Tax Planning for Retirees

Transfers to Roth IRAs: Part 1

Roth Conversions Allowed for High-Income Individuals after 2009. A taxpayer ordinarily may
not transfer any of the funds in an IRA or employer retirement plan to a Roth IRA if (1) the taxpayer’s modified “adjusted gross income” for the tax year exceeds $100,000 or (2) the taxpayer is married filing a separate return. However, after 2009, a taxpayer will be able to make such transfers to a Roth IRA regardless of the level of his or her income – and regardless of a separately filed return. Furthermore, one-half the income from such a transfer in 2010 will not be taxable until 2011 and the other half will not be taxable until 2012 (unless the taxpayer elects to report it all in 2010). However, if the taxpayer takes a distribution of any of the transferred funds before 2012, the taxpayer must accelerate payment of the deferred tax on the distributed funds. (Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. No. 109-455, § 512; I.R.C. §408A.) See Chapter 6 of the treatise for a more complete discussion of Roth conversions.

IRS Focus on Transactions between Roth IRAs and Related Businesses. – The IRS has announced it will closely scrutinize transactions involving a Roth IRA and business entities related to the owner of the Roth IRA. Since a Roth IRA and its distributions are generally not taxable, the IRS is concerned the owner of a Roth IRA may attempt to shift value tax-free to it by selling or transferring business assets for less than actual value. The IRS notes it has many statutory tools available to attack this type of transaction. (Notice. 2004-8, 2004-4 I.R.B. 333.) See Chapter 6 of the treatise for an explanation of the taxation of Roth IRAs.

The Taxable Value of an IRA Annuity Converted to a Roth IRA. – The IRS has acted to thwart new IRA annuity products designed to have artificially low cash values subject to taxation when converted to Roth IRAs. (The artificially low cash values subsequently inflate to their proper levels.) Under new regulations, a taxpayer must pay tax on an annuity’s “fair market value” upon conversion to a Roth IRA, without regard to the annuity’s artificial cash value. The regulations provide several potential methods for determining the fair market value. Some of these methods may require help from the taxpayer’s insurance company or tax advisor. (Reg. Sec. 1.408A-4T, Q&A 14.) The IRS has also authorized simpler safe harbor valuations for certain converted annuities. (Rev. Proc. 2006-13, 2006-1 C.B. 315. See Chapter 6 of the treatise for an explanation of the taxation of Roth IRAs.

Correction of Defective Roth Conversion Denied where Statute of Limitations Had Run. – In some situations, the IRS may allow a taxpayer to correct retroactively an IRA trustee’s failure to convert an IRA to a Roth IRA. However, the IRS denied this relief where (1) the taxpayer attempted the failed conversion in a  tax year barred by the statute of limitations and (2) the taxpayer had not paid the tax on the failed conversion. (Ltr. Rul. 200437037.) See Chapter 6 of the treatise for an explanation of Roth conversions.

Reversal of Defective Roth Transfers Allowed though Reversal Period Had Expired. – Normally, a taxpayer may reverse a previous transfer of funds from a regular IRA to a Roth IRA (i.e., a Roth conversion) by taking action within a specified period. In addition, though, the IRS may allow a taxpayer to reverse a defective Roth conversion even though the normal reversal period has expired. If allowed, retroactive reversal of a defective conversion avoids penalties and other adverse tax consequences.

The IRS has generally allowed the reversal of a defective Roth conversion where (1) the taxpayer requested relief before IRS discovery of the mistake, (2) the taxpayer acted reasonably and in good faith, and (3) the statute of limitations had not run on the year of the conversion. For example, the IRS has allowed taxpayers to reverse defective Roth conversions after the normal period for reversal has expired where:

1.  A husband and wife learned their Roth conversions were invalid because their income exceeded the allowable threshold, even though they had relied in good faith on a professional tax advisor. (Ltr. Rul. 200431016. Similarly Ltr. Ruls. 200431017, 200429014, and 200416014.)

2.  A taxpayer did not timely discover his ineligibility for the Roth conversion because of a catastrophic illness. (Ltr. Rul. 200432030.) A taxpayer missed the 60-day deadline because of severe illness and heavy medication. (Ltr. Rul. 200729037.)

3.  The taxpayer mistakenly believed the allowable income threshold for a Roth conversion was higher than it actually was. (Ltr. Rul. 200432020.)

4.  A taxpayer misunderstood the advice of his tax advisor – after becoming ineligible for his Roth conversion due to an unanticipated divorce and his former spouse’s refusal to assent to a joint return. (Ltr. Rul. 200438050.) Similarly, for a taxpayer who received an employer tax information form that erroneously stated that the conversion was not taxable. (Ltr. Rul. 200716033.)

5.  The taxpayer was unaware of the need to reverse a defective Roth conversion, believing erroneously that the defect in the conversion nullified it. (Ltr. Rul. 200428035.)

6.  The taxpayer married after his Roth conversion and discovered that the combined incomes of he and his spouse exceeded the allowable threshold for a conversion. (Ltr. Rul. 200426023.)

7.  A husband and wife did not satisfy the income threshold for their Roth conversions because the husband subsequently realized a large gain on sale of a partnership interest, and they received erroneous and confusing advice from their tax advisors. (Ltr. Rul. 200423030.)

8.  The taxpayer’s Roth conversion was invalid because the income of he and his wife exceeded the allowable threshold, and he mistakenly believed he had until the end of the following year to reverse the conversion. (Ltr. Rul. 200414047.)

See Chapter 6 of the treatise for an explanation of Roth conversions and recharacterizations.

Extension of Roth Conversions to Eligible Retirement Plans. – Taxpayers have long been able to convert their regular IRAs to Roth IRAs. However, to convert funds in an employer retirement plan to a Roth IRA, taxpayers have generally had to roll the funds over first to a regular IRA and then convert the regular IRA to a Roth IRA. By contrast, after 2007, a taxpayer may directly convert all or part of an “eligible plan” to a Roth IRA without using a regular IRA as an intermediary. For this purpose, an eligible plan is a qualified retirement plan, a section 403(b) tax-sheltered annuity (TSA), or an eligible state and local government plan.

Such “taxable qualified rollover contributions” (TQR contributions) from eligible plans to Roth IRAs will be subject to the same conditions that apply to regular IRA conversions. That is, before 2010, a taxpayer could generally make a TQR contibution only if (1) the taxpayer’s modified “adjusted gross income” for the tax year did not exceed $100,000 and (2) the taxpayer was not a married individual filing a separate return. After 2009, a taxpayer may make the conversion regardless of the level of his or her income – and regardless of a separately filed return. Of course, conversions to Roth IRAs are taxable (exclusive of return of investment) whether the converted funds come from a regular IRA or an eligible plan.

See Chapter 6 of the treatise for a more complete discussion of Roth conversions. (Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. No. 109-455, § 512; Pension Protection Act of 2006, Pub. L. No. 109-280, § 824(a), (b), (c); I.R.C. § 408A.)

Some Additional Important Aspects of Taxable Contributions to Roth IRAs. – An IRS Notice helps answer many questions relating to “taxable qualified rollover contributions” to Roth IRAs (TQR contributions). For example:

1.  A taxpayer does not aggregate a TQR contribution from a qualified plan with distributions from other plans or IRAs (unlike the required aggregation of distributions and TQR contributions from regular IRAs).

2.  A taxpayer may choose to make a TQR contribution of an amount distributed from the taxpayer’s qualified plan limited to the excess of the distribution over the investment portion, and retain the investment portion tax-free.

3.  The IRS apparently accepts the practice of using IRAs as mere instantaneous conduits for qualified plan funds intended for TQR contributions.

4.  A taxpayer may be able to achieve substantial tax savings by choosing whether to (1) run a TQR contribution from a qualified plan through his or her IRAs or (2) make the TQR contribution directly from the qualified plan.

5.  If a taxpayer has an existing IRA with investment, it will usually be more beneficial to roll over a qualified plan distribution (stripped of personally retained investment) to an IRA and make a TQR contribution from the IRA.

Note that the IRS will deny reversal of a defective Roth conversion if the Roth IRA no longer contains the contributed funds because the taxpayer subsequently transferred the funds to a non- IRA account. (Notice 2009-75, 2009-39 I.R.B. 436; Ltr. Rul. 201239015.) See Chapter 6 of the treatise for the taxation of TQR contributions.

Beneficiary Transfers to Roth IRAs. – A surviving spouse of a retiree may make taxable transfers of funds from the retiree’s eligible plans or IRAs to the spouse’s own Roth IRA to the same extent the retiree could have during his or her lifetime. Furthermore, if the plan or IRA permits, any beneficiary (whether or not a surviving spouse) may make such a taxable transfer to a newly formed Roth IRA designated as an “inherited Roth IRA,” provided the transfer is a trustee- to-trustee transfer. The inherited Roth IRA must be in the form “James Smith, Decedent, for the benefit of William Smith, beneficiary.” However, in any such case, the spouse or other beneficiary must personally satisfy the usual requirements for such a transfer (e.g., modified adjusted gross income of $100,000 or less before the year 2010). (Notice 2008-30, 2008-12 I.R.B. 638.) See Chapter 6 of the treatise.

» Transfers to Roth IRAs: Part 2