There’s Something About Roth

by Greg Reymann, J.D., LL.M.
© 1998, Greg Reymann

The following copyrighted article is available exclusively on the Roth IRA Web Site:

The Taxpayer Relief Act of 1997, signed into the law on August 5, 1997, includes perhaps the most significant individual retirement account (IRA) legislation since 1974 when the Employee Retirement Income Security Act of 1974 (ERISA) introduced IRAs. Under the Act, an individual may establish an IRA under which all distributions are free from federal income taxation if certain conditions are met (see V below). This type of IRA, named the Roth IRA after its advocate Senator William Roth of Delaware, has the same contribution limits as regular IRAs, but is subject to different distribution rules that makes it extremely attractive for certain investors.

The outline below covers the distribution rules for the Roth IRA, along with other issues recently answered by legislation and administrative guidance.

Why the Roth IRA?

There are several reasons justifying the emergence of the Roth IRA. First, the national saving rate is too low. The 8% savings rate that existed in this country in 1980 has decreased to a saving rate of 0% in mid-1998.1 This, coupled with the fact that IRA usage has decreased dramatically since the passage of the Tax Reform Act of 1986,2 lends support to a new type of IRA that should encourage Americans to save more.

Of course, the Roth IRA also benefits Congress in the short-term since revenue generated from conversions can be used to offset other revenue-losing provisions.

II.  Legislative History of the Roth IRA

The Roth IRA was first formally proposed in the House Republican’s Contract with America.3 Initially called an "American Dream Savings Account", or "ADS Account", it failed to become law when the legislation was subsequently vetoed. Two years later, the Taxpayer Relief Act of 1997 (the "1997 Act") made the Roth IRA a reality, effective for tax years starting in 1998. The Roth IRA as proposed by the 1997 Act required two significant clarifications from subsequent legislation: first, the 1997 Act permitted IRA owners to convert their IRA into a Roth IRA, and then take distributions from the Roth IRA penalty-tax free (assuming the penalty tax applies). This was commonly referred as the "Roth loophole"; second, the 1997 Act used current year’s income to determine eligibility, which means that eligibility for some may not be determined until after the conversion deadline.

Only two months after the passage of the 1997 Act, the Chairman’s Mark of the Tax Technical Corrections Act of 1997 dealt with the Roth loophole. It’s method of correction was to impose a 20% excise tax on distributions made with 5 calendar years of a conversion made in 1998, and a 10% excise tax for all other conversions. Although this legislation did not become law, it did serve to warn investors not to use the Roth IRA to avoid paying the 10% penalty tax.

The Internal Revenue Service (IRS) Restructuring and Reform Act of 1998 (the "1998 Act") addressed both the Roth loophole and the method of correction for contributions or conversions made in error.4 With regard to the error correction, the 1998 Act introduced a new concept called "recharacterization", which is the process of reversing a conversion to a Roth IRA, or reversing a contribution to a Roth or traditional IRA. The proposed regulations under Internal Revenue Code (IRC) Section 408A increased to usage of recharacterizations by permitting this process even when a mistake was not made.5 As a result of these proposed regulations, many investors recharacterized and reconverted their Roth IRAs, sometimes on multiple occasions, in an effort to reduce their conversion tax. The IRS in Notice 98-50 put a stop to multiple reconversions by limiting reconversions to one per calendar year,6 and the final regulations under Section 408A ("Final Regulations") went further by prohibiting reconversions in the same year as the conversion (see VIII below).7

III.  Eligible Roth IRA Participants

A Roth IRA can be established by individuals, under certain adjusted gross income limits, by means of an annual $2,000 contribution, or by rolling over one’s traditional IRA8 into the Roth IRA, a process known as "conversion." The cost of converting an IRA is that the entire amount of the IRA (excluding nondeductible contributions) becomes taxable in the year of conversion (the pre-age 59 ½ penalty tax is not applicable to conversions).9

Not all IRA owners are eligible to convert or contribute to a Roth IRA. The 1997 Act specifies that those with an Adjusted Gross Income (AGI) over $100,000 (regardless of whether filing joint or single),10 or who file married but separate are not able to covert their IRAs.

In addition to the conversion AGI limit, there are also AGI limits that apply to Roth IRA contributions. Those with AGIs in excess of $110,000 for single tax filers, and $160,000 for joint tax filers, are prohibited from contributing to a Roth IRA. Those with AGIs in excess of $95,000, if a single tax filer, or $150,000, if a joint tax filer, can only contribute a proportionate amount. For example, a single tax filer with an AGI of $102,500 is only entitled to contribute $1,000 to a Roth IRA. Both the AGI conversion and contribution limits do not include gross income resulting from conversions.

IV.  Conversion Issues

The 1998 Act confirmed that SEP-IRAs may be converted into a Roth IRA. Previous to the Act, there was confusion on this issue since the Chairman’s Mark of the Technical Corrections Act of 1997 prohibited SEP-IRA conversions. SIMPLE-IRAs may also be converted, but only after two years of plan participation. The reason for this restriction is that conversions during the first two years of plan participation allows one to take distributions from the Roth IRA at the 10% penalty tax instead of the 25% penalty tax applicable to SIMPLE-IRAs.

Direct rollovers from qualified retirement plans into a Roth IRA are prohibited. This really is just a procedural inconvenience because nothing prohibits one from effecting a direct rollover into their traditional IRA, then converting that IRA the next day into a Roth IRA.

A common question is whether, if one does a partial conversion, conversion taxes can be lessened by converting the IRA which has the larger basis (more nondeductible contributions). For instance, if one has a nondeductible IRA and a deductible IRA, is there a tax advantage to converting the nondeductible IRA instead of the deductible IRA? The answer is "no" since an investor is treated as owning one IRA, and therefore a distribution from a nondeductible IRA is treated for tax purposes as a proportional distribution from the entire IRA.

V.  Tax-Free Distribution Rules

Distributions from a Roth IRA are completely tax-free (contributions and earnings) if the following two requirements are met:

A. The account has been established for at least five years. This five-year period begins on January 1 of the first calendar year in which a contribution or conversion applies; therefore, a contribution to a Roth IRA on 4/15/99 for 1998 starts the 5-year period on 1/1/98. Note also that the first year of a conversion is the year that the distribution was made that is subsequently converted. (Example: a distribution made from an IRA on 12/31/98 that is converted on 1/31/99 is considered to have been converted in 1998, therefore starting the 5-year period as of 1/1/98.)

As a result of the 1998 Act, there is only one 5-year holding period for purposes of determining whether a distribution is tax-free (previously, there could be two 5-year holding periods, one for contributions, one for conversions). Note that the 5-year period for purposes of the 10% penalty tax, described in VII(A) below, can be a separate period.

B. The IRA owner is at least age 59 1/2, is disabled or has died, or is using the distribution in a manner that meets the "first-time home purchase" exception under new IRC Section 72(t)(2)(F). Under that Code Section, up to $10,000 may be distributed to a qualified first-time homebuyer to acquire, construct or reconstruct a principal residence, and this includes reasonable settlement and closing costs. A qualified first-time home buyer is anyone who had no interest in a principal residence two years from the date his or her new home is purchased. The $10,000 limit is a lifetime limit under this exception.

VI.  Other Reasons to have a Roth IRA

A. Contribution basis can removed at anytime tax-free. Another advantage of a Roth IRA is the method by which distributions are made from the account. Contributions made into a Roth IRA, having been taxed once, will not be taxed again when distributed, and will always be deemed to be distributed first. This is different from a traditional IRA, which prorates any nondeductible contribution from each distribution. For example, if an individual has a basis in a traditional IRA of $8000, and takes a distribution of $6000 when the IRA is worth $16,000, half of the distribution would be taxable ($6000 times the $8000 basis/$16,000 account value). In contrast, should one decide to take a Roth IRA distribution which is taxable, all previous contributions will be deemed distributed first. Therefore, if in the above example the IRA was an Roth IRA, a $6,000 distribution would be completely tax-free since the $8,000 of contributions are distributed first.

This method of distribution eliminates one of the concerns of establishing a traditional IRA, which is the inability to access one’s investment penalty-free until age 59 1/2. The 1997 Act did help in this area by allowing pre-age 59 1/2 distributions for first-time home purchases, but obviously there could be many other reasons for needing to access one’s IRA investments.

B. No required distributions for the Roth IRA owner. The 1997 Act also exempts the Roth IRA owner from the requirement of required minimum distributions beginning at age 70 1/2. The obvious reason for this is that the government has no interest in these distributions since it generally receives no tax revenue from them. As a result of this exemption, a Roth IRA owner need not ever take a distribution from his or her IRA. Since the Roth IRA is not subject to the required minimum distribution rules, contributions may be made after the age of 70 1/2 as long as one has earned income. Therefore, unlike the traditional IRA, the Roth IRA can provide a tax shelter to those over age 70 1/2 who still have earned income.

Beneficiaries of Roth IRA assets, however, are subject to the required minimum distribution rules.

C. A Roth IRA can be used for estate planning reasons. As long as the two tax-free distribution requirements are met, Roth IRA distributions are tax-free, even if made to a beneficiary. As stated above, upon death, the required minimum distribution rules do apply, which means that, depending upon IRA document provisions, a nonspousal beneficiary has to take the balance of the account within 5 years, or start lifetime payments before the end of the next calendar year. A spousal beneficiary has the above two options, plus can roll the Roth IRA proceeds into his or her own Roth IRA.

Caution: Beneficiary distributions from a Roth IRA are only tax-free if made after the five-year period. Therefore, if a beneficiary is interested in taking a lump sum distribution, they should wait until after the 5-year period is satisfied. Also, if a spousal beneficiary rolls over the Roth IRA proceeds into his or her own Roth IRA, distributions from that IRA will not be considered made due to the original Roth IRA owner’s death.11 Consequently, for spousal Roth IRA distributions to be made tax-free, they will have to be made after the 5-year period and after attainment of age 59½ (or the spouse’s death/disability/first time home purchase).

VII.  How Roth Distribution taxes work

If distributions are taken from a Roth IRA that do not meet the 5 year/death-disability-59 ½-1st home purchase requirements, there is a potentially taxable distribution under the rules below.

A. The Roth loophole, and how Congress fixed it. Prior to the passage of the 1998 Act, an individual could convert his or her traditional IRA to a Roth IRA, and withdraw the account value penalty-tax free the next day since the withdrawal consists of IRA basis. This method of avoiding the 10% penalty tax was obviously not intended by Congress. To close this loophole, the 1998 Act imposes a 10% penalty on any amounts withdrawn within 5 calendar years of a conversion that were already taxed at conversion.

B. Ordering Method. The 1998 Act also permits conversions and Roth IRA contributions to be commingled in the same Roth IRA account (previous to the Act this was not generally done). Since two types of contributions can be held in the same account, the 1998 Act set forth ordering rules for distributions from a Roth IRA. Assuming that a Roth IRA distribution is taxable because it does not meet one of the two tax-free conditions, money withdrawn from the account comes out in the following order:

Example

Suppose Leslie, age 40, converts her IRA worth $15,000, consisting of $6,000 of deductible contributions, $4,000 of nondeductible contributions, and $5,000 of earnings, to a Roth IRA. Two years later, when the IRA is worth $20,000, she withdraws $18,000. The withdrawal is potentially taxable, since the 5-year rule has not been met, and money is withdrawn in the following manner:

Leslie also accelerates her "conversion" tax payments, as described below.

C. Acceleration of the "Conversion" Tax. Under the 1998 Act, the payment of the taxes on a conversion is accelerated if a distribution is made from "converted" money before the end of the last year of the 4-year spread. As a practical matter, acceleration is not triggered unless a distribution is made in the year of conversion or the next two years. When a distribution has been made before the last year of the 4-year spread, the taxable amount under the 4-year spread is computed as follows:

Example

Assume Tom has an IRA worth $20,000 with a basis (the amount of nondeductible contributions) of $8,000. Tom converts his IRA in 1998, which means he will have to include in his income $3,000 in 1998, 1999, 2000, and 2001 ($12,000 divided by 4). In 1999, Tom takes out $5,000. In 1999, he includes in income the $3,000 that he already had to include, plus $5,000 [this is the lessor of the amount of the distribution ($5,000) or the remaining taxable amounts due under the 4-year spread (which is $6,000 due in 2000 and 2001)]. This totals $8,000. In year 2000, Tom includes $1,000 in income, since he has already been taxed on $11,000, and in year 2001, he does not include anything extra in income.

By taking this distribution, Tom includes the following amounts in income:

1998   1999   2000   2001   Total
$3,000   $8,000   $1,000   $0   $12,000

Had Tom not taken the $5,000 distribution, he would have included the following amounts in income:

1998   1999   2000   2001   Total
$3,000   $3,000   $3,000   $3,000   $12,000

Either way Tom includes $12,000 in income, but by taking a distribution before the end of the 4-year spread, he accelerates when he has to take the $12,000 into income. Also, since Tom took the $5,000 distribution within 5 years of converting to his Roth IRA, the distribution is subject to a 10% penalty tax.

VIII.  What if I make a mistake?

A.    Recharacterizations. Because the Roth IRA uses current year income figures for determining eligibility, many people may not know whether they are eligible to convert until after the end of the year (note that the distribution which is converted must be made by year end). A fix to this problem is to allow people who subsequently discover that they were ineligible to convert, to "un-convert" or "recharacterize" their conversion to a traditional IRA. There are no tax consequences to this process, and it must be completed before the tax filing date, plus extensions, for the year of the conversion. Therefore, if one converts in 1998, and receives a bonus which increases their income to over $100,000, this person has until his or her tax filing due date, plus extensions, to recharacterize back to a traditional IRA.

Recharacterizing to reduce taxes. Recharacterizations can also be used to reduce taxes if the IRA value drops after a conversion. For instance, if Judy converts her deductible IRA of $20,000 on 2/1/99, and on 6/1/99 her IRA value is $12,000, she can recharacterize this Roth IRA back to a traditional IRA, and then convert again (commonly called a "reconversion"). By doing so she reduces her conversion tax by $8,000. Note that IRS Notice 98-50 restricts the number of reconversions to one in 1999. In the year 2000, as a result of the Final Regulations, reconversions are prohibited until the beginning of the taxable year following the taxable year of the conversion, of if later, the 30-day period beginning on the date of the recharacterization.12 The Final Regulations basically took way the ability to reduce conversion taxes within a taxable year; however, reconversions can still be made in the succeeding taxable year.

C. Excess Reconversions/Failed Conversions. A couple of new terms have been introduced by the Roth IRA regulations. An "excess reconversion" is any subsequent reconversion made in a calendar year in which one reconversion has already been made. This term is only relevant in 1999.13 An excess reconversion is not recognized for tax purposes, so when it does occur, the taxable conversion amount is based on the reconversion immediately preceding the first excess reconversion. A "failed conversion" is any conversion made after 1999 which does not meet conversion eligibility requirements or, if a reconversion, is made prior to the deadlines made under the Final Regulations.14

IX.  The Decision to Convert

The primary reason for anyone to convert his or her IRA is to lower the amount of taxes applicable to that IRA. In short, is paying the tax now cheaper than paying the tax later? For certain IRA owners, conversions can lead to tremendous tax savings. The following example illustrates this:

Example

Jessie, age 40, converts his deductible IRA worth $50,000 in 1999. At a 28% tax rate this conversion costs Jessie an extra $14,000. At age 65, Jessie decides to take a lump sum distribution from his IRA to purchase a second home. His Roth IRA grew at an 8% growth rate, and is now valued at $342,424. Had he not converted his IRA, his tax on the lump sum distribution would be $95,879 (at a 28% tax rate), or $136,969 (at a 40% tax rate). Depending upon the applicable tax rate at the distribution, the tax paid by not converting could be substantially higher than the tax paid at conversion.15

There are basically three factors that should be reviewed in determining whether a conversion makes sense: length of time before distributions, conversion tax rate versus distribution tax rate, and the growth rate of the IRA assets. The longer the time period before distribution, the more favorable a conversion. While an analysis of conversion projections is beyond the scope of this article, in general anyone 20 years away from taking distributions will save taxes by converting. Of course, if one projects that their tax rate at distribution will be higher than their current tax, than a conversion is a easy decision. Where a lower tax rate is projected at distribution, a conversion may still make sense depending upon the assumptions made. Lastly, the high growth rate of IRA assets is also a factor that favors conversion.

Probably the best advice for anyone considering a conversion is to utilize some of the contribution or conversion calculators linked to from the www.rothira.com website.

X.  Roth IRA Plan Document

The IRS has produced four model IRA plan documents: Form 5305-R (Roth Individual Trust Account); Form 5305-RA (Roth Individual Retirement Custodial Account); Form 5305-RB (Roth Individual Retirement Annuity Endorsement); and Form 5305-TRA (Combined Traditional and Roth IRA Agreements). Each of these documents can be used by investor to establish a Roth IRA by either or both contributions or conversions. The documents do have some limitations. Under each document, if a "Roth Conversion IRA" is established, that account cannot accept Roth IRA contributions. In addition, under each document upon death, a surviving spousal beneficiary to a Roth IRA is automatically deemed to be the owner of the Roth IRA. This means that the surviving spouse can no longer use the owner’s death to meet the second tax-free distribution rule, and would then have to wait until he or she turns age 59½ (or is disabled or meets the first-time home owner exception) to take a tax-free distribution.

For those who wish to provide a model Roth IRA plan document, IRS Notice 98-49 permits Article IX of the plan to be amended in accordance with the instructions to the plan document. The Notice specifies how an amendment could be made to give the surviving spouse distribution options at the death of the owner, instead of requiring that he or she elect to treat the Roth IRA as his or her own.

Revenue Procedure 98-59 sets forth the rules for obtaining an opinion letter for a prototype Roth IRA, and transitional relief for those who have previously used prototype Roth plans. Under this Revenue Procedure, prototype sponsors may apply for an opinion letter on their Roth IRA in much the same way as they would for a traditional IRA, except that the plan document may permit either Roth or traditional IRA contributions, as long as certain conditions are met.16 Under the transitional rules, an individual who has been using a Roth IRA document other than the model IRA document will be considered to have been using an approved document as long as specified procedures are followed, including the plan sponsor applying for an opinion letter on or before June 30, 1999.17

XI.  Tax Reporting

There are no special IRS Form 1099-R distribution codes for reporting distributions that are converted (or reconverted) to a Roth IRA. The IRA custodian will generally use distribution code "2" ("Early Distribution - Exception Applies") if the IRA owner is under age 59½, or "7" ("Normal Distribution") if the IRA owner is age 59½ or older. The distribution amount will be shown in both boxes 1 and 2a of that form.

The IRA owner will also receive a Form 5498 from the Roth IRA custodian which receives the Roth conversion. Box 3 ("Roth conversion amount") of that form will show the amount converted. If a contribution was also made to a Roth IRA, the Form 5498 will show the contribution amount in box 1.

Recharacterizations from Roth IRAs are reported on Form 1099-R with the distribution code "G" ("Direct Rollover to IRA"). For 1999, a new distribution code, "R", will be used to report recharacterizations on Form 1099-R. The recharacterized amount will be shown in box 1 only of the Form 1099-R. If the IRA owner completes both a (re)conversion and a recharacterization, he or she will receive a separate form for each transaction.

The IRA custodian which recieves a recharacterization from Roth IRA will provide the IRA owner a Form 5498, showing the recharacterized amount in box 3 of the form. If the recharacterization was from a traditional IRA, this amount will be shown in box 2.

Any IRA owner who converted his or her traditional IRA to a Roth IRA will need to complete Part II of Form 8606. This form should be completed even if the IRA owner recharacterizes his or her conversion and thereby not incurring additional taxes. Contributions to a Roth IRA are not to be reported on Form 8606, although distributions are reported in Part III of the form.

XII.  Future Roth IRA Legislative?

Senator Bill Roth has recently proposed the Retirement Savings Opportunity Act of 1999. There are a few provisions under this legislation which would make the Roth IRA an even more attractive savings vehicle. First, the contribution limits of $2,000 to IRAs would be increased to $5,000. As noted in the legislation, the IRA contribution limit of $2,000 has been frozen since 1981, and with cost of living adjustments it would be $4,930 today. Many trade organizations are very active with increasing the $2,000 limit, and it is likely that the limit will be increased this year. Second, the legislation eliminates both the AGI caps on contributions and conversions. As a result, any individual with compensation would be able to contribute or convert to a Roth IRA. Lastly, although not directly related to IRAs, the legislation would allow "after-tax" or Roth contributions to be made to a 401(k) or 403(b) plan. Distribution to these contributions would then be received tax-free.

There is some support for increasing AGI caps for conversion IRAs. The Medical Health Bill proposed to increase the $100,000 AGI conversion limit to $145,000 for single filers and $290,000 for joint filers, and in doing so was projected to raise of revenue was $2.4 billion over 5 years. This increase of revenue generated by conversion makes it a possible addition to spending bills which need additional revenue in order to be balanced.

Summary

For many individuals, the Roth IRA is a better retirement vehicle than the traditional IRA. It can potentially offer larger retirement benefits by lowering taxes, and in some circumstances can be transferred to beneficiaries income tax free. Those considering the Roth IRA should be familiar with the tax free distribution rules, and understand that the failure to abide by these rules could cause distributions to be taxable. Due to the complexity of some the Roth IRA rules, the decision to establish or convert to a Roth IRA may be best made with the assistance of one’s tax advisor.

1. Datastream International.
2 According to the Investment Company Institute, in 1986, over $37 billion was contributed to IRAs, while the next year contributions were only approximately $14 billion.
3. House Report 6, The American Dream Restoration Act.
4. The 1998 Act also accelerated the payment of conversion taxes under the 4-year spread (see VII(C)).
5. The proposed regulations also clarified that SEP-IRAs could be converted and SIMPLE-IRAs could be converted after 2 years of plan participation; that the effective year of a conversion is the year in which the distribution that is converted was made; that required minimum distributions (RMDs) are not eligible to be converted; that the IRA owner may elect out of the 4-year spread for conversions made in 1998; and that the withholding rules which apply to IRAs pursuant to IRC Section 3405 also apply to Roth IRAs.
6. Under IRS Notice 98-50, one reconversion could be made between November 1, 1998 and December 31, 1998, and one reconversion can be made during 1999.
7. The Final Regulations also made the following clarifications: that a change in filing status or a divorce had no effect on the application of the 4-year spread for 1998 conversion; that a conduit IRA which is converted into a Roth IRA and then recharacterized to a traditional IRA retain its status as a conduit IRA; that recharacterizations are not considered distributions and therefore not subject to withholding or the withholding notice rules; and that a recharacterization is not treated as a rollover for purposes of the one-rollover-per-year limitation of IRC Section 408(d)(3)(B).
8. Any type of IRA (traditional IRA, SEP-IRA, SARSEP-IRA, rollover IRA, or spousal IRA) or a SIMPLE-IRA after two years of plan participation is eligible to be converted into a Roth IRA.
9. The 1997 Act provided relief for conversions made before January 1, 1999, by allowing the taxable amount of the IRA be included ratably in one’s gross income over the four year-period beginning with the conversion year (although the 1998 Act did permit taxpayers to elect to pay the tax on one year). There has been no proposal to extend the January 1, 1999 deadline. Upon the death of the Roth IRA owner, amounts remaining to be included in income as a result of a 1998 conversion is included in the final tax return of the IRA owner, with the exception that if the surviving spouse is the sole beneficiary to the Roth IRA, he or she may elect to continue the deferral by including the remaining amounts in his or her income over the remaining time period.
10. Pursuant to the 1998 Act, for tax years beginning in 2005, income generated from the receipt of required minimum distributions is not included in one’s AGI for purposes of the $100,000 conversion limit.
11. Treasury Regulation Section 1.408A-2, Q&A-4.
12. Treasury Regulation Section 1.408A-5, Q&A-9.
13. Treasury Regulation Section 1.408A-5, Q&A-9(b)(2).
14. Treasury Regulation Section 1.408A-5, Q&A-9(a)(2).
15. In this example, the value of the money used to pay the conversion tax is $60,086 using a 6% growth rate (6% is used since earnings on this money are taxable).
16. Section 3.03 of Revenue Procedure 98-59.
17. Section 4.01 of Revenue Procedure 98-59.

The Author:
Greg Reymann, J.D., LL.M., is Corporate Counsel to Franklin Resources, Inc., the nation's largest publicly traded fund company. Mr. Reymann specializes in ERISA, and has been part of Franklin for the past 8 years. Prior to joining Franklin, Mr. Reymann worked as a Tax Law Specialist in the Employee Plans Technical and Actuarial Division of the IRS in Washington. Mr. Reymann can be reached at 800/237-0738, ext. 28050, or at reymann13@prodigy.net.

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Last modified: April 06, 2006