ROTH IRA

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Additional Penalty for Premature Withdrawal of Roth Conversion Amount

Technical corrections bill H.R. 2645, contains a new penalty for converted amounts that are withdrawn before the 5-year holding period is satisfied. In this case, to the extent attributable to amounts includible in income due to the conversion, the amount withdrawn would be subject to (1) the 10% early withdrawal tax (unless a qualified exeption applies) and (2) for conversions during 1998, an additional 10% tax (to compensate for the deferral of income created by the 4-year income inclusion rule for 1998 conversions).In addition, any withdrawal from a Roth IRA containing converted amounts before the 5-year holding period is satisfied would be treated as coming first from amounts that were included in income because of the conversion.

The House Ways and Means Committee Chairman's Mark of the technical corrections bill anticipated that appropriate forms would be developed to clearly differentiate Roth Conversion IRAs from other Roth IRAs and, for taxpayers who make conversions in more than one year, to differentiate Roth Conversion IRAs for different years, so that taxpayers would be able to easily maintain separate IRAs for conversion amounts for each year in which a conversion is made. It also expected special rules to apply if separate Roth IRAs are not maintained. Where a Roth IRA contains conversion contributions and other contributions, or conversion contributions from more than one year (i.e., the account is not a Roth Conversion IRA), the 5-year period would begin with the most recent tax year for which a conversion contribution was made. For purposes of determining the amount of a withdrawal attributable to amounts included in income due to a conversion, all Roth IRAs with the same 5-year holding period would be aggregated. (JCX-56-97, Oct. 8, '97, p. 11)

IRS Issues New Forms for Establishing Roth IRAs and Roth Conversion

Ann 97-122, 1997-50 IRB; Form 5305-RA (Roth Individual Retirement Custodial Account); Form 5305-R (Roth Individual Retirement Trust Account)

IRS has issued model Forms that may be used by financial institutions to establish Roth IRA trust or custodial accounts beginning on Jan. 1, '98. A checkbox on the Forms is used to designate the account as a Roth Conversion IRA. IRS has also issued Ann 97-122, 1997-50 IRB which provides interim guidance for prototype sponsors and individual contributors to Roth IRAs.

Observation: The Forms and their instructions reveal important details about how IRS interprets the Roth IRA distribution rules in Code
Sec. 408A.

Roth IRA. The instructions say that unless the Roth IRA is designated as a Roth Conversion IRA (see below), it may be used for:

(1) annual cash contributions of up to $2,000 from the taxpayer,

(2) amounts rolled over or transferred from another Roth IRA, and

(3) IRA conversion contributions (amounts transferred from a nonRoth IRA to a Roth IRA).

Observation: Article II of the Forms explains that the $2,000 contribution limit is phased out between modified AGI of $95,000 and $110,000 ($150,000 and $160,000 for a married depositor who files jointly). However, taxpayers also should keep in mind that under Code Sec. 408A(c)(2), the $2,000 annual contribution limit is reduced by nonRoth IRA contributions made during the year.

Roth Conversion IRA. By checking a box on Form 5305-R or Form 5305-RA, a taxpayer designates the account as a Roth Conversion IRA. If the account is so designated, no contributions other than IRA conversion contributions made during the same tax year can be accepted by that account.

The trustee or custodian cannot accept IRA conversion contributions for a tax year if the depositor's modified AGI for that year exceeds $100,000, or if the depositor is married and files a separate return. Modified AGI doesn't include income from IRA conversion contributions.

The Forms encourage taxpayers to maintain IRA conversion contributions for each tax year in a separate Roth IRA, in order to simplify the identification of funds distributed from Roth IRAs. Ann 97-122 also says that prototype sponsors should encourage individuals to use separate accounts.

Observation: By designating two different types of Roth IRA accounts-one that can hold three different types of contributions, and another that can hold only one kind (conversion contributions)-IRS paves the way for Roth IRA distribution changes that would be made by the technical corrections bill that has passed the House but has yet to be taken up by the Senate.

Background. Roth IRA distributions are tax-free if they are (1) made after the 5-tax-year period that begins with the first tax year for which the taxpayer made a contribution to the Roth IRA (or in the case of conversions from nonRoth IRAs to Roth IRAs, the 5-tax-year period beginning with the tax year in which the conversion took place) and (2) made when the account owner is 59-1/2 years of age, or older, or on account of death, disability, or the purchase of a home by a qualified first-time homebuyer (limited to $10,000). (Code Sec. 408A(d)(2)) Otherwise, distributions from the account are taxed (to the extent of earnings in the account) and are hit by a 10% penalty (unless an exception applies, such as for disability). Distributions are treated as coming first from nontaxable contributions to the account.

Post-death distributions from a Roth IRA. Code Sec. 408A(c)(5) provides that the required distribution rules of Code Sec. 401(a)(9)(A) do not apply to Roth IRAs. These rules require distributions to begin by the account owner's required beginning date and be paid over his life or life expectancy, or the combined lives or life expectancies of the account owner and designated beneficiary. However, the '97 TRA did not detail exactly how post-death distributions are to be made to Roth IRA beneficiaries. Article V of Form 5305-R and Form 5305-RA explains how these post-death payout rules work.

Where the account owner dies before the balance in the Roth IRA has been distributed, and his surviving spouse is not the sole beneficiary of the account, the entire remaining Roth IRA account balance is, at the account owner's election (or if he hasn't elected, at the election of the beneficiary or beneficiaries), distributed as follows:

(1) by the end of the year containing the fifth anniversary of the account owner's death, or

(2) over the life expectancy of the designated beneficiary, starting no later than Dec. 31 of the year following the year in which the account owner died.

Where distributions haven't begun by Dec. 31 of the year following the year in which the account owner died, the first distribution method applies. If the second distribution method is used, each year's minimum payment is found by dividing:

… the account balance as of Dec. 31 of the preceding year by

… the designated beneficiary's life expectancy, using the beneficiary's attained age as of his birthday in the year distributions must commence and subtracting 1 for each passing year.

Observation: These rules are essentially the same as those that apply to regular IRA distributions to a nonspouse beneficiary where the account owner dies before his required beginning date.

Observation: Under the regular IRA rules, a designated beneficiary's life expectancy is found in Table V of Reg §1.72-9, or in Table E of IRS Pub No. 590 (1996) p. 65.

Observation: Presumably, where there are multiple beneficiaries of a Roth IRA, the life expectancy of the oldest beneficiary will be used for that particular account. That's the rule that applies to regular IRAs.

If the account owner dies before the balance in a Roth IRA has been distributed, and his surviving spouse is the sole beneficiary of the account, Article V of Form 5305 R and Form 5305-RA provides that the survivor is then treated as the account owner.

Observation: Where the account owner dies before the required beginning date, a surviving-spouse beneficiary of a regular IRA must begin taking distributions from the account (1) in the year following the year in which the survivor attains age 70-1/2 (if the survivor rolls over the decedent's IRA into his own IRA), or (2) no later than Dec. 31 of the year following the year in which the account owner died, or the end of the year in which the decedent would have attained age 70-1/2 (if the IRA remains in the decedent's name). By contrast, a surviving spouse beneficiary of a Roth IRA who can afford to do so may leave the Roth IRA untouched and thus pass on a bigger income-tax-free nest egg to the family.

Separate trusts. Contributions to a Roth IRA must be maintained as a separate trust, custodial account or annuity from a traditional (nonRoth) IRA, and separate accounting within a single trust, custodial account or annuity isn't allowed. However, IRS will allow a prototype sponsor to combine a Roth IRA and a traditional IRA in the same document, as long as (1) the separate trust requirement is satisfied, and (2) the document, as completed by the owner, clearly indicates whether it is to be used as a traditional IRA or a Roth IRA.

IRS also announced that it will provide transitional relief for Roth IRA sponsors and their customers similar to the relief that had been offered in Rev Proc 97-29, Sec. 7.01, 1997-24 IRB 9 for users of documents establishing SIMPLE IRAs that had not been pre-approved by IRS.

References: For Roth IRAs, see FTC 2d/FIN ¶ H-12290 et seq.; USTR ¶ 408A4 et seq.; Tax Desk ¶ 28,395 et seq.; TG ¶ 8971 et seq.

Maxwell Shmerler & Co., CPAs would like to than RIA for their contribution to this page.

Maxwell Shmerler & Co, CPAs (c) 1997