Under the Roth IRA provisions as passed in the Taxpayer Relief Act of 1997, there exists a loophole that would allow one to avoid the 10% penalty on pre-59½ distributions from a traditional IRA. All you would have to do is to roll over the balance from an existing IRA to a Roth IRA. This could be done as early as January 1, 1998. You would, of course, still be liable for income tax on the rollover although you would have the benefit of the four year spreadout of the taxability of the income (this special benefit is only available for conversions in 1998). Immediately after the rollover or conversion to a Roth IRA, a taxpayer could immediately withdraw the full balance from the Roth IRA without being subject to the 10% penalty that would normally apply to pre-59½ distributions from an IRA. Such a withdrawal would be a recovery of one's contribution to the Roth IRA and would have no other tax consequences.
Does the above sound too good to be true? Well, it is. This unintended loophole has not gone unnoticed by the taxing authorities. The House Ways and Means Committee is expected include a provision that gets rid of this loophole in a bill fixing errors in the Taxpayer Relief Act of 1997. This is expected to happen in the first week or two of October with a bill being passed before year's end.
Discussion of Technical Corrections
Bill
This change was
scheduled to be marked up October 9th by the House Ways and Means Committee. We posted on
10/10/97 at this web site the Joint Committee Explanation of the proposed technical corrections. The changes are important
since they make it more difficult to pay the income tax on a Roth IRA conversion from the
Roth IRA itself and to have withdrawals of contributions during the initial five year
period. Unfortunately, it looks like the writers of the technical corrections bill have
decided to go beyond what was necessary to fix the loophole. Under the proposed technical
corrections, there would generally be a 10% penalty on withdrawals prior to age 59½
during the initial five year period, even those made to pay the income tax! A second 10%
penalty would apply to withdrawals within the five year period if one took advantage of
1998's four year spreadout of the taxable income (and you don't have any other option in
1998 because all 1998 conversions get the four year spreadout). It also appears that there
would be no way for one under age 59½ to do a conversion while paying the income tax on
the conversion from the traditional IRA or the Roth IRA without incurring a 10% penalty.
(To make matters worse, in such a case where you needed to pay both the income tax on the
conversion and the penalty from the Roth IRA itself, you would need perform an
interrelated calculation in order to figure out how much to withdraw!)
It now appears unlikely the technical corrections bill will be acted upon in 1997. Although technical corrections seem likely to eventually pass, they will probably be acted upon in early 1998 (and would almost certainly be retroactive to the beginning of the 1998). Congress is slated to adjourn in early November. The Senate Finance Committee is apparently working on a technical corrections bill, but it has been reported that it is unlikely they will finish in time for this year. Also, there is uncertainty whether the existing bill in House will even be reported to the floor this year. With action on the technical corrections on the slow burner, maybe there is now some hope of changes to the original proposals.
UPDATED 10/29/97:
A Staff member with the Joint Committee on Taxation has been quoted for the proposition
that when the technical corrections bill does pass, the changes will have a retroactive
effective date.
UPDATED
11/13/97:
The Technical Corrections (H.R. 2645) were included in IRS Reform Bill (H.R. 2676) that
was passed by the House on 11/5/97 by a 426-4 vote. However, over in the Senate, Sen. Roth
has resisted calls to pass the IRS Reform Bill in its current form, apparently delaying
any action until next year.
We have heard a rumor of some substance that the technical corrections may ultimately be modified to allow payment of Roth IRA conversion taxes from an IRA without the imposition of a penalty. But there is nothing concrete on it at this time; so we'll just have to wait and see. We'll post any further developments here.