Roth IRA Conversions
Susan D. Diehl
In part one of this article, which appeared in the October, 2010 issue, Susan Diehl, president of PenServ, explained the importance of taxpayers and advisors being well versed in the tax consequences and other rules applicable to Roth conversions. In this issue, Diehl provides additional guidance on how to handle the conversion process.
Two-Year Spread Election
If a taxpayer converted an eligible retirement plan to a Roth IRA in 2010, the entire taxable amount of the conversion can be either: (a) included in gross income for the year of the conversion (2010); or (b) included in gross income by including only one-half of the taxable amount the year following the conversion (2011) and the remaining one-half of the taxable amount the next year (2012). Using the two-year spread will be an irrevocable election and will be notated on the Form 8606 filed with the IRS by the taxpayer. For example, Christine converted her traditional IRA in the amount of $50,000 to a Roth IRA in 2010. Assume she has no basis in her traditional IRA, thus the entire $50,000 is taxable. Christine can either: (a) include the entire $50,000 in her gross income in 2010; or (b) include $25,000 in her gross income in 2011 and the remaining $25,000 in her gross income in 2012. If she includes the entire $50,000 in her gross income in 2010, she will pay income taxes based upon her tax bracket applicable to 2010. If she elects the two-year spread, the $25,000 included in her 2011 gross income is taxed based upon her tax bracket applicable to 2011. The final $25,000 included in her 2012 gross income is taxed based upon her tax bracket applicable to 2012. In other words, Christine is spreading the income over 2011 and 2012—she is not spreading the tax liability as if the amount were taxed in 2010.
No Conversion of Required Minimum Distribution to Roth IRA1
The law prohibits the rollover (or transfer) of any required minimum distribution to another plan, including a Roth IRA. If a minimum distribution is required for a year (including the year during which the participant attains age 70½) with respect to the eligible plan being converted to a Roth IRA, (regardless of the methodology used in the conversion) the first dollars distributed during that year are treated as consisting of the required minimum distribution until an amount equal to the required minimum for that year has been distributed.
Any converted amount is treated as a distribution from the other plan, even if the conversion is accomplished as a direct transfer or as a direct rollover. Thus, the minimum distribution must be made first before the remaining amount can be converted.2
Example: Sally is required to receive a minimum distribution from her traditional IRA of $10,000. If Sally attempts to convert $11,000 to a Roth IRA prior to receiving the required distribution amount, then $10,000 of the conversion amount would be treated as a required minimum distribution and would be ineligible for conversion. This result would be the same regardless of the methodology used in completing the conversion (rollover or transfer) or whether an amount greater than or equal to $10,000 remains in Sally's traditional IRA after the conversion.
If a required minimum is contributed to a Roth IRA, it is treated as having been distributed to the individual, subject to the normal taxation rules, and then contributed as a regular contribution to a Roth IRA and an excess contribution could arise. The required minimum distribution cannot be treated as an eligible conversion contribution.
Although a required minimum cannot be converted to a Roth IRA, beginning in 2005 the RMD amount was to be ignored in determining conversion eligibility.
Acceleration of Income Inclusion
If a taxpayer elects the two-year spread rule and then takes a distribution from the Roth IRA prior to including in gross income the entire taxable amount of the conversion, the income inclusion will be accelerated.
For example, Paul converts his qualified plan in the amount of $20,000 to a Roth IRA in 2010 and he is using the two-year spread. Assume that the entire $20,000 is taxable. Without any distributions, Paul would include in gross income $10,000 in 2011 and $10,000 in 2012.
Assume next that during 2011 he takes a distribution of $5,000. The normal Roth IRA ordering rules continue to apply. For purposes of this example, further assume that Paul has never made any regular Roth IRA contributions. Therefore, the $5,000 distribution taken in 2011 is "deemed" coming from his taxable conversion. He will include in gross income for 2011 the normal half scheduled to be included, $10,000, plus the $5,000 distribution for a total of $15,000.
In 2012, he will include in gross income the remaining $5,000 of the original $20,000 taxable conversion where he is using the two-year spread rule. Under this acceleration rule, Paul will not include in gross income more than the original taxable conversion. If Paul withdraws $5,000 in 2010, he will include $5,000 in his 2010 gross income; $10,000 in 2011; and the remaining $5,000 in his 2012 gross income. Note that since Paul is under age 59½, he will be subject to the recapture tax as he has made a distribution of conversion funds before they have been in the Roth IRA for five years.
How is the Taxable Amount of the Conversion Determined?
Any "basis" that is part of the amount being converted is not included in the taxpayer's gross income. Basis in a traditional IRA includes nondeductible regular IRA contributions, after-tax employee contributions that were rolled over to any traditional IRA, and repayments of qualified reservist distributions to any traditional IRA. For example, Sophie has made nondeductible contributions to her traditional IRA over several years of $20,000. In 2010, she takes advantage of the new conversion rules, but decides to convert just $20,000, although she has other traditional IRAs. Sophie cannot isolate just her "basis" amount of $20,000 and treat the entire conversion amount as nontaxable. As a result, part of the $20,000 will be taxable based upon the pro-rata taxation requirements under §408(d)(2) by taking into consideration balances she holds in all traditional-type IRAs, including SEP IRAs and SIMPLE IRAs. Sophie must file Form 8606 with her 2010 income tax return and complete Part II based on the instructions to that form. In this example, the distributing IRA trustee or custodian will issue a 2010 Form 1099-R entering $20,000 in both Boxes 1 and 2a; the receiving Roth IRA trustee or custodian will issue a 2010 Form 5498 entering $20,000 in Box 3 (since in this example the conversion is coming from a traditional IRA).
Employer Plans Converted to a Roth IRA
Basis in an employer's plan includes after-tax employee contributions and loan repayments after a default which also create basis in the account. For this discussion, we are not talking about designated Roth accounts under the employer's §401(k) or §403(b) plan. We are talking about the other portions of the plan, such as pre-tax deferrals, matching, profit sharing, rollovers and after-tax employee contributions. For example, Amber has a total balance of $100,000 in her employer's §401(k) plan. Amber has never made any designated Roth contributions to her §401(k) plan.
The $100,000 is comprised of the following:
If Amber has a distributable event under the §401(k) plan, and she takes a distribution, the taxable amount would be $92,000. The $8,000 after-tax principal amount comes out of the plan as nontaxable return of basis. If Amber doesn't want to pay any income taxes on her distribution, she could elect a direct rollover to her traditional IRA of at least $92,000 that represents the taxable amount of the distribution. She could also roll over the $8,000 after-tax principal amount to her traditional IRA that would then become part of her total traditional IRA "basis" subject to the pro-rata taxation rules of §408(d)(2). Or, she could direct the payer to direct roll the $92,000 to her traditional IRA and distribute the $8,000 directly to her. In this example, none of the distribution is taxable to her. In this case, the §401(k) plan would issue Form 1099-R and the receiving traditional IRA would issue Form 5498 entering the amount of her rollover in Box 2. She could then convert the $92,000 to a Roth IRA.
What about a conversion directly from the qualified plan to a Roth IRA? If Amber rolls over the $100,000 to her Roth IRA, this will be considered a conversion and she must include $92,000 in her gross income (where she can decide whether to include the $92,000 in her income for 2010 or use the two-year spread discussed earlier). Can Amber isolate just the basis amount of $8,000 in the employer's plan (after-tax employee contributions) and elect a rollover conversion of just that basis to a Roth IRA, while at the same time electing a rollover of the taxable portion ($92,000) to a traditional IRA thus escaping any taxation? The general answer is "no." However, it has been the author's opinion that if the participant receives his or her entire balance in the plan, and part of the distribution consists of after-tax employee contributions, then the participant can elect a direct rollover of the after-tax principal to a Roth IRA and elect a direct rollover of the taxable amount to a traditional IRA. This would result in none of the distribution being subject to Federal income tax.
This same situation could also be accomplished by a 60-day rollover. If Amber takes a partial distribution of the after-tax employee portion of the §401(k) plan, the prorated taxation rules would apply to the partial distribution. However, there may be one exception to the prorate taxation rules if the participant is not receiving a total distribution. If the employer's plan as of May 6, 1986, permitted in-service withdrawals of the employee's after-tax contributions, then the principal amount of the employee's after-tax contributions already in the plan as of December 31, 1986, may be withdrawn. (This exception is often referred to as the "pre-1987 grandfather rule.") In this case, the pro-rata taxation rules would not apply, but only if the participant meets the criteria explained above. Again, the §401(k) plan will issue the Form 1099-R entering the taxable amount of the conversion in Box 2a, and the receiving Roth IRA will issue the Form 5498 entering the amount converted in Box 2 (rather than Box 3). Caution: Do not give tax advice! If a client asks, "can I direct roll $92,000 to my traditional IRA and convert $8,000 to my Roth IRA?" the answer is absolutely "Yes." We strongly recommend that you not specifically address the tax consequences in this situation.
Conversions of an Annuity Contract
Final regulations under §1.408A-4, Q&A 14 regarding converting an IRA Annuity in kind to a Roth IRA were published in the Federal Register on July 29, 2008. These regulations are applicable to any Roth IRA conversion where an annuity contract is distributed or treated as distributed from a traditional IRA on or after August 19, 2005. These final regulations provide guidance concerning the tax consequences of converting a traditional IRA Annuity to a Roth IRA and how to value such conversion for purposes of issuing Form 1099-R to the taxpayer. These final regulations adopt the provisions of the proposed regulations issued in 2005, with certain modifications.
Eligibility Requirements Still Apply to Regular Roth IRA Contributions
As a reminder, the eligibility requirements for making regular Roth IRA contributions continue to apply. However, if a taxpayer cannot make regular Roth IRA contributions because his or her AGI is too high, that individual may be able to make a regular contribution to a traditional IRA as a nondeductible contribution (if under age 70½). After the regular contribution is made to the traditional IRA, the individual could then convert from the traditional IRA to a Roth IRA. However, it is critical to remember that the amount converted is still subject to the pro-rata basis recovery calculation by considering balances held in all traditional-type IRAs, including SEP IRAs and SIMPLE IRAs. Moreover, the IRA owner will be required to complete both Parts I and II of Form 8606.
Keep in mind that an individual could contribute to his or her employer plan and make an annual conversion.
A taxpayer may recharacterize a contribution to or from a Roth IRA under two different circumstances:4
A taxpayer may recharacterize regular contributions or conversions if he or she is ineligible for the contribution or merely wishes to change his or her mind. Also, a taxpayer is permitted to recharacterize all or just a portion of a regular contribution or conversion.
If a conversion contribution is determined to be ineligible (a failed conversion) and it is not recharacterized in accordance with these rules, the contribution amount will be treated as a regular contribution to the Roth IRA, and, thus, may be an excess contribution if it exceeds the individual's regular contribution limit. In addition, the distribution from the traditional IRA that was converted in error will not be eligible for the two-year spread and will be subject to the 10 percent additional tax for premature distributions unless an exception applies.5
If an individual makes a contribution to an IRA (the FIRST IRA) for a taxable year and then transfers the contribution (or a portion thereof) in a trustee-to-trustee transfer to another IRA (the SECOND IRA), the individual treats the contribution as having been made to the SECOND IRA, instead of the FIRST IRA, for Federal income tax purposes.
Miscellaneous Recharacterization Rules
Nothing in the law or the regulations prevents an IRA owner from recharacterizing a regular contribution and then re-recharacterizing it again back to the FIRST IRA, provided, however, that the election is timely made. For example, Alice made a regular contribution to her traditional IRA of $3,000 in 2010 for 2010. Knowing that none of the contribution would be deductible, she recharacterizes the contribution, plus earnings, to a Roth IRA in January of 2011. In preparing her 2010 tax return, she realizes that she would rather the amount be in her traditional IRA. She then re-recharacterizes the amount, again plus earnings, back to her traditional IRA on a timely basis and reports it as a nondeductible contribution on her Form 8606.
Recharacterizations must be reported by both the FIRST IRA and the SECOND IRA in accordance with the instructions for Forms 1099-R and 5498.
If the participant makes a direct rollover or 60-day rollover from a designated Roth account under a §401(k) or §403(b) plan to a Roth IRA, the Roth IRA owner cannot recharacterize such amount to a traditional IRA. Also, the amount cannot be rolled back into a §401(k) or §403(b) plan.
If the participant makes a rollover conversion contribution from an employer's qualified plan, §403(b) plan or governmental §457(b) plan (from funds other than a designated Roth account) to a Roth IRA (either by way of a direct rollover conversion or 60-day rollover conversion), the Roth IRA owner may elect to recharacterize such amount to a traditional IRA even if the taxpayer was eligible to have converted the amount to a Roth IRA.
If a spouse beneficiary makes a conversion contribution from an employer's qualified plan, §403(b) plan or governmental §457(b) plan (from funds other than a designated Roth account) to a Roth IRA (either by way of a direct rollover conversion or 60-day rollover conversion), the spouse beneficiary may elect to recharacterize such Roth IRA to a traditional IRA. If the spouse beneficiary elected to treat the Roth IRA as his or her own Roth IRA, the traditional IRA receiving the recharacterization must also be the spouse's own traditional IRA. However, if the spouse beneficiary elected to treat the Roth IRA as an inherited Roth IRA (as permitted in Notice 2008-30), the traditional IRA receiving the recharacterization must also be an inherited traditional IRA.
If a spouse beneficiary makes a direct rollover or 60-day rollover from a designated Roth account under an employer's §401(k) or §403(b) to a Roth IRA (either as his or her own Roth IRA or as an inherited Roth IRA), such Roth IRA cannot be recharacterized to a traditional IRA.
If a nonspouse beneficiary makes a direct rollover conversion contribution from an employer's qualified plan, §403(b) plan or governmental §457(b) plan (from funds other than a designated Roth account) to an inherited Roth IRA (which must be done only as a direct rollover), the nonspouse beneficiary may elect a recharacterization from the inherited Roth IRA to an inherited traditional IRA.
If a participant, spouse beneficiary or nonspouse beneficiary makes a rollover from an employer's plan (from funds other than a designated Roth account) to a traditional IRA, such rollover cannot be recharacterized to a Roth IRA. The only type of contribution made to a traditional IRA that is eligible for recharacterization to a Roth IRA is a regular contribution. However, if a participant or spouse beneficiary makes a rollover from an employer's plan to a traditional IRA, the participant or spouse beneficiary could elect a conversion to a Roth IRA.
If a nonspouse beneficiary rolls over (direct rollover) from an employer's plan (from funds other than a designated Roth account) to an inherited traditional IRA, such nonspouse beneficiary cannot elect a conversion to an inherited Roth IRA.
If a nonspouse beneficiary rolls over (direct rollover) from a designated Roth account under an employer's §401(k) or §403(b) plan to an inherited Roth IRA, such inherited Roth IRA cannot be recharacterized to a traditional IRA.
Additional IRS Guidance Issued in 2009
IRS Notice 2009-75 reiterated the tax consequences of rolling over (converting) an eligible rollover distribution from a qualified plan [including a §401(k) plan], a §403(b) plan or a governmental §457(b) plan to a Roth IRA of amounts that are not designated Roth accounts. It also provided an explanation of rolling a designated Roth account under an employer's §401(k) or §403(b) to a Roth IRA.
In the Background section of the Notice, the IRS states "… a rollover from an eligible employer plan (other than from a designated Roth account) to a Roth IRA results in the same federal income tax consequences for a participant as a rollover to a [traditional] IRA immediately followed by a conversion to a Roth IRA [except that the special rule at §408(d)(2) for aggregating after-tax amounts would not apply]." This statement equates to requiring a pro-rata calculation when "after-tax" contributions are a part of the employer's plan.
Therefore if the employee has made after-tax employee contributions, the taxable amount of the conversion equals the total amount converted reduced by the after-tax amount. It now appears that the employee cannot isolate just after-tax employee contribution amounts, convert that amount and claim that nothing is taxable.
Thus, if an employee splits the eligible rollover distribution by rolling part of the amount to a traditional IRA and converting the other part to a Roth IRA, any after-tax employee contribution amounts is pro-rata allocated to each part as if the entire amount were first rolled over to a traditional IRA and then immediately converted to a Roth IRA.
However, if the conversion is made directly from the employer's plan to a Roth IRA, the person's other traditional IRAs are NOT aggregated in determining the taxable conversion amount.
On the other hand, let's assume that the employee first rolls over to a traditional IRA (with or without after-tax employee contributions), and then converts from the traditional IRA to a Roth IRA. The aggregation of all of the person's traditional-type IRAs are included in determining the taxable amount of the conversion.
Rollovers from Designated Roth Accounts
This Notice also describes the tax consequences of rolling over a designated Roth account from an employer's §401(k) or §403(b) to a Roth IRA. In this case, none of the amount rolled over is taxable even if the distribution is not a qualified distribution from the designated Roth account (one that is after a five-year aging period and after the employee is 59½, has died or has become disabled).
Ordering Rules for Distributions from a Roth IRA
If an employee rolls over to a Roth IRA from a designated Roth account under an employer's §401(k) or §403(b), the principal amount is added to the Roth IRA owner's "bucket #1" money (the regular contribution source); the earnings go in "bucket #3" (the earnings source). (On the other hand, in the future when these distributions are "qualified distributions" where the earnings are tax-free and the participant rolls over the designated Roth account to a Roth IRA, the entire amount will be added to the Roth IRA owner's "bucket #1" money.) If an employee directly converts to a Roth IRA from an eligible employer's plan (other than from a designated Roth account), the entire amount is added to the Roth IRA owner's "bucket #2" money (the conversion source).
When there are conversion funds in a Roth IRA and a distribution occurs, there are specific ordering rules for the funds being distributed (instead of pro-rata). Note: All Roth accounts are aggregated for these rules (Roth and non-Roth are not aggregated).The Roth ordering rules are as follows:
Ordering Rules Example In 2009, the Roth IRA has a cumulative amount of $15,000 of Roth IRA contributions, excluding earnings. In addition, there is $40,000 of conversion from a non-Roth IRA in 2008. In 2009, the taxpayer (age 35) withdraws $16,000. The first $15,000 is treated as from the regular Roth IRA contributions. $1,000 is treated as from the conversion amount. The $1,000 is subject to the 10 percent penalty, due to withdrawal being made before five years of conversion.
Susan D. Diehl is president of PenServ, a nationally recognized pension consulting firm in Horsham, Pa., dedicated to providing its clients, institutional and retail, with the ability to sponsor retirement plans. Susan is highly respected in Washington, where she served as the 1995 Chairperson on the Department of Labor's ERISA Advisory Council and often testifies before the IRS and DOL on matters relating to retirement plan regulatory issues. She served a two-year term during 2000 and 2001 on the IRS's Information Reporting Program Advisory Committee (IRPAC) as vice chairperson. In 2007, Susan was appointed to a three-year term on the IRS's Advisory Committee on Tax Exempt and Government Entities (ACT), and she served on the Employee Plans Subcommittee. Through the ACT Committee, Susan assisted in the formation of the new IRS 403(b) Liaison Group, which meets periodically with the IRS to assist employers and financial institutions regarding issues specifically dealing with 403(b) plans. Through 2009, she also was a co-author of the SIMPLE, SEP and SARSEP Answer Book, the Roth IRA Answer Book, the Health Savings Account Answer Book and the AICPA's Understanding the Mechanics of Health Savings Accounts. (email@example.com)
This article was previously published in The ASPPA Journal, which is a quarterly technical publication providing critical insight into legislative and regulatory developments. The ASPPA Journal also features technical analysis of benefit plan matters as well as information regarding ASPPA's programs. For information visit ASPPA.org.