by Michael J. Finch, CPC and Jennifer L. Olsen
Ó 1998 Universal Pensions, Inc.
Selected provisions of the Taxpayer Relief Act of 1997 (TRA-97) gave taxpayers and financial organizations an exciting new option for retirement saving: the Roth IRA. Beginning in 1998, an eligible individual may contribute the lesser of $2,000 or 100 percent of earned income annually. Also, in certain circumstances, an IRA holder may convert an existing Traditional IRA to a Roth IRA. Contributions to the Roth IRA are nondeductible, but distributions (including earnings) are potentially tax and penalty free if the individual satisfies certain distribution conditions. Now, portions of the Tax Technical Corrections Act of 1998 (TTCA-98) modify the Roth IRA distribution rules. This article covers Roth IRA distribution rules in light of TTCA-98, and focuses on the tax implications resulting from the interplay between the TTCA-98 distribution ordering rules, qualified distribution rules and special conversion distribution rules.
Roth IRA Distribution Ordering Rules
TTCA-98 amends IRC Sec. 408A(d)(4)(B), thereby imposing strict ordering rules on distributions of Roth IRA contributions for tax purposes. First, the distribution ordering rules require a Roth IRA holder to treat all of his or her Roth IRAs as one. This is similar to, but separate from, the rule which requires a Traditional IRA holder to treat all of his or her Traditional IRAs as one for determining the taxable portion of a distribution when the Traditional IRAs contain both deductible and nondeductible contributions. Next, the Roth IRA distribution ordering rules require a Roth IRA holder to separately track Roth IRA assets according to three basic categories: contributory assets, conversion assets and total earnings.
Contributory Assets
Contributory assets represent the total amount of assets contributed as regular Roth IRA contributions to all Roth IRAs of the individual up to the point of distribution.
Conversion Assets
Conversion assets represent the total amount of assets converted from Traditional IRAs to Roth IRAs up to the point of distribution. The distribution ordering rules require the Roth IRA holder to identify all conversion assets by tax year of conversion, and further subdivide each tax year’s conversion amount into taxable preconversion assets (i.e., amounts which were pre-tax assets, such as deductible Traditional IRA contributions and eligible rollover contributions, held in the Traditional IRA prior to conversion) versus nontaxable preconversion assets (i.e., nondeductible contributions held in the Traditional IRA prior to conversion).
Total Earnings
The amount of total earnings is the aggregate amount of earnings which have accumulated on all Roth IRA contribution sources within all Roth IRAs. In other words, total earnings would be the aggregate value of Roth IRAs at the point of distribution, minus undistributed regular Roth IRA contributory amounts and conversions amounts.
Once the Roth IRA assets have been categorized by source, the distribution ordering rules require the Roth IRA holder to treat any amounts distributed as coming from the following sources in the order listed
1. contributory assets,
2. conversion assets, chronologically by tax year of conversion (i.e., first-tax-year in, first out), and, within each tax year’s conversion, taxable preconversion assets first, followed by nontaxable preconversion assets; and
3. finally, from total earnings.
Roth IRA Qualified Distributions
While a Roth IRA holder may request a distribution from his or her Roth IRA at any time, distributed earnings are exempt from taxes only if they are distributed as part of a qualified distribution. To be a qualified distribution, the distribution must both occur after the completion of the five-year nonexclusion period, and after one of four qualifying events.
Nonexclusion Period
TTCA-98 defines the Roth IRA nonexclusion period as the five-taxable-year period beginning with the first taxable year for which the individual made a contribution of any kind to a Roth IRA. This rule eliminates the necessity of physically segregating Roth IRA contributory assets from conversion assets.
Qualifying Event
TRA-97 and TTCA-98 identify a qualifying event as
attainment of age 59 1/2,
disability,
the purchase of a first home or
death.
Additional Distribution Rules For Conversion Assets
In addition to the new ordering rules and the qualified distribution rules, TTCA-98 created two additional distribution rules for Roth IRA conversion assets which affect taxability.
Distributions Accelerate Ratable Taxation Of 1998 Conversion
Provisions of IRC Sec. 408A(a)(3)(A)(iii) allow a Roth IRA holder who completes a 1998 Roth IRA conversion from a Traditional IRA to include the conversion amount in income ratably over a four-year period. A Roth IRA holder may voluntarily elect to include the entire conversion amount in income in 1998, if done so by his or her tax return due date for 1998.
TTCA-98 technical corrections mandate that the Roth IRA holder increase the amount required to be included in income under the ratable taxation rule for 1998 conversions by any distributions of 1998 taxable preconversion amounts (defined earlier), which are subsequently distributed from the Roth IRA between 1998 and 2000.
Penalty On Conversion Amounts Distributed Within Five Years
TTCA-98 imposes a 10 percent penalty under IRC Sec. 72(t) on certain conversion assets (i.e., the taxable preconversion amounts) if distributed during the five-year period beginning with the year in which the conversion contribution was made. For purposes of the penalty, separate five-year periods apply for conversions completed in separate tax years (IRC Sec. 408A(A)(d)(3)(F)). A Roth IRA holder is exempt from the penalty if he or she has attained age 59 1/2, dies, becomes disabled, takes the distribution as part of a series of substantially equal periodic payments, or takes the distribution to pay for certain qualified expenses related to health insurance, medical expenses, education expenses or the purchase of a first home (IRC Sec. 72(t)).
NOTE: The new ordering rules, not the particular Roth IRA from which assets are distributed, will dictate whether a distribution contains conversion amounts.
Tax Consequences Of Roth IRA Distributions
While financial organizations must report Roth IRA distributions to the IRS based on information gathered from completed withdrawal statements, the burden for determining the tax consequences of a Roth IRA distribution lies with the Roth IRA holder or beneficiary, except for the return of an excess contribution (plus earnings) before the Roth IRA holder’s tax return due date. To assist the Roth IRA holder in determining the taxability of a Roth IRA distribution, the IRS will likely modify or develop a form similar to the current Form 8606, Nondeductible IRAs (Contributions, Distributions, and Basis).
When an individual takes a distribution from his or her Roth IRA, he or she must apply the distribution ordering rules, the qualified distribution rules and the conversion distribution rules, if applicable, in order to determine the tax consequences, if any, of the distribution. The following chart summarizes the tax implications of a Roth IRA distribution considering the source of assets, the time when taken (i.e., within the applicable five-year period or after) and whether taken subsequent to a qualifying event.
QUALIFIED DISTRIBUTION |
NONQUALIFIED |
DISTRIBUTION | |
Penalty Exception |
No Penalty Exception |
||
| Contributory Assets | no tax no penalty |
no tax no penalty |
no tax no penalty |
| Taxable Preconversion Assets | no tax no penalty |
no tax no penalty |
no tax penalty if within 5 years of conversion |
| Nontaxable Preconversion Assets | no tax no penalty |
no tax no penalty |
no tax no penalty |
| Earnings | no tax no penalty |
tax no penalty |
tax penalty |
: On January 12, 1998, Georgia, age 52, opened a Roth IRA at Ace Financial Organization with a $2,000 contribution. Later in the year on April 10, 1998, Georgia completed a conversion of $10,000 from her Traditional IRA to a Roth IRA and elected to and paid all of the taxes on the conversion for 1998. All of Georgia’s Traditional IRA dollars that were converted were pre-tax dollars.EXAMPLE 1
Georgia was let go from her job in May 1999. In July 1999, Georgia withdrew $1,000 from her Roth IRA to pay the mortgage. Georgia may think that this distribution would be subject to the 10% early distribution penalty. Georgia, however, will not have a 10% early distribution penalty because the ordering rules state that the first assets out will be a return of contributory assets if the Roth IRA holder has contributory assets in any of his or her Roth IRAs. Therefore, Georgia’s $1,000 distribution is considered to be made from the $2,000 contributory Roth IRA assets. Because the $2,000 represents contributory (not conversion) assets, the $1,000 is tax and penalty free. Remember that the 10% penalty does not apply to nonqualified distributions attributable to contributory assets.
EXAMPLE 2: In the previous example, if Georgia needed to take a $12,000 distribution in May 1999, $2,000 would be tax and penalty free as a return of contributory assets. The remaining $10,000 attributable to taxable preconversion assets would be tax free, but would be subject to a 10% penalty unless Georgia met one of the exceptions under IRC Sec. 72.
EXAMPLE 3: Assume from example 1 that Georgia needed to take a distribution of all of her Roth IRA assets: $13,000 (i.e., $2,000 contributory assets, $10,000 taxable preconversion assets and $1,000 earnings). The $2,000 return of contributory assets would be tax and penalty free. The return of the $10,000 taxable preconversion assets would be tax free, but would be subject to the 10% early distribution penalty (unless an exception applies). The distribution of the $1,000 in earnings would be taxable and subject to the 10% penalty (unless an exception applies). The earnings are taxable since the distribution was nonqualified as defined previously.
Conclusion
Roth IRAs became an exciting reality for taxpayers and financial organizations in 1998 with the passage of TRA-97. TTCA-98 further defined distribution rules applicable to Roth IRAs. As a result, a Roth IRA holder determines taxability of a distribution based on the interplay of distribution ordering rules, qualified distribution rules and conversion distribution rules, if applicable. While responsible for reporting Roth IRA distributions to the IRS, in most cases, a financial organization is not responsible for tracking the taxability of Roth IRA distributions, except for the return of certain excess contributions.
Although challenging to master, Roth IRA holders must nonetheless play by the new Roth
IRA distribution rules.
Authors:
Michael J. Finch, Certified Pension Consultant, is the Technical
Compliance Manager for Universal Pensions, Inc. (UPI). He asists in plan document drafting
and in insuring the continued compliance of UPI's retirement plan documents and forms. Jennifer
L. Olsen is the Manager of Publications at UPI. She oversees the production and
promotion of UPI's entire line of publications products. Based in Brainerd, MN, UPI
delivers a full-range of retirement plan services to more than 9,000 financial
organizations nationwide. UPI's web site is at www.universal-pensions.com.