By Natalie Choate
© 1998, North Carolina Bar Association
From "The Will and the Way"
February 1998, Vol. 17, No. 2
(This article is available on the World Wide Web exclusively at the Roth IRA Web Site)
New Code Section 408A establishes a whole new kind of IRA, called a "Roth IRA," beginning in 1998. The basic idea of this new breed of IRA is that contributions are nondeductible, but "qualified distributions" are tax free. In addition to tax-free "qualified distributions," the Roth IRA offers other benefits: no minimum required distributions during life; no maximum age for making contributions; and even a favorable rule for tax treatment of "non-qualified" distributions.
There are two ways to create a Roth IRA. One is by nondeductible contributions of up to $2,000 per year from earned income; the other is by rollover from an existing "traditional" IRA. The rollover of a traditional IRA to a Roth IRA causes the full amount of the rollover to be currently taxed (although if the rollover occurs in 1998 the tax is spread over four years).
Each of the two methods has its own rules and eligibility requirements. From a planning perspective, the two methods of creating a Roth IRA offer quite different sets of opportunities. The Roth IRA funded by annual contributions from earned income will be of interest exclusively to those who are still working. The rollover-funded Roth IRA will be of interest mainly to retired people.
This article discusses primarily the rollover-funded IRA. Natalie Choate describes the rules, including who is eligible to create a Roth IRA, how distributions are taxed (or not taxed) and what distribution rules apply. Carl Brooks looks at whether the Roth conversion is profitable. Both authors offer ideas on estate planning uses for Roth IRAs, and on "what can go wrong."
A technical corrections bill has been proposed to clean up and clarify various aspects of Roth IRAs, but has not been enacted. Whenever the technical corrections bill would change a statement in this text, the change is noted in italics after the statement.
Official materials include the statute, new Code Section 408A, added by Section 302(a) of TAPRA; IRS Announcement 97-122 (providing interim guidance on Roth Individual Retirement Accounts), Dec. 2, 1997; IRS forms 5305-R and 5305-RA, providing model agreements for Roth individual retirement trust and custodial agreements; and the so-called "legislative history," or "Blue Book," the Jont Committee on Taxation’s "General Explanation of Tax Legislation Enacted in 1997" (JCS-23-97) (issued Dec. 22, 1997).
The website www.rothira.com provides downloadable copies of the portions of TAPRA, legislative history and technical corrections bill dealing with Roth IRAs, as well as a collection of articles about Roth IRAs, links to online software to compute the benefits of Roth IRAs, IRS pronouncements and other items of interest concerning Roth IRAs.
Brentmark Software has updated its excellent "Pension and Excise Tax Planner" software (now renamed "Pension and Roth IRA Analyzer") to enable planners and their clients to determine whether it is worthwhile to convert a traditional IRA to a Roth IRA, as well as making numerous other useful determinations regarding retirement plan distributions. For information about this software, call 1-800-879-6665.
Definition of "Qualified Distribution"
"Qualified distributions" from Roth IRAs are not included in the recipient’s gross income for federal income tax purposes, regardless of whether the recipient is the participant or a beneficiary. §408A(d)(1)(A). A "qualified distribution" is one made after the five-year period beginning with the first taxable year for which a contribution was made to the Roth IRA (§ 408A(d)(2)(B)) (see "Definition of the Five Year Period" below); and which in addition (§408A(d)(2)(A)) is a distribution (1) made on or after the date on which the participant attains age 59½; or (2) made after the participant’s death; or (3) attributable to the participant’s being totally disabled; or (4) of up to $10,000 for certain purchases of a "first home." §408A(d)(5).
Definition of "Five-Year Period"
For a Roth IRA funded only with annual $2,000 contributions, the "five-year period" begins with the first year for which a contribution was made to any Roth IRA maintained for the participant.
A different rule applies "in the case of a...distribution properly allocable (as determined in the manner prescribed by the Secretary) to a qualified rollover contribution" from a traditional IRA. The determination of the five-year period is made separately for rollovers made in different years. In other words, each year’s rollover contributions, the way the statute is written, have their own separate five-year period.
The technical corrections bill would amplify and clarify the mechanics of determining the five-year period for multiple-year conversions from traditional IRAs. In the case of a Roth IRA which contains any "conversion" money, the five-year period would begin with the most recent year in which a rollover contribution from a traditional IRA was made. For a Roth IRA that contains both annual contributions and onversion contributions, the five-year period will begin with the year of the most recent addition to the account by means of a rollover or conversion from a traditional IRA.
These rules for determining the "five-year period" suggest the following planning principles:
Never commingle a Roth IRA funded with annual $2,000 contributions with a Roth IRA containing funds that were rolled over from a traditional IRA.
If a participant converts traditional IRA funds to Roth IRA status in more than one calendar year, a separate Roth IRA should be established for each year’s rollovers.
Tax Treatment of Nonqualified Distributions
A nonqualified distribution is one made before the five-year period is up; or which is made after expiration of the five-year period but not for one of the specified reasons (age 59½, disability, death, etc.). A nonqualified distribution is not per se excludable from gross income. However, even if a distribution is not "qualified" it receives favorable tax treatment compared with distributions from the traditional IRA.
A Roth IRA contains two types of money. First, it contains the participant’s own annual contributions and/or conversion contributions; since the participant has by definition already paid taxes on these funds, there is no tax when these originally-contributed funds are distributed. This amount constitutes the participant’s "basis" or "investment in the contract."
If the account has grown to be worth more than this "basis," the rest of the account value (which represents the earnings and growth that have occurred since the original contribution(s)) has not yet been taxed (and will never be taxed if it is distributed in the form of a qualified distribution).
In a traditional IRA which contains nondeducted contributions, all distributions are deemed to come proportionately from the "basis" (nontaxable) portion of the account and the post-contribution earnings. §408(d); 72(e)(2)(B), (e)(5)(A) and (D)(iii) and (e)(8). Thus, the participant’s basis or investment in the contract is recovered only gradually, as he makes withdrawals from the account, and some part of every distribution is taxable.
In contrast to this unfavorable treatment of the traditional IRA, all distributions from a Roth IRA are deemed to come first out of the non-taxable basis, until it has been entirely distributed. §408A(d)(1)(B).
The Annual Contributions Roth IRA
How Much May Be Contributed Annually
One way to fund a Roth IRA is by making annual contributions. The maximum amount which may be contributed is defined in a convoluted manner, but may be summarized simply: it is (1) the lesser of $2,000 or the individual’s "compensation" income for the year, mius (2) the amount contributed to any traditional IRA for that year.
Who May Contribute to a Roth IRA: Income Limits
Not just anyone who has compensation income can contribute to a Roth IRA. As with many tax breaks granted by TAPRA ’97, there is an income limit.
The income limit for contributing the full $2,000 to a Roth IRA is: adjusted gross income (AGI) may not exceed $95,000 for a single taxpayer; $150,000 for a married taxpayer filing a joint return; or zero for a married taxpayer filing a separate return. The $2,000 contribution ceiling is phased out above these levels to zero at AGI of $110,000 (single), $160,000 (married filing jointly), or $10,000 (married filing separately). §408A(c)(3)(A), (C). For the definition of "income" for this purpose, see discussion under "Conversion Roth IRAs," below.
Who Can Contribute: Other Limits
There is no maximum age limit for contributing to a Roth IRA, as there is for contributions to a traditional IRA; a taxpayer can contribute to a Roth IRA even after age 70½. § 408A(c)(4); compare §§408(o)(2)(B)(i), 219.
As with other IRAs, contributing to a Roth does depend on having "compensation income" for the year in question. §§408(o)(2)(B)(i), 219. Thus individuals who are totally retired cannot contribute to a Roth IRA just as they cannot contribute to a regular IRA for themselves. (However, retirees may want to consider "conversion" Roth IRAs, discussed below, and establishing Roth IRAs for young working family members.)
Participation in an employer plan is irrelevant for purposes of determining whether (and how much) an individual may contribute to a Roth IRA.
Deadline for Contributions and Other Rules
The contribution for a particular year must be made no later than the (unextended) due date of the individual’s tax return for that year. §408A(a), § 219(f)(3). In other words, the deadline for most individuals is April 15 following the year in question.
Roth Conversion (Rollover) IRAs
The second way to get money into a Roth IRA is to transfer it from a traditional IRA. The amount so transferred is included in the participant’s gross income ("treated as a distribution from" the traditional IRA); thereafter the account will enjoy the favorable tax treatment afforded to Roth IRAs. §408A(d)(3)(A), (B), (C). As with the annual contributions, there is an income limit imposed on who may do this — naturally, a different limit from the income limit applicable to making annual contributions.
Rolling over from a traditional IRA to a Roth IRA is sometimes described as "converting" a traditional IRA to a Roth IRA. This convenient term (which is used in Section 408A) distinguishes the "traditional-to-Roth" rollover (a "conversion," which is a taxable event) from a "normal" rollover (from one traditional IRA to another traditional IRA, or from one Roth IRA to another Roth IRA), which is a nontaxable event.
However, in fact a traditional IRA cannot be truly "converted" to a Roth IRA, because a Roth IRA is a separate and distinct account, with its own account agreement. Therefore the assets are transferred (either by trustee-to-trustee or custodian-to-custodian transfer, or by a true "rollover") from the old, traditional IRA to the new Roth IRA. In this text as in most discussions of Roth IRAs, "conversion" means transferring funds from a traditional IRA to a Roth IRA pursuant to Section 408A(d)(3)(B).
At present there is no way to transfer funds directly from a qualified plan or 403(b) arrangement to a Roth IRA, or to "roll over" a distribution from a qualified plan directly into a Roth IRA. This is because Section 408A(c)(6) says "No rollover contribution may be made to a Roth IRA unless it is a qualified rollover contribution"; and Section 408A(e) defines a qualified rollover contribution as "a rollover contribution to a Roth IRA from another such account or from an individual retirement plan." However, a participant in a qualified plan or 403(b) plan apparently can roll over his distribution to a traditional IRA and then roll that to a Roth IRA.
Who May Convert: The Income Limit
No conversion is permitted if (1) the taxpayer is married filing a separate return for the year or if (2) "the taxpayer’s adjusted gross income for such taxable year exceeds $100,000." There is no distinction in this flat-dollar limit between single and married-filing-jointly taxpayers. There is no provision for any future COLAs or other increases in this limit. AGI for this purpose does NOT include the amount included in gross income because of the conversion of the traditional IRA to a Roth IRA. §408A(c)(3)(C)(i).
The definition of AGI for this purpose is the same as the definition of AGI used under Section 219(g)(3), which contains the income limits for making a deductible contribution to a traditional IRA when the individual is also a participant in an employer plan. The Section 219(g)(3) definition of AGI includes the individual’s taxable Social Security benefits (Section 86), and takes into account the disallowance of "passive activity losses" (Section 469) if applicable. §408A(c)(3)(C).
What if the Minimum Required Distribution for the Year Pushes Income Above $100,000
Example: Jeanette is past her "required beginning date," so she is already taking minimum required distributions from her traditional IRA. Now it is 1999 and she would like to convert her $500,000 traditional IRA to a Roth IRA. Her adjusted gross income, before taking any IRA distributions, is $50,000, so based on this she meets the income limitation. But her minimum required distribution for 1999 from the traditional IRA is (assume) $75,000. If she has to take that much out of her IRA on a taxable basis she will be over the $100,000 income cap and cannot convert to a Roth IRA. Is there any way around this dilemma?
First question: Can the realization of deemed income that comes from converting to a Roth IRA "count" as fulfilling her minimum distribution requirement for 1999? After all, the point of the minimum distribution rules is simply to make sure you pay some income tax on your retirement plan, and she will have paid tax on 100 percent of the IRA value by converting it to a Roth. If the conversion "counts" as fulfilling her minimum distribution requirement, then the problem goes away. She does not have to take any actual distribution from the IRA.
[Note: If this works, then an eligible individual who does not need to withdraw cash from his traditional IRA, but is forced to take annual distributions because of his age, could decide each year instead of actually taking a minimum required distribution from the traditional IRA to simply convert that amount of the traditional IRA to a Roth IRA each year. He would have to pay tax on that amount, but he would have had to pay tax on that amount anyway if he had simply taken a distribution from the traditional IRA, and this way he continues to enjoy tax-free compounding on the IRA’s investment return.]
Second question: Returning to Jeanette’s problem, if the conversion of her traditional IRA to a Roth IRA does not "count" toward her $75,000 minimum required distribution for the year, and she is required to take an actual distribution in 1999, can she avoid the problem by first converting the IRA to a Roth, and then taking the distribution? The withdrawal from the brand new Roth IRA is nontaxable because it is deemed to be a return of her basis — she has already paid tax on it by virtue of the conversion — and therefore the post-conversion distribution does not put her over the $100,000 income cap.
Unfortunately, she may not be able to execute this maneuver, because of the rule that a required distribution may not be rolled over. For example, if she withdraws all the money from her traditional IRA (in order to roll it to the Roth IRA), she will not be permitted to contribute all of it to the new Roth IRA — because part of the money constitutes a required distribution from the traditional IRA which cannot properly be rolled over (§408(d)(3)(E). Rollovers to Roth IRAs must meet the requirements of Section 408(d)(3)), so the Roth IRA will not accept this part of the contribution. And then she will be stuck with $75,000 of taxable income in addition to her other $50,000 and she will be over the $100,000 limit.
Can this problem be avoided by transferring to the Roth IRA everything except the minimum required distribution amount? In other words, the total value of her traditional IRA is $500,000; can she (1) roll $425,000 of it to a Roth IRA, leaving the 1999 minimum required distribution amount ($75,000) in the traditional IRA; then (2) take $49,999 of her $75,000 required distribution for 1999 from the traditional IRA to partially fulfill the minimum required distribution requirement for the year; and finally (3) leave $25,001 in the traditional IRA, to avoid going over the $100,000 income limit, thereby becoming subject to the 50-percent penalty on that amount?
Even if she is willing to go to the extreme of paying the 50-percent penalty by not taking all of her 1999 minimum required distribution in order to avoid going over the income limit it is not clear that she can do ths. A corollary of the rule that "you may not roll over the minimum required distribution" is that "the first dollars distributed are deemed to be part of the minimum required distribution until the minimum required distribution has been entirely distributed." Reg. §1.402(c)(2), A-7.
Thus, it would appear that the Roth IRA provider cannot accept any rollover from Jeanette’s traditional IRA until he sees proof she has actually withdrawn the minimum required distribution for the year. And if she actually withdraws the minimum required distribution of $75,000, her income is over $100,000 and she cannot convert any part of the IRA to a Roth IRA.
The bottom line: If a taxpayer is past his required beginning date, and his minimum required distribution is large enough to put him over the $100,000 limit for the year, he apparently cannot convert to a Roth IRA.
Tax Treatment of Converting to a Roth
The rollover from a traditional IRA to a Roth IRA is treated as a taxable distribution from the traditional IRA. §408A(d)(3)(A), (B), (C). Thus, the rollover amount is included in the individual’s gross income.
The 10-percent penalty under Section 72(t) (applicable to certain distributions before age 59½) does not apply to this "deemed" distribution. Thus an (otherwise eligible) young person may convert his traditional IRA to a Roth IRA without penalty. See discussion of technical corrections bill for proposed penalties to prevent devious young people from using Roth conversion to circumvent Section 72(t).
For rollovers in 1998 only, the inclusion in gross income is spread equally over the four taxable years 1998, 1999, 2000 and 2001 — whether you want it to be or not, apparently. § 408A(d)(3). And if the client dies before the end of this four-year spreadout? The statute is silent on this point.
The technical corrections bill would fix this glitch by providing that all the deemed income for the rest of the four year period is accelerated onto the decedent’s final return — unless the participant’s surviving spouse "acquires" the Roth IRA, in which case she can elect to include the income on her return each year for the balance of the four year spread out period, i.e., the same years the decedent would have included it had he lived. [But what if she then dies before the end of the four years?]
No Required Distributions During Participant’s Life
There are no "minimum required distributions" from a Roth IRA during life. Section 408A(c)(5) provides that "the provisions of §401(a)(9)(A)" and the "incidental death benefit requirement" do not apply to Roth IRAs. Section 401(a)(9)(A) contains the "lifetime" minimum distribution rule: that the participant’s interest in the plan must be distribute, beginning no later than the required beginning date (generally, April 1 following the year the participant reaches age 70½) over the life expectancy of the participant, or over the joint life expectancy of the participant and his beneficiary. So the participant who reaches age 70½ does not have to start taking distributions from his Roth IRA as he does from his traditional IRA.
After Death, Rules are the Same as for Traditional IRAs
The Roth IRA is not exempted from any minimum distribution rules other than Section 401(a)(9)(A) and the incidental death benefit rule, both of which apply only during the participant’s life. Accordingly, the post-death minimum distributions rules (Section 401(a)(9)(B)) apply the same as to other IRAs.
Therefore, a participant who converts to a Roth before his "required beginning date" apparently will never have a "required beginning date" (RBD) for his Roth IRA. Whenever he dies, even if he dies after reaching age 70½, his death will be "before his RBD," meaning that all benefits must be distributed from the Roth IRA either (1) by Dec. 31 of the calendar year which includes the fifth anniversary of his death or (2) if payable to a designated beneficiary, then (beginning by Dec. 31 of the year which includes the first anniversary of the participant’s death) in installments over the life expectancy of the designated beneficiary or (3) if payable to the participant’s spouse, there are additional options. §401(a)(9)(B)(ii), (iii) and (iv).
The Roth IRA participant will have the additional advantage of being able to change his "designated beneficiary" after age 70½, and have that change be "effective" for determining minimum required distributions after his death; the new designated beneficiary’s life expectancy will be used for determining the amount of the required distributions. This makes planning much more flexible.
Converting to a Roth IRA After the Required Beginning Date
In its first pronouncements on Roth IRAs, the IRS has confirmed that, for purposes of the minimum distribution rules, the holder of a Roth IRA who dies is considered to die "before his required beginning date" with regard to his Roth IRA, regardless of whether the conversion to a Roth occurred before or after the required beginning date applicable to the traditional IRA.
Simply put, there is no "required beginning date" for a Roth IRA. Therefore, a participant who converted after his required beginning date is treated the same as a participant who converted before his required beginning date: Whenever he dies, his death will be "before" his required beginning date, meaning that all benefits must be distributed from the Roth IRA under one of the three alternatives provided in Section 401(a)(9)(B)(ii), (iii) and (iv), discussed above.
Under this interpretation, converting a traditional IRA to a Roth IRA after age 70½ offers a golden opportunity to "clean up" unfortunate choices made for the traditional IRA at age 70½. A participant who at his required beginning date named the "wrong" (o no) beneficiary, or who regrets his choice of a method of determining life expectancy, can get a fresh start by converting to a Roth IRA, and naming the "right" beneficiary.
A participant who named his spouse as the designated beneficiary of his traditional IRA at his required beginning date, but is concerned that his spouse might die before him (thus causing loss of the potential for spousal rollover and eventual long-term payout over the life expectancies of younger generation beneficiaries), can convert to a Roth so that the long-term post-death payout will be available regardless of which spouse dies first.
In addition to various example already discussed, there are several situations in which a Roth IRA should be considered.
Retiree With Long Life Expectancy
Roth IRAs have great appeal to those retirees who do not need to withdraw any funds from their IRAs during life, especially those who expect to live well beyond the average life expectancy due to their sex, genetic heritage and/or health. A traditional IRA participant approaching age 70½ faces the unwelcome prospect of forced distributions which will substantially diminish if not obliterate the account over a long life span. With a traditional IRA, the way to maximize tax deferral is to die prematurely (leaving benefits to a younger generation beneficiary).
By converting the traditional IRA to a Roth, this person can eliminate the forced lifetime distributions and reverse the usual rule of thumb — the way to maximize tax deferral with a Roth IRA is to live as long as is humanly possible, deferring the commencement of any distributions until that way-later-than-normal death (and then leaving benefits to a young beneficiary).
The Deathbed Conversion
Converting to a Roth IRA just before death should be considered when benefits will otherwise have to be paid out just after death — for one thing, such conversion may permit the longer post-death deferral of distributions.
But even if there is no need to "fix" the beneficiary designation by converting to a Roth (i.e., the traditional IRA is already set up so that it will be paid out after death over the life expectancy of a designated beneficiary), there can be an advantage to converting: it is a great convenience to beneficiaries not to have to wrestle withthe valuable but complicated "income in respect of a decedent" (IRD) deduction (Section 691) every year as they do their income tax returns.
Solving Estate Planning Problems with Roth IRAs
Similarly, whether or not "the numbers" show an advantage to prepaying the income tax by converting to a Roth, such conversion could make estate planning substantially easier for certain clients, particularly when:
(1) The client who has no assets other than IRAs to fund a "credit shelter trust." Such a client has had, until now, only the following choices, none of which is very palatable:
Make a sufficient portion of the IRA benefit payable to the "credit shelter trust" to fully use up the unified credit (drawbacks: part of unified credit "wasted" paying income taxes; benefits taxable at trust rates, which might be higher than the rate of tax normally paid by participant and his family members; benefits might be subject to income tax sooner than if paid outright to spouse); or,
Don’t fund the credit shelter gift at all (drawback: wastes participant’s unified credit, ultimately increasing estate taxes); or
Withdraw enough from the IRA during life to be able to fund the credit shelter trust at death with after-tax money (drawback: loss of further deferral on all the money withdrawn from the IRA, and loss of the money paid in income taxes).
Now this individual has an additional choice (if he meets the $100,000 maximum income requirement): converting to a Roth IRA, before death, enough of the traditional IRA to fund the credit shelter trust at death. Although this still involves the loss of the money used to pay the income taxes (a cost which could have been deferred for a while longer), it at least enables the individual to fund his credit shelter trust with a tax-deferred vehicle — without wasting any of the unified credit paying income taxes;
(2) The individual who wants to apply his generation-skipping transfer tax (GST) exemption to retirement benefits payable to grandchildren (or a trust for their benefit). By funding the generation-skipping gift with Roth IRA death benefits (rather than traditional IRA death benefits), the participant still gives his beneficiaries the advantage of long-term tax deferral on investment growth; and this approach has the additional advantages of totally tax-free distributions and not "wasting" any of the GST exemption paying income taxes; or
(3) The individual who wants to leave his retirement benefits to a QTIP or QDOT trust rather than outright to the surviving spouse. One drawback of funding a QTIP trust with traditional IRA death benefits is that distributions of principal from the IRA to the trust are whacked with income taxes (taxes which may be at a higher rate than that paid by the surviving spouse and other family members).
Horrendous additional complications arise if the surviving spouse is not a U.S. citizen. Because many of these problems are caused by the fact that traditional IRA distributions are "income in respect of a decedent" (IRD), the problems are greatly diminished if the IRA is a Roth IRA, distributions from which are not IRD.
Projections of the benefits of converting an existing IRA to a Roth IRA are all based on assumptions as to future tax rates, investment returns and withdrawal amounts. The projections tend to assume the following: some constant rate of investment return (typically based on the unprecedentedly high stock market returns of recent years) continuing indefinitely into the future; that today’s tax rates will last forever; and that participants and their beneficiaries will withdraw from the account no more than required by (today’s) minimum distribution rules. These projections tend to show a substantial financial benefit from the conversion once the money has remained in the Roth for a long period of time.
Other possible scenarios should be considered.
Stock Market Crash
It would be a shame to pay income tax on today’s stock values, only to find out later that this was the all-time market high. When the account is later cashed out at lower values, there will not even be the satisfaction of a loss deduction.
Income Tax Scrapped in Favor of Flat Tax or VAT
There are some in Congress calling for repeal of the Internal Revenue Code and its replacement by a value added tax or a "flat tax" in the range of 20 percent. Needless to say, it would be disappointing to pay income tax on the entire value of one’s IRA at today’s rates and then discover one could have withdrawn the benefits at a much lower rate due to changes in the law.
Reform of Minimum Distribution Rules
Whether or not Congress radically changes our tax system, Congress could decide to bring the minimum distribution rules back into line with the original purpose of tax-favored retirement plans, and require that all benefits be distributed within some much shorter period of time after the deaths of the participant and his spouse, such as five, 10 or 20 years. If this change is made, some of the scenarios for spectacular profits from Roth IRAs, which are predicated on multiple decades of deferral over the life expectancies of very young beneficiaries, will not materialize.
Repeal of Roth IRA Provisions or Limitations On Roth IRA Tax Breaks
Once people actually start converting to Roth IRAs, Congress will presumably not take away, retroactively, the tax-free status of Roth IRA accumulations that meet the criteria of "qualified distributions." However, it is possible that Congress could decide after some period of time that the Roth IRA was too good a deal, and take away some of its favorable tax features on a prospective basis.
For example, Congress could decree that, while existing accumulations would never be taxed (as promised), future investment gains after that point would be subject to tax; or that Roth IRAs would continue to be totally tax free, but that the account would have to be 100 percent distributed within a year after the surviving spouse’s death, making post-death tax-free accumulations for heirs impossible.
"Abusive" Planning Opportunities that will Probably Disappear
The Roth IRA offers various planning opportunities. Some of these may have been unintended and will probably be eliminated by legislative corrections or regulatory action. A currently pending technical corrections bill will eliminate these if it is passed.
Abuse No. 1: Conversions in 1998 followed shortly by distributions. As initially written, Section 408A offers an "abusive" planning opportunity to anyone who converts his traditional IRA to a Roth IRA in 1998.
Example: Sidney is 66 years old and retired. His income is under $100,000 in 1998. He wants to withdraw $500,000 from his traditional IRA to help pay for his new retirement dream house. He converts his $500,000 IRA to a Roth IRA in 1998. The day after the conversion, he withdraws all the money from the Roth IRA. Even though he has cashed out the entire IRA in 1998, Section 408A says the $500,000 is included in his income over four years, 1998-2001. He is pleased because he gets the money now but doesn’t have to pay the tax until later; and also because spreading out the income over four years will reduce the tax on the $500,000 by keeping him out of the highest tax bracket.
The technical corrections bill would not change the income tax treatment of Sidney’s conversion/distribution. However, it would impose a 10-percent penalty on any amount that is distributed during the five-year period and that was originally converted from a traditional IRA. All distributions during the five-year period from a "1998 Roth Conversion IRA" will be deemed to come first from the conversion amount. Note that the penalty applies to distributions during the five-year period (see definition discussed elsewhere in this article), even though the income tax-spreadout period is only four years.
Unfortunately, if this penalty is put into law, it will also apply to people who want to withdraw from the newly-created Roth Conversion IRA only enough money to pay the income tax resulting from the conversion itself.
Moral: Converting to a Roth IRA will generate an income tax. Those who cannot pay that tax from other (non-IRA) assets should withdraw the tax money from the traditional IRA before converting the (rest of the) IRA to a Roth.
Abuse No. 2: Conversions followed by distributions before age 59½. As the law is written, the Roth IRA offers a way for the under-59½-year-old client to take money out of an IRA without penalty.
The technical corrections bill would specify that the 10-percent premature distributions penalty shall apply to any amount that is (a) converted or rolled from a traditional to a Roth IRA and (b) distributed during the five-year period, "as if" the distribution were included in gross income in the year of the distribution, to the extent the amount was included in gross income at the time of the original conversion. If the conversion had occurred during 1998, this "premature distribution" penalty would be in addition to the 10-percent penalty for distributions from a 1998 Roth Conversion IRA during the five-year period. All distributions during the five-year period from a 1998 Roth Conversion IRA will be deemed to come first from the conversion amount. See proposed new subsection 408A(d)(3)(F).
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Choate is of counsel to the law firm of Bingham, Dana, L.L.P., in Boston
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(EDITOR’S NOTE: Portions of the previous article were reproduced with permission of the author from the forthcoming 1998 supplement to the book Life and Death Planning for Retirement Benefits by Natalie B. Choate (Ataxplan Publications, 1996). Copyright 1998 by Natalie B. Choate. All rights reserved.)
The preceding article has been reprinted with permission from The Will & the Way, Vol. 17, No. 2 (February 1998), a publication of the North Carolina Bar Association's Estate Planning & Fiduciary Law Section. Copyright 1998 N.C. Bar Association.
For a list of speaking engagements by Natalie Choate, see her Ataxplan web site.