by Natalie B. Choate, Esq.
© 1998, Natalie B. Choate
Several "technical corrections" (some of which were actually substantive changes) to the Roth IRA rules were included in the IRS Restructuring and Reform Bill of 1998, signed into law by President Clinton on July 22, 1998. This article discusses the Roth IRA aspects changed by the new law. In this article "Technical Corrections" refers to the changes made by this July 1998 law. These changes were made retroactive "as if included in the Taxpayer Relief Act of 1997" unless otherwise noted.
Definition of "Five Year Period"
"Qualified distributions" from a Roth IRA are income tax-free. One requirement of a "qualified distribution" is that it must be made after the end of a five year "nonexclusion period." The Technical Corrections changed (liberalized) the rules for computing this five year period; the version in the original statute--and in the IRS’s Roth IRA forms--is now obsolete. The new rule:
The Five Year Period (called in the statute the "nonexclusion period") begins with the first year for which any type of contribution (whether "annual" or "rollover") was made (whether by the participant or his spouse) to any Roth IRA maintained for the participant. S. 408A(d)(2)(B).
Note the following points:
First, it appears that the Five Year Period starts running the first year a contribution is made to any Roth IRA, even if that contribution is as little as $1 and even if it is withdrawn the very next day. In other words, opening a token Roth IRA in the first year you are eligible to do so starts the five year clock running for future "real" contributions you may make to a Roth IRA, even if you cash out the token account years before opening a "real" one. Query whether the IRS might tighten up this loose scheme in regulations.
Second, the "Five Year Period" could in actuality be as short as three years and eight months. For example, a person can make a contribution "for" 1998 as late as April 14, 1999; the Five Year Period will be over by January 1, 2003.
Third, as originally enacted, s. 408A provided two different methods for calculating the Five Year Period, one to be used for Annual Contribution Roth IRAs and the other for Roth Conversion IRAs. The Technical Corrections Law dropped this distinction. This change appears to have made obsolete the recommendation originally made for Roth IRA owners to establish separate Roth IRAs for "annual contributions" and "rollover contributions," and to establish separate Roth IRAs for rollover contributions made in separate years.
The new "ordering rules"
As originally enacted, s. 408A provided simply that Roth IRA distributions were deemed to come, first, out of contributions to the Roth IRA. Technical Corrections rewrote the provision and created new "ordering rules" for Roth IRA distributions. Any distribution from a Roth IRA will be deemed to come from the following sources, in the order indicated. S. 408A(d)(4)(B).
[Note: the ordering rules speak in terms of contributions to "the" Roth IRA, as if the rules were applied separately to each separate Roth Individual Retirement Account. Since these rules follow immediately after the statement that "s. 408(d)(2) shall be applied separately with respect to Roth IRAs and other individual retirement plans" (see discussion under "Aggregation of IRAs for purposes of computing income tax," below), it is my conclusion that these ordering rules are intended to be applied on the basis of all Roth IRAs collectively, not each individually, but this is not certain.]
--Any distribution is deemed to come, first, from contributions to the Roth IRA (to the extent that all previous distributions from the Roth IRA have not yet exceeded the contributions); and
--If the participant has made both "annual-type" and "rollover-type" contributions, the distributions are deemed to come, first, from the "annual contributions"; then,
--Second, from rollover contributions, on a first-in, first-out, basis; and
--If a particular rollover contribution is being analyzed, the dollars that were includible in gross income by virtue of the rollover come out before non-taxable dollars come out; and
--Finally, once all contributions have been distributed out, the balance of the distribution comes out of post-contribution earnings. Whew!
Example: In 1999, Bette Ann rolls her $50,000 traditional IRA to a Roth IRA. Her traditional IRA contained $6,000 of non-deductible contributions she had made over the years; the rest of the money in her traditional IRA constituted deductible contributions plus earnings. So for 1999 she must report $44,000 of gross income on account of this conversion ($50,000 gross amount of IRA, minus her basis of $6,000). In 2000, she contributes $2,000 to the same Roth IRA from her earned income for that year. In 2001, she withdraws $10,000 from the Roth IRA. This is deemed to be, first, a return of her $2,000 non-deductible (non-rollover) contribution to the Roth IRA made in 2000 (because "annual contributions" are distributed first). The $8,000 balance of the distribution is deemed to come out of the $44,000 rollover amount she paid tax on in 1999. So she pays no tax on the withdrawal.
When do these ordering rules matter?
1. The ordering rules matter most significantly for IRA owners who (A) convert a traditional IRA to a Roth in 1998 and (B) choose to spread the tax on the conversion over four years and (C) then take a distribution before 2001. See discussion below.
2. The ordering rules may matter also for IRA owners who (A) convert a traditional IRA to a Roth in 1998 and (B) choose to spread the tax on the conversion over four years and (C) then die before 2002, leaving the Roth IRA to a surviving spouse. See discussion below.
3. The ordering rules matter also for IRA owners who (A) convert a traditional IRA to a Roth (regardless of whether they use the four year spread), and then take a distribution from the Roth (B) before reaching age 59½ and (C) within the five taxable years beginning with the year of the conversion. See discussion below.
4. In general, the ordering rules matter for purposes of determining whether a non-qualified distribution is taxable; the ordering rules essentially mean that the distribution is NOT taxable until all contributions have been distributed out. A distribution that is taxable would also be subject to the 10% penalty under s. 72(t) if the participant is under age 59½.
Aggregation of IRAs for purposes of computing income tax
Under s. 408(d)(2), all (traditional) IRAs are generally treated as one account (and all distributions in one year treated as one distribution) for purposes of determining what part of a particular year’s distributions represents return of the participant’s basis (i.e., his non-deducted contributions).
S. 408A(d)(4)(A) provides that "section 408(d)(2) shall be applied separately with respect to Roth IRAs and other individual retirement plans." Under this provision, it is clear that the taxation of distributions from traditional IRAs will be computed without regard to the existence of, or distributions from, Roth IRAs in the same year.
The following question then remains: Are all Roth IRAs aggregated for purposes of determining how much of a distribution from any particular Roth IRA constitutes a return of the participant’s basis? If the answer to this is yes, then all Roth IRAs are treated as one account for purposes of the taxation of distributions, just as all traditional IRAs are treated as one account for that purpose. If the answer is no, then each Roth IRA must be looked at separately to see how much of that particular account contstitutes the participant’s contributions (non-taxable when distributed) and how much represents earnings (taxable, if distributed in a "non-qualified distribution").
Your author concludes that the statement that "section 408(d)(2) shall be applied separately with respect to Roth IRAs and other individual retirement plans" would be completely meaningless if it does not mean that all Roth IRAs are treated as one for purposes of determining the amount of basis included in any distribution. However, certain other statements in the statute (as amended by Technical Corrections) cast some doubt on the issue, particularly the ordering rules (which speak in terms of distributions from "the Roth IRA," rather than "the Roth IRAs" or "Roth IRAs"), and the provision for a surviving spouse to assume unpaid tax installments (which speaks of "any Roth IRA to which" a particular 1998 rollover contribution is properly allocable, as if basis is allocated to particular accounts rather than "floating" among all Roth IRAs collectively).
Note: The Technical Corrections Bill as originally proposed would have required that s. 408(d)(2)’s aggregation rule be applied separately not only for "Roth IRAs and other individual retirement plans," but also for: (1) Roth IRAs which contain any rollovers from traditional IRA(s) (as opposed to "pure" Annual Contributions Roth IRAs) and for (2) Roth Conversion IRAs established in different tax years. This proposal was dropped in the final version of Technical Corrections.
SEP-IRAs
Contributions to a SEP-IRA or SRA are not treated as "IRA contributions" for purposes of determining whether a person has "used up" his $2,000 IRA contribution limit for the year. In other words, a person who is otherwise eligible to make a $2,000 contribution to a Roth IRA in a particular year does not lose that eligibility just because $2,000 was contributed for him or her to a SEP-IRA or SRA. S. 408A(f) (added by Technical Corrections).
Although a "simplified employee pension" individual retirement account (SEP-IRA) (s. 408(k)) and a "simple retirement account" (SRA) (s. 408(p)) cannot themselves be "designated" as Roth IRAs (s. 408A(f), added by Technical Corrections), it appears that these types of plans can be rolled or converted into Roth IRAs.
If minimum distributions push you over the $100,000 AGI limit for Roth conversions...
This problem goes away after 2004. Under the Technical Corrections passed in July 1998, minimum required distributions (from any type of plan) are excluded for purposes of applying the $100,000 adjusted gross income limit, but only after the year 2004. S. 408A(c)(3)(C)(i)(II). Thus, in 2005, suppose a person’s minimum required distribution from her traditional IRA is $130,000 and her other income is $60,000. She will still be required to take, and pay tax on, the $130,000 distribution, and she can not roll that distribution over to a Roth IRA; but she will be able to convert the rest of her IRA to a Roth IRA in that year, because her adjusted gross income (not counting the minimum distribution of $130,000, or the "deemed" income arising from the conversion) is only $60,000, and thus under the $100,000 limit.
Four year spread option for 1998 conversions
For rollovers in 1998 ONLY, the inclusion in gross income may be spread equally over the four taxable years 1998, 1999, 2000, 2001. This treatment occurs unless the taxpayer elects not to have it apply. S. 408A(d)(3)(A)(iii). (Prior to the Technical Corrections Law, this treatment was mandatory, not elective.)
The election not to use the four year spread may not be changed after the due date of the participant’s 1998 tax return (including extensions). Presumably, if a taxpayer makes no election, so the four year spread applies, he will not be able to make the election after the due date (as extended) of his 1998 return, but this is not clear.
The election out of the four year spread, if made, apparently must apply to all of the taxpayer’s traditional IRA money transferred to a Roth IRA in 1998; there is no such thing as a partial election. The statute says that the four year spread will apply "unless the taxpayer elects not to have this clause apply for" the taxable year; it does not say "except to the extent the taxpayer elects not to have this clause apply..."
Accelerated inclusion for distributions before 2001
Under the Technical Corrections, if an individual converts to a Roth IRA in 1998, and chooses to spread the resulting taxable income over four years, but then takes a distribution from the conversion money during the first three years of the four year spread period, he gets punished: he loses the benefit of further deferral of tax on the amount of the distribution. (The 10% penalty once proposed for such early withdrawals was not included in the final version of Technical Corrections.)
S. 408A(d)(3)(E)(i) provides for an "acceleration of inclusion" in this situation. Specifically, taxable income for the year of the distribution "shall be increased by the aggregate distributions from Roth IRAs for such taxable year which are allocable under" the ordering rules "to the portion of such [1998 conversion] required to be included in gross income." However, the amount required to be included in any one of the first three years may not exceed (A) the amount that would have been included in income in 1998 on account of the conversion, if the taxpayer had not chosen to do the four year spread; minus (B) the amounts includible in all prior years on account of this conversion.
It is not clear how this acceleration affects the reporting of subsequent installments.
Example: Priscilla converts her $1 million IRA to a Roth IRA in 1998, and elects to spread the resulting taxable income over four years. On her 1998 return, accordingly, she reports $250,000 of income from the conversion. To pay the tax on this, she withdraws $100,000 from the Roth IRA on April 15, 1999. Her gross income for 1999 is increased by the amount of this distribution, so her 1999 income will include (A) the $250,000 "normal" installment for 1999 (one-fourth of $1 million), plus (B) the $100,000 acceleration amount on account of the distribution. So, through the end of 1999 she will have paid tax on $600,000 of the $1 million conversion amount. There’s $400,000 left to be taxed. When does she include that? The statute is silent, so presumably regulations will have to resolve this. The choices appear to be: the acceleration amount reduces the next year’s installment (unlikely the IRS would pick that one); or the acceleration amount reduces the final year’s installment (I’d bet on this one); or the remaining untaxed amount is included pro rata over the remaining years of the four year period.
If participant dies before the end of the four year period
What if the participant dies before the end of this four year spread period? The statute as originally enacted was silent on this point, but the Technical Corrections fixed 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. S. 408A(d)(3)(E)(i).
However, if the participant’s surviving spouse acquires the decedent’s "entire interest in any Roth IRA to which such qualified rollover contribution is properly allocable, the spouse may elect to treat the remaining amounts [that have not yet been included in the decedent’s return] as includible in the spouse’s gross income in the taxable years of the spouse ending with or within the taxable years of such [decedent] in which such amounts would otherwise have been includible." This election may not be made (or changed) after the due date of the spouse’s tax return for the year of death. S. 408A(d)(3)(E)(ii).
Are all Roth IRAs aggregated for this purpose or not? The wording of this section makes it appear that the spouse need succeed only to the specific Roth IRA which received the 1998 rollover, not all Roth IRAs of the decedent. But since the basis recovery rules are, apparently, supposed to be applied to all Roth IRAs collectively (under the principles of s. 408(d)(2)), how do we know which Roth IRA the 1998 conversion is "properly allocable to?" This problem will arise only if the decedent (A) has more than one Roth IRA and (B) does not leave all of his Roth IRAs to the spouse.
Presumably, the surviving spouse will make the election if (1) she is also the beneficiary of the rest of the estate and (2) accelerating the income onto the decedent’s final return would cost her (as beneficiary of his estate) more than if she pays the taxes herself (as beneficiary of the Roth IRA) over the rest of the four year spread period. Query, if she is not the beneficiary of the rest of the estate (e.g., if the rest of the estate goes to their children), does electing to take over the tax liability constitute a gift by the surviving spouse to the beneficiaries of the estate?
If the surviving spouse, having made the election, then herself dies before the end of the four year period, it appears that the remaining installments are accelerated onto her return; see s. 408A(d)(E)(ii)(I); although possibly if she has remarried and leaves the Roth IRA to the new spouse, he could again make the election to take over the payments.
The 10% "premature distributions" penalty
S. 72(t) imposes a 10% penalty on any distribution from a "qualified retirement plan (as defined in section 4974(c))" made while the participant is under age 59½ (with various exceptions). The definition of "qualified retirement plan" in s. 4974(c) includes traditional IRAs, but was not amended by TAPRA (or Technical Corrections) to specifically include Roth IRAs. Nevertheless it is assumed that the 10% penalty would apply to non-excepted "premature distributions" from Roth IRAs, the same as to traditional IRAs, under the rule that Roth IRAs are treated the same as traditional IRAs "for purposes of this title" unless s. 408A provides otherwise. S. 408A(a).
If there is a distribution from a Roth IRA before the participant reaches age 59½, what does the penalty apply to? In general, it does not apply to the return of the participant’s own contributions to the account (with the exception of conversion contributions distributed within five years--see discussion below). Specifically:
Normally, the penalty applies only to the portion of a distribution that is "included in gross income." Thus an individual who has not reached age 59½ can (subject to one exception, described in the next paragraph) withdraw from a Roth IRA the amount of his own original contributions to the account, and still not pay the penalty, because such withdrawals are not includible in gross income, even though they are not "qualified distributions" (see discussion of non-qualified distributions and the ordering rules, above).
As previously discussed, the 10% penalty normally does not apply to the gross income generated by converting a traditional IRA to a Roth IRA. The exception (added by Technical Corrections) is this: If a participant who is under age 59½ receives a distribution from a Roth IRA; and if "any portion" of that distribution is "properly allocable" under the ordering rules (discussed above) to funds rolled over to the Roth from a traditional IRA that were includible in gross income; and "such distribution is made within the 5-taxable year period beginning with the taxable year in which such contribution was made"; then the section 72(t) penalty shall apply to the distribution "as if such portion were includible in gross income." S. 408A(d)(3)(F). Note that this five year period is not the same as the five year period for determining "qualified distributions." The latter begins in the first year any contribution is made to any Roth IRA; the former begins, as to any conversion of a traditional IRA to a Roth IRA, with the year of the conversion.
Example: Billman contributes $2,000 of his earned income to a Roth IRA in each of the years 1998 through 2004 (total contribution, $14,000). In 2005, he rolls his $100,000 traditional IRA to the same Roth IRA. $4,000 of his traditional IRA represents his basis (non-deducted contributions), so the amount includible in his gross income for 2005 on account of this conversion is $96,000. He has never made any other contributions of any type to (or taken any distributions from) any Roth IRA. In 2007, when he is 49 years old, he withdraws $20,000 from the Roth IRA to pay the dues at his country club. Under the ordering rules, the $20,000 is deemed to come, first, from the $14,000 of annual contributions he made in 1998 through 2004, and there is no 10% penalty on this. But the balance ($6,000) is deemed to come from the conversion of his traditional IRA in 2005, and all from the taxable portion of that conversion, and that conversion took place less than five years before the distribution. Assuming no other exceptions to s. 72(t) are available, he will owe a penalty of $600 on the Roth IRA distribution.
What if you make a mistake or change your mind?
The Code provides that any contribution made to any type of individual retirement plan during the taxable year may be transferred to any other type of individual retirement plan before the due date of the person’s tax return for that year, and it will be treated as a contribution to the transferee plan for tax purposes. S. 408A(d)(6), (7). For example, if a person converts a traditional IRA to a Roth IRA in 1998, and then discovers that his income for 1998 exceeds the $100,000 limit so he is not eligible to do that conversion, he can move the money back to a traditional IRA before the due date of his tax return for 1998 and it will be treated as a rollover contribution to the traditional IRA. Here are the limits and requirements for these correcting transfers:
1. The transfer must be by a trustee-to-trustee transfer (not by a true "rollover"--a distribution to the participant followed by a recontribution to the other account).
2. Not only the original contribution but "any net income allocable to such contribution" must be retransferred. (This may create difficulties of application if the original contribution was commingled with other funds that are not to be transferred back, or if the contribution declined in value between the date of the contribution and the date it is transferred out.)
3. The IRS can limit this provision in regulations.
4. The due date of the tax return includes extensions.
5. The original contribution that is being corrected must be
made before the unextended due date of the tax return for the taxable year (s.
219(f)(3); s. 408A(c)(7); only the corrective transfer can be made at any time up to the extended
due date of the return.
Author:
Natalie Choate is of counsel to the law firm of Bingham, Dana, L.L.P., in Boston. She
is the author of what is generally regarded as the best available book on
pension distribution planning, Life and Death Planning for Retirement Benefits.
For a list of speaking engagements by Natalie Choate, see her Ataxplan web site.