardless of the conversion method used, contributions not properly recharacterized may be subject to the Sec. 4973 excise tax, under Regs. Sec. 1.408A-4, Q&A-3(b).
Taxpayers who timely filed 1998 Federal income tax returns and would like to recharacterize 1998 IRA contributions (including Roth IRA conversions for which they were ineligible) have until Oct. 15,1999 to take corrective action.(6)
According to the preamble, a conduit IRA converted to a Roth IRA and later recharacterized as a traditional IRA retains its status as a conduit IRA and is treated as though it had been transferred from one conduit IRA to another.
In response to comments, Regs. Sec. 1.408A-5, Q&A-6(c), was added to allow a deceased taxpayer's representative to make a recharacterization election on the decedent's final return.
Observation: Either a taxpayer or a decedent's representative can recharacterize a contribution, but only a taxpayer can convert an IRA. Therefore, the election to convert a traditional IRA to a Roth IRA should be included in the list of deathbed planning decisions, with the understanding that the conversion could be recharacterized by the decedent's representative after death.
Regs. Sec. 1.408A-5, Q&A-2(c), clarifies that, in the case of commingled IRAs, the calculation of the income associated with the amounts to be recharacterized includes any net losses on those amounts. According to the preamble, a recharacterization is not a Sec. 3405 distribution subject to withholding.
Regs. Sec. 1.408A-5, Q&A-5, prohibits the recharacterization of employer contributions under a SIMPLE or SEP IRA when those contributions are made. Once those contributions are made, however, all amounts in a SIMPLE or SEP IRA can be converted to a Roth IRA, then recharacterized back to the SIMPLE or SEP IRA.
The preamble clarifies that only actual contributions can be recharacterized. Therefore, excess contributions made in a prior year and applied against the contribution limits in the current year under Sec. 4973 cannot be recharacterized, unless the actual contribution still meets the recharacterization requirements.
Observation: The new reconversion limits described below limit a taxpayer's ability to convert back to a Roth IRA after recharacterization. Therefore, a recharacterization decision should be carefully considered; reconversions are limited during a taxpayer's life and prohibited after death.
Perhaps the final regulations' most dramatic changes from the proposed rules are the new limits placed on reconversions to a Roth IRA. As originally enacted, neither Sec. 408A nor the proposed regulations limited how often a conversion could be reversed and repeated. During 1998, some taxpayers used multiple reconversions to minimize the taxable conversion amount. In response, Notice 98-50 provided interim rules for 1998 and 1999 reconversions.
Regs. Sec. 1.408A-5, Q&A-9, now provides rules for reconversions. It continues the Notice 98-50 rules for 1998 and 1999 reconversions, but provides different rules for 2000 and thereafter. According to the preamble, there are three major differences between the rules for pre-2000 reconversions and post-1999 reconversions:
1. Effective Jan. 1, 2000, a taxpayer who converts an amount from a traditional IRA to a Roth IRA during the tax year, then recharacterizes it as a traditional IRA, cannot reconvert that amount to a Roth IRA before the later of (1) the beginning of the tax year following the conversion tax year or (2) the end of the 30-day period beginning on the day the amount is recharacterized as a traditional IRA.
Observation: Alternative (1) above permits reconversions after December 31 of the calendar year in which the conversion distribution is made. Alternative (2) above permits reconversions after the thirtieth day following the day on which the recharacterization is accomplished. Deadlines for conversions and recharacterizations do not coincide. Conversions for any tax year must be made before year-end; recharacterizations of conversions for any tax year can be made until the extended due date for the conversion year tax return. Under the new rules, taxpayers must wait at least 30 days (and possibly, as long as one year) to reconvert after the preceding conversion or reconversion. In effect, the same dollars can be converted or reconverted only once during any one calendar year.
2. A conversion that fails because the taxpayer does not meet the $100,000 MAGI limit or the Sec. 408(d)(3) qualified rollover contribution requirements and is recharacterized as a traditional IRA is treated as a conversion in determining when a reconversion can be made.
Example 1: A converts a traditional IRA to a Roth IRA in 2000, then recharacterizes it as a traditional IRA on March 1, 2001 because he does not meet the MAGI limit. A cannot reconvert that amount back to a Roth IRA before March 31, 2001 (the first day after the 30-day period beginning on the day of the recharacterization).
Example 2: B converts a traditional IRA to a Roth IRA in 2000, then recharacterizes it as a traditional IRA on Sept. 1, 2000, because he does not meet the MAGI limit. B cannot reconvert that amount back to a Roth IRA before 2001.
3. Post-1999 reconversions that occur before the permitted time are classified as failed conversions (not excess reconversions), but are not treated as conversions in determining when an IRA owner may make a reconversion.
Example 3: C (1) converts a traditional IRA to a Roth IRA in 2000, (2) recharacterizes that amount as a traditional IRA on March 1, 2001 and (3) attempts to reconvert the amount on March 15, 2001. The March 15 reconversion is a failed conversion, because it occurred before March 31, 2001. C must recharacterize the March 15 reconversion to avoid penalty taxes. However, if C recharacterizes the March 15 failed conversion, she may reconvert the amount once in 2001 at any time after March 30, because the March 15 failed conversion does not count as a conversion in determining when the next reconversion is permitted.
Observation: In a real sense, the one (re) conversion-per-year restriction increases the tax cost of converting to a Roth IRA, because it limits the taxpayer's ability to time the conversion (and, therefore, to reduce conversion income). The importance of timing was very evident to taxpayers in 1998.
The taxation of distributions from a Roth IRA is complex. The final regulations did not simplify the rules, but clarified issues raised by commentators.
Under Kegs. Sec. 1.408A-6, Q&A1, Roth IRA distributions are excluded from a taxpayer's income if they are:
1. Corrective distributions.
2. Rolled over to another Roth IRA.
3. Qualified distributions.
4. Nonqualified distributions made from the taxpayer's Roth IRA contributions.
Corrective distributions: Regs. Sec. 1.408A-6, Q&A-i(d), provides that contributions returned to the taxpayer (corrective distributions) in accordance with Sec. 408((t)(4) are not included in income; the net income associated with the returned contribution is included in income.
Rollovers: Under Regs. Sec. 1.408A-6, Q&A-I(c), distributions rolled over to another Roth IRA taxfree in accordance with Secs. 408(d)(3) and (e) are excluded from income.
Qualified distributions: According to Regs. Sec. 1.408A-6, Q&A-1(b), qualified distributions occur if both of the following are met:
* Made after a five-tax-year period (FTYP) that begins on the earlier of the first day of the taxpayer's tax year (1) for which the first regular contribution is made to any Roth IRA or (2) in which the first conversion contribution is made to any Roth IRA. The FTYP ends on the last day of the taxpayer's fifth consecutive tax year. A contribution to any of the taxpayer's Roth IRAs will begin the FTYP for all of the taxpayer's Roth IRAs. According to the preamble, if the entire Roth IRA account balance is distributed to the taxpayer before he makes any other Roth IRA contributions, the FTYP does not start again. If an initial Roth IRA contribution is revoked within seven days or is recharacterized, the initial contribution will not start the FTYE. Regs. Sec. 1.408A-6, Q&A-2, clarifies that a contribution distributed as a corrective distribution is treated as if it was never contributed; thus, it does not affect the FTYE.
Example 4: D, a calendar-year taxpayer, made his first regular Roth IRA contribution on April 15, 1999 and designated the contribution as a 1998 contribution. The FTYP for qualified distributions began on Jan. 1,1998 for all of D's Roth IRAs; qualified distributions from any of his Roth IRAs can begin in 2003.
Example 5: E converted his traditional IRA to a Roth IRA on Feb. 1, 1999. The FTYP for qualified distributions began on Jan. 1, 1999 for all of E's Roth IRAs; qualified distributions from any of E's Roth IRAs can begin in 2004.
* Made on or after (1) the taxpayer reaches age 59 1/2, (2) the taxpayer's death (to the taxpayer's beneficiary or estate), (3) the taxpayer becomes disabled or (4) the taxpayer qualifies under Sec. 72(t)(2)(F) for a first-time home purchase. A distribution to a surviving spouse who is the sole beneficiary of a deceased spouse's Roth IRA and who treats the Roth IRA as his own is deemed to be made from the survivor's own Roth IRA, not the decedent's Roth IRA. Therefore, the distribution is not treated as if it was made after the decedent's death; consequently, it is not a qualified distribution on that basis.
Nonqualified distributions from owner's contributions: Under Regs. Sec. 1.408A-6, Q&A-4, a nonqualified distribution made from the owner's contributions to the Roth IRA is tax-free.
In determining the taxable portion of a nonqualified distribution, Regs. Sec. 1.408A-6, Q&A-4, allows nonqualified distributions to be reduced by prior distributions previously included in gross income. The preamble clarifies that the taxable portion of a nonqualified distribution is determined as follows:
Current nonqualified distribution
+ All prior distributions (qualified or nonqualified) - Distributions previously includible in income - All contributions to all Roth IRAs
Whether or not a distribution is taxable, any distribution in 1998, 1999 or 2000 allocable to a 1998 conversion contribution, to which the four-year spread applies, accelerates the recognition of the deferred income. Regs. Sec. 1.408A-6, Q&A-6, states that the accelerated amount is recognized in addition to the amount otherwise includible in income from the conversion that year.
Order of Distributions
According to Regs. Sec. 1.408A-6, Q&A-9, Roth IRA distributions made during a tax year are aggregated and deemed made at the end of the tax year. Sec. 408A(e) rollover distributions and corrective distributions (including net income) are not included in determining contributions, earnings and distributions. Distributions are treated as made in the following order, exhausting each category before moving to the next:
1. From regular contributions. Regular contributions for the same tax year to all of the taxpayer's Roth IRAs are aggregated and are added to the taxpayer's total undistributed regular prior-tax-year contributions. Regs. Sec. 1.408A-6, Q&A-9(b), clarifies that regular contributions for a tax year include contributions designated as made for a particular year, but actually made by the due date of the return in the following year (in accordance with Regs. Sec. 1.408A-3, Q&A-2). Regs. Sec. 1-408A-6, Q&A-11, clarifies that a beneficiary can aggregate all Roth IRAs inherited from the same decedent, but cannot aggregate those Roth IRAs with the beneficiary's other Roth IRAs, unless the beneficiary is the decedent's spouse and the sole beneficiary of the decedent's Roth IRAs.
2. From conversion contributions, on a first-in-first-out basis (and first, from any portion included in income due to the conversion). Conversion contributions received by all of the taxpayer's Roth IRAs during the same tax year are aggregated. However, 1999 conversion contributions distributed from a traditional IRA in 1998 and for which the four-year income spread was elected are deemed to be the first conversion contribution amounts received.
3. From earnings. The following rules apply in determining the source of a distribution:
* Contributions made to a traditional IRA, then recharacterized as contributions to a Roth IRA, are considered made in the year the contribution was originally made to the traditional IRA, under Regs. Sec. 1.408A-6, Q&A-9(f).
* Regular and conversion contributions made to a Roth IRA, then recharacterized to a traditional IRA, are disregarded in determining the amount of the contributions and distributions for the tax year in which the original Roth IRA contributions were made, under Regs. Sec. 1.408A-6, Q&A-9(g). When (1) contributions to a Roth IRA are recharacterized as a traditional IRA or (2) contributions to a traditional IRA are recharacterized as a Roth IRA, the contribution amount is based on the original contribution, according to Regs. Sec. 1.408A-6, Q&A-9(h).
Sec. 72(t) Penalty
Roth IRA distributions may be subject to the 10% tax on early distributions. The penalty is assessed under Regs. Sec. 1.408A-6, Q&A-5, if (1) a distribution is included in income, but is not described in Sec. 72(t) or (2) a nonqualified distribution that is not currently included in income is allocable to a conversion contribution and made within an FTYP beginning on the first day of the tax year in which the conversion contribution was made (FTYP2). FTYP2 differs from the FTYP used to determine whether a distribution is a qualified distribution. Thus, taxpayers can have only one FTYP, but may have as many FTYP2s as they have conversion contributions.
Example 6: F converted $10,000 to a Roth IRA in 1999 and an additional $10,000 in 2000. In 2004, when F is age 50, he withdraws $16,000 from the Roth IRA to purchase a car. F's FTYP is satisfied (it began on Jan. 1, 1999 for both IRAs), but because F is not age 59 1/2 or disabled, the distribution is not a qualified distribution. The distribution is not subject to regular tax, because it is made from contributions. Because the withdrawal is made after the FTYP2 ended for the 1999 contribution, but before the FTYP2 ended for the 2000 contribution, the 10% tax will apply to the amount distributed from the 2000 contribution ($6,000). However, if F is age 62 when the distribution is made, neither the regular nor the additional tax will apply. Although FTYP2 is not met for the distribution from the 2000 contribution, the entire distribution would be a qualified distribution to which the 10% tax would not apply
Example 7: G, age 40, converts $10,000 to a Roth IRA in 1999. In 2001, he withdraws $12,000 ($2,000 is earnings) to pay qualified higher education expenses (as defined in Sec. 529(e)(3)). The distribution is nonqualified; thus, G must include $2,000 in gross income. However, the 10% tax does not apply, according to Regs. Sec. 1.408A-6, Q&A-5(a), because the distribution meets an exception in Sec. 72(t)(2)(E).
Income Tax Withholding
Regs. Sec. 1.408A-6, Q&A-12 and -13, state that a Roth IRA distribution is an individual retirement plan distribution, regardless of the means of conversion, for purposes of Sec. 3405 (e) (1) (A) (ii); thus, it is a designated distribution subject to the Sec. 3405 withholding rules. Unless one of the Sec. 3405(e)(1)(B) exceptions applies, periodic payments are subject to withholding as if they were wage payments; nonperiodic distributions are subject to 10% withholding. However, Sec. 3405(a)(2) and (b)(2) allow taxpayers to elect not to be subject to withholding. Although a Roth IRA conversion is considered a designated distribution subject to withholding, a 1998 trustee-to-trustee transfer (using the same trustee or different trustees) from a traditional IRA to a Roth IRA is not a designated distribution subject to withholding.
Although the Roth IRA final regulations do not relieve complexity, they do clarify many of the concerns raised by commentators. In addition, the regulations provide new rules for reconversions after 1999 that differ significantly from those provided in Notice 98-50. To avoid costly errors, close attention to detail is needed when dealing with Roth IRAs.
For more information about this article, contact Dr. Foran at (316) 978-6258 or nforan@ twsuvm.uc.twsu.edu.
(1) KEG-1153963-98 (9/3/98).
(2) Notice 98-49, IRB 1998-38, 5.
(3) Notice 98-50, IRB 1998-44, 10.
(4) TD 8816 (2/3/99).
(5) For a comprehensive discussion of Roth IRAs, see Lange, "IRAs After the TRA '97--What Hath Congress Roth?," 29 The Tax Adviser 318 (May 1998).
Nancy J. Foran, Ph.D., CPA Associate Professor School of Accountancy Wichita State University Wichita, KS
Jeffrey J. Bryant, J.D., Ph.D., CPA Associate Professor School of Accountancy Wichita State University Wichita, KS3
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|Title Annotation:||IRS regulations|
|Author:||Bryant, Jeffrey J.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 1999|
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