Roth IRA final regs. offer clarity and guidance.

• Author: Foran, Nancy J.
• Position: IRS regulations

EXECUTIVE SUMMARY

* In addition to regular annual contributions to a Roth IRA, taxpayers may also make rollover (conversion) contributions from SEP, SIMPLE and traditional IRAs to a Roth IRA.

* If a decedent's spouse is the sole beneficiary of all of the decedent's Roth IRAs, he can elect to continue the decedent's four-year spread.

* A failed conversion is not eligible for the four-year income spread and is subject to the 6% Sec. 4973 tax on excess contributions and the 10% Sec. 72(t) tax on early distributions.

When introduced, Roth individual retirement accounts (IRAs) were complex, as taxpayers had to meet income limits to contribute regular IRAs to Roth IRAs. The final regulation make great progress in clarifying many confusing issues, such as recharacterization of conversions, treatment of the four-year spread at death or divorce and whether a penalty applies to distributions within five years.

To encourage individual saving, Congress created Sec. 408A, the Roth individual retirement account (IRA), in the Taxpayer Relief Act of 1997 (TRA '97), Section 302. Several Roth IRA provisions were then modified by Section 6005(b) of the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA '98). To clarify certain aspects of Roth IRAs, the Treasury issued proposed regulations(1) in 1998. In addition, Notices 98-49(2) and 98-50(3) provided interim guidance on Roth IRA reporting requirements and conversions. Treasury then issued final regulations in February 1999(4) that generally adopt the approach taken by the proposed regulations, but clarify and modify those rules. Exhibit 1 on p. 660 and Exhibit 2 on p. 662 summarize these changes. The final regulations continue to apply the interim guidance of Notice 98-50 for 1998 and 1999 reconversions, but adopt a new approach for post-1999 reconversions. The regulations were effective Feb. 3, 1999 and apply to tax years beginning after 1997.

Exhibit 1: Roth IRA final regs.' changes/clarifications

Regs. Sec./Topic Change/Clarification 1.408A-3, Q&A-7 Undistributed aggregate excess contribu- Contributions tions are reduced as deemed Roth IRA contributions in subsequent years. 1.408A-4, Q&A-1(b)(1) The rollover of a traditional IRA to a Conversions Roth IRA must occur within the 60-day period described in Sec. 408(d)(3)(A)(i). 1.408A-4, Q&A-1 (b)(3) Redesignating a traditional IRA as a Roth Conversions IRA is treated as a transfer of the traditional IRA to a Roth IRA. 1.408A-4, Q&A-1(d) Attempted reconversions before the Conversions permitted time period are not conversions. 1.408A-4, Q&A-3(b) Contributions not properly recharacterized Conversions may be subject to the Sec. 4973 excise tax, regardless of the conversion method used. 1.408A-4, Q&A-11(c) Taxpayers who use the four-year income Conversions spread and who file separately or divorce before including the entire taxable conversion amount in income must include the remaining taxable amount in gross in- come over the remaining four-year period. 1.408A-4, Q&A-12 Roth IRA distributions that are part of Conversions the substantially equal periodic payments converted from a traditional IRA are nonqualified Roth IRA distributions until they meet the qualified distribution requirements. The Sec. 72(t) tax does not apply, but the income acceleration rules apply if the four-year spread is used. 1.408A-5, Q&A-1(a) For recharacterizations, redesignating an Recharacterizations IRA is treated as a transfer of the IRA account balance. 1.408A-5, Q&A-1(b) A recharacterization via a rollover must Recharacterizations occur within 60 days after the distribution (as described in Sec. 408(d)(3)(A)(i)). 1.408A-5, Q&A-2(c) The income attributable to a recharacter- Recharacterizations ized contribution includes net losses on the recharacterized amount. 1.408A-5, Q&A-5 Amounts converted from SEP or SIMPLE IRAs Recharacterizations can be recharacterized as a contribution to a SEP or SIMPLE IRA. 1.408A-5, Q&A-6(c) The executor, administrator or other Recharacterizations person responsible for filing the decedent's final tax return can elect to recharacterize his IRA contribution. 1.408A-5, Q&A-9 Rules for reconversions. Also, Regs. Sec. Recharacterizations 1.408A-5, Q&A-9(a)(1),provides that post-1999 reconversions occurring before the permitted time are failed conversions. 1.408A-6, Q&A-1(d) Returned contributions (corrective Distributions distributions) are not includible in gross income, but net income is includible. 1.408A-6, Q&A-2 For purposes of the FTYP, corrective Distributions distributions are treated as if never contributed. 1.408A-6, Q&A-4 The amount of nonqualified distributions Distributions subject to tax is reduced by distributions previously included in income. 1.408A-6, Q&A-9(b) Regular contributions include Distributions contributions made by the return's unextended due date. 1.408A-6, Q&A-11 A beneficiary can aggregate all Roth IRAs Distributions inherited from the same beneficiary, subject to limits. 1.408A-8, Q&A-1(b)(4) A failed conversion is a conversion from a Definitions traditional or SIMPLE IRA to a Roth IRA in a transaction that does not meet the MAGI and rollover contribution requirements. Regs. Sec./Topic Prop. Regs. provision 1.408A-3, Q&A-7 None Contributions 1.408A-4, Q&A-1(b)(1) Rollover had to occur within Conversions 60 days after the distribution. 1.408A-4, Q&A-1 (b)(3) None Conversions 1.408A-4, Q&A-1(d) None Conversions 1.408A-4, Q&A-3(b) None Conversions 1.408A-4, Q&A-11(c) None Conversions 1.408A-4, Q&A-12 None Conversions 1.408A-5, Q&A-1(a) None Recharacterizations 1.408A-5, Q&A-1(b) Clarifies the distribution as one Recharacterizations described in Sec. 408(d)(3)(A)(i). 1.408A-5, Q&A-2(c) None Recharacterizations 1.408A-5, Q&A-5 None Recharacterizations 1.408A-5, Q&A-6(c) None Recharacterizations 1.408A-5, Q&A-9 None Recharacterizations 1.408A-6, Q&A-1(d) Contributions were referred to as Distributions "excess contributions." 1.408A-6, Q&A-2 None Distributions 1.408A-6, Q&A-4 None Distributions 1.408A-6, Q&A-9(b) None Distributions 1.408A-6, Q&A-11 None Distributions 1.408A-8, Q&A-1(b)(4) None Definitions Exhibit 2: Roth IRA clarifications included in the preamble, but not in the final regs.

* Roth IRAs can be established for minor children meeting the compensation requirement.

* Sec. 408(d)(5) rules for tax-free distributions of excess IRA contributions after the tax return due date do not apply to Roth IRAs.

* Sec. 219(f)(6) rules allowing excess traditional IRA contributions to be deduded in subsequent years do not apply to Roth IRAs.

* Contributions to Education IRAs are disregarded in applying the Roth IRA contribution limits.

* A rationale for retaining the RMD rules is provided.

* The basis for Regs. Sec. 1.408A-4, Q&A-1 l(b), regarding surviving spouses, is provided in Sees. 408A(d)(3)(E)(ii)(11) and (d)(4).

* Excess contributions to a Roth IRA made in a prior year and applied against the contribution limits in the current year cannot be recharacterized, unless the recharacterization would be timely for the contribution itself.

* A conduit IRA converted to a Roth IRA and recharacterized as a traditional IRA retains its status as a conduit IRA.

* The final regulations continue the interim rules of Notice 98-50 (for 1998 and 1999).

* Recharacterization is not subject to withholding, but trustee- to-trustee Roth IRA conversions are distributions subject to withholding.

* The FTYP is not affected if the entire Roth IRA balance is distributed before the taxpayer makes any other Roth IRA contributions.

* The initial Roth contribution will not start the FTYP if it is recharacterized or revoked within seven days.

* Regs. Sec. 1.408A-6, Q&A-8(b), conversion contribution distributions, is based on Sec. 408A(d)(4)(B)(ii).

Roth IRA Accounts

Roth IRAs allow taxpayers who meet a modified adjusted gross income (MAGI) requirement an alternative type of individual retirement plan.(5) Under Sec. 408A, Roth IRA contributions are not deductible; the earnings thereon are not taxed. Distributions from a Roth IRA are tax-free if the account has existed for at least five years...