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 has allowed a taxpayer to correct retroactively (recharacterize) 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. (IRC § 408A(d)(6)(B)(iii); Ltr. Rul. 200437037.) See Chapter 6 of the treatise for an explanation of Roth conversions.

Recharacterization of Defective Roth Transfers Allowed though Recharacterization Period Has Expired. – Before 2018, a taxpayer could recharacterize a previous rollover of funds from a regular IRA to a Roth IRA (i.e., a Roth conversion) by taking action within a specified period. After 2017, recharacterizations are not allowed for valid (non-defective) Roth conversions but are still allowed for defective Roth conversions. In addition, though, the IRS can allow a taxpayer to recharacterize a defective Roth conversion even though the normal recharacterization period has expired. When allowed, such a recharacterization of a defective conversion avoids penalties and other adverse tax consequences. (IRC § 408A(d)(6)(B)(iii).)

The IRS generally allows the late recharacterization 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 allowed taxpayers to recharacterize defective Roth conversions after the normal period for recharacterization had 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 recharacterize the conversion. (Ltr. Rul. 200414047.)

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

Some Additional Important Aspects of Taxable Conversions to Roth IRAs. – An IRS Notice helps answer many questions relating to Roth conversions. For example:

1.  A taxpayer does not aggregate Roth conversions from a qualified plan with distributions from other plans or IRAs (unlike the required aggregation of distributions and Roth conversions from traditional IRAs).

2.  A taxpayer may choose to make a Roth conversion 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 Roth conversions.

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

(Notice 2009-75, 2009-39 I.R.B. 436; Ltr. Rul. 201239015.) See Chapter 6 of the treatise for the taxation of Roth conversions.

Roth Conversions by Beneficiaries. – A surviving spouse of a retiree may make Roth conversions from the retiree’s qualified 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 a qualified plan permits, any beneficiary (whether or not a surviving spouse) may convert qualified plan funds 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.” (Notice 2008-30, 2008-12 I.R.B. 638.) See Chapter 6 of the treatise.

» Transfers to Roth IRAs: Part 2