by Barry C. Picker, CPA/PFS, CFP
© 1998, Barry C. Picker
The following copyrighted article is available exclusively on the Roth IRA Web Site:
The Taxpayer Relief Act of 1997 (P.L. 105-34) added Code section 408A which created a new type of Individual Retirement Account, known as Roth IRAs. The basic premise of the Roth IRA is that there is no tax deduction for money going in, and no tax due on money coming out, as long as the conditions of the section are met. The conditions are that the Roth IRA has been in existence for five years, AND the distribution occurs after the account holder attains age 59½, OR after the death of the individual OR on account of disability, OR for a first time home buyer as defined in the Code.
Immediately after the passage of the new tax law, questions arose and loopholes were discovered in the Roth IRA rules. For example, an individual is permitted under certain circumstances to convert an existing traditional IRA into a new Roth IRA. The amount so converted will be included in taxable income in the year of conversion, except that for conversions made in 1998, the resulting income will be spread ratably over four years. Since the additional 10% penalty tax on early withdrawals would not be applicable to these conversions, there was nothing to stop a taxpayer from converting their traditional IRA to a Roth and immediately withdrawing the money, thus getting the benefit of a four year spread on the tax while avoiding the early withdrawal penalty. Also, the law was silent as to what would happen if the taxpayer died within the four year period.
These issues, and more, are now addressed in the Technical Corrections included in the Internal Revenue Service Restructuring and Reform Act of 1998. The following is a discussion of the changes.
The rule for annual contributions states that an individual can contribute to a traditional IRA, a Roth IRA, or both, in any year, as long as the total amount contributed does not exceed $2,000. A drafting error in the original law would have limited certain taxpayers to a total contribution of less than $2,000, if their adjusted gross income (AGI) was such that their Roth IRA contribution was limited, but not eliminated. The Technical Correction clarifies this so that if a single taxpayer has an AGI between $95K and $110K or married taxpayers filing a joint return have an AGI between $150K and $160K, they can make a Roth contribution to the extent permitted, and still contribute the difference between the Roth contribution and $2,000 to a traditional IRA.
Individuals who wish to convert their traditional IRA to a new Roth IRA can do so only in a year in which their AGI does not exceed $100K. The $100K AGI is computed, for this code section only, without including the income that results from the conversion. This has now been clarified to state that all components of AGI are computed, for this section only, with the conversion income excluded. For example, a taxpayer has a salary of $105,000 and a active participation rental loss of $6,000. If they are permitted to convert their traditional IRA to a Roth IRA, they will recognize $50K of conversion income. However if they include the conversion income, the rental loss will not be allowed. It is now clear that for purposes of determining AGI to see if the taxpayer is eligible to convert, the AGI in this example would be $99K ($105K salary less $6K rental loss), even though the actual tax return will not permit the rental loss.
Taxpayers who do a traditional to Roth conversion in 1998 will be permitted to make an election to include the entire conversion income in their 1998 taxable income, rather than taking it into account ratably over four years. This election cannot be changed after the (extended) due date of the tax return.
If a taxpayer converts his or her IRA in 1998 and then dies in either 1998, 1999 or 2000, the amount of conversion income not previously reported, will be included in the decedent's final tax return. However an exception is made if the Roth IRA is inherited by the spouse. If the spouse so elects, the spouse can continue to report the conversion income on the same schedule as the decedent would have. This election cannot be made or rescinded after the due date of the spouse's tax return for the year of the decedent's death.
The loophole whereby a taxpayer could convert their IRA to a Roth and then pull the money out has been closed by a combination of two new provisions. The first provision applies to the case of a 1998 conversion where the conversion income is being reported ratably over four years. Any withdrawal of the converted amount within the four years will mean an acceleration of the inclusion of the conversion income. The acceleration is accomplished by adding the withdrawal of the converted amount to income in the year of the withdrawal. However the inclusion is limited to the remaining taxable amount of the conversion. For example, if the taxpayer converted $80K in 1998 (no amount attributable to non deductible contributions) and then withdrew $10K in 1999, the taxpayer would have to report $30K of conversion income in 1999, instead of the $20K that would otherwise have to be included. In subsequent years, assuming no additional withdrawals, the taxpayer would report $20K conversion income in 2000, and $10K in 2001, bringing the total to the $80K. If the taxpayer had withdrawn $50K in 1999, then $60K would be included in income in 1999 ($80K total less $20K included in income in 1998), and nothing would be reported in subsequent years. In no event would the total reported income exceed the taxable portion of the converted amount. If the taxpayer has basis in his traditional IRA, the basis is deemed to come out AFTER the taxable portion of the traditional IRA. So if the taxpayer converts a traditional IRA of $100K in 1998 which had a basis of $20K, the timing of the inclusion of income would remain the same, in the above examples.
The second provision designed to close the loophole states that if a withdrawal is made of a converted IRA within the five taxable year period beginning with the year of the conversion, section 72(t) (the 10% early withdrawal penalty excise tax) will be applied to that withdrawal, as if the withdrawal was included in gross income, with the taxable portion of the IRA being deemed distributed first. If there was any IRA basis at the time of conversion, due to non-deductible contributions, the portion of the subsequent withdrawal attributable to that basis will not be subject to section 72(t). To illustrate, assume taxpayer converts an IRA of $50K in 1999, and the taxpayer has a basis in the IRA of $10K. The taxpayer will report income of $40K in 1999, due to the conversion. In 2003, the taxpayer withdraws $10K attributable to the conversion. The $10K is attributable to the income portion of the original IRA, and is therefore subject to an additional tax of $1,000, unless one of the exceptions of section 72(t) is met. Had all $50K been withdrawn within the five year period, the additional tax would be limited to $4,000, since only $40K is the amount originally included in income.
In the original Roth IRA statute, it was stated that all contributions would be deemed distributed first. This had the effect of permitting tax and penalty free withdrawals from the Roth IRA to the extent of contributions, even if the withdrawal was made prior to age 59½, or prior to the account having been in existence for five years. The technical corrections reaffirm this, but add ordering rules to cover amounts converted from traditional IRAs. Under the revised rules, the first money coming out from a Roth IRA will be the annual contributions that have been made, followed by any converted amounts, on a first in first out basis. However, as stated above, if the taxpayer had basis in the converted IRA, the basis comes out after the income portion of the conversion. Lastly, the income earned or the appreciation of the assets in the account will come out. Except for the case of a withdrawal attributable to a conversion that will be subject to section 72(t) as discussed above, only the withdrawal of the income earned or asset appreciation will be subject to income tax and section 72(t), in the case of a nonqualifying withdrawal.
At one time, it appeared that taxpayers would be required to keep their converted Roth IRAs separate from their contributory IRAs. At the very least, the IRS was recommending this course of action. Technical Corrections' aggregation rules eliminates the need to do this; in fact, there will be no difference whether the accounts are separate or not, since they will be treated as one for distribution rule purposes.
The distribution rules can be illustrated by the following example: Taxpayer contributes $2,000 to her Roth IRA each year for 1998, 1999 and 2000. In 2000, she converts her traditional IRA to her Roth IRA. The value at the time of the conversion is $60K, of which $20K is her basis. She reports and pays tax on $40K on her tax return for 2000. In 2001, her Roth IRA has a value of $80K, and she takes a withdrawal of $6K. Since this $6K is attributable to her annual contributions, there is no tax consequence to this withdrawal. She then withdraws an additional $40K. This $40K comes from the taxable portion of her converted IRA. It will not be subject to income tax, since income tax was paid in 2000. However it is subject to the 10% early withdrawal tax of section 72(t), unless an exception applies. At this point, the next $20K can be withdrawn free of income or penalty tax, since it will be attributable to the basis in the original IRA. Anything after that will be considered as coming from income, and will be subject to both income tax and penalty tax, until such time as the distribution would constitute a qualified distribution.
One very large question that had come up after the original statute was passed, was what would happen if a taxpayer did a conversion, or made an annual Roth contribution, and then found that their AGI was too high? Theoretically, in the case of a conversion, the taxpayer would have emptied his entire IRA, being subject to income tax and section 72(t) tax (unless an exception was met) and losing the continued tax deferred compounding. The technical corrections addresses this issue by allowing taxpayers until the extended due date of their tax return to do a trustee-to trustee transfer of any amount back to a traditional IRA as long as the transfer includes any income allocable to the amount being transferred. In fact, this ability to make a trustee-to-trustee transfer works both ways, so that a person can contribute to a traditional IRA and then transfer over to Roth prior to the extended due date, if the taxpayer wishes to and is otherwise eligible. Keep in mind, however, that any conversion must be done by December 31st of any given year, and this provision in no way changes that. But it does remove the cloud hanging over taxpayers' heads, so that those who are unsure if their income will be over the $100K limit can go ahead and convert their IRAs, and can just convert back if it turns out that the conversion is not permitted. There is an added advantage to this provision. Eligible taxpayers can now go ahead and convert their IRAs into Roth IRAs, and if the value of the IRA should then decrease due to market conditions, the taxpayer can then convert the account back to a traditional IRA and not have to pay tax on the loss in value. They can then subsequently re-convert the account back to a Roth, at the lower value.
(Roth IRA Web Site Editor's Note: It will be interesting to see to what extent the IRS will try to limit one from unconverting and then converting again in order to reduce the income tax on conversions.)
Lastly, come 2005, if any individual past his required beginning date is taking a required distribution from a retirement plan, such required distribution will NOT count towards the $100K AGI limit for conversions. Thus, more people would be able to convert their IRAs to Roths. However, the required distribution will still be counted as taxable income, and such required distribution MUST be taken, and CANNOT be converted to a Roth.
Hopefully, with all these corrections, Congress has now gotten it right. Taxpayers can go ahead with their Roth contributions and conversions, knowing exactly where they stand. That is, unless more glitches come to light, or Congress decides at some future point to once again tinker with the tax code.
The Author:
Barry C. Picker is a Certified Public Accountant with the Personal Financial Specialist
designation, and is a Certified Financial Planner licensee. He runs his own accounting and
financial planning firm located in Brooklyn, NY, and is also a member of the NYS Society
of CPAs Estate Planning Committee. He has taught seminars and written articles on tax
topics, and has been quoted in various publications. In addition, he is part of a panel
that answers tax questions on America Online at keyword:TaxLogic. He can be reached at
(718) 934-4300, or via E-Mail at BPickerCPA@cs.com.