by Barry C. Picker, CPA/PFS, CFP
© 1998, Barry C. Picker
Immediately upon creation of the Roth IRAs in The Taxpayer Relief Act of 1997, realization set in that the law did not address the question of a taxpayer converting a traditional IRA to a Roth IRA, only to later discover that their income was too high. This has been solved in the Technical Corrections portion of the Internal Revenue Service Restructuring and Reform Act of 1998. Under the new provision, the taxpayer can now do a trustee-to-trustee transfer of any contribution from one type of IRA to any other type of IRA, and such contribution will be deemed contributed to the transferee account. This permits a taxpayer who has made an improper conversion to undo it. It also allows a taxpayer who made an improper contribution to a Roth IRA to change to a contribution to a traditional IRA. This transfer could take place any time up to the extended due date of the tax return for the year.
The question now is whether this provision has created new advantages for taxpayers, that may not have been intended. The answer may depend upon how the IRS interprets this section and whether they put restrictions on the manner of transfer, or how many times during the year the taxpayer can "change their mind."
The language of the law does not specifically state that the transfer is limited to situations where the Roth conversion or contribution is not permitted. In fact, the transfer can be TO a Roth, if, for example, a taxpayer contributed their annual $2,000 to a regular IRA and then decided later that they preferred a Roth. A situation where a traditional to Roth transfer under this section would be advantageous is the case of a taxpayer who wishes to avail himself of the tax deduction of a traditional IRA. However if he participates in a qualified plan, the deductibility of the IRA would then depend upon the level of the taxpayer's adjusted gross income. If at the time the return is prepared, it is determined that all or part of the IRA contribution will not be deductible, that portion can then be transferred to a Roth, since a Roth is definitely a better deal than a non deductible traditional IRA.
A prime example of a situation where a taxpayer might want to take advantage of this provision, and undo a traditional-to-Roth conversion, is where the value of the IRA has dropped significantly after having been converted. If the value declines, the taxpayer is stuck paying tax on the higher date of conversion value. By undoing the conversion, the taxpayer is no longer paying tax on value that is not there. Unless the IRS issues rules limiting the transfers, the taxpayer can then redo the transfer to the Roth, and thus pay tax on the lower account value.
The wording of the statute contemplates that the transfer can involve only a portion of the amount that had previously been converted or contributed. For instance, if a married taxpayer contributes $2,000 to a Roth IRA, and then has an adjusted gross income of $155,000, only $1,000 will be permitted as a Roth contribution. The other $1,000 will have to be transferred to a traditional IRA. Note that the section does not permit the taxpayer to withdraw the excess; it must be transferred to the traditional IRA.
Since partial transfers can be made, the question then arises as to what extent and under what circumstances the IRS will permit a partial transfer. Consider a situation where an investment portfolio is converted to a Roth IRA. Subsequently, one security has a substantial decline in value. Will the taxpayer be able to transfer only that security back to the traditional IRA? Can the taxpayer then reconvert that security back to the Roth, thus saving the income tax on that security's decline in value?
Another way in which the partial transfer could be useful to a taxpayer is in the efficient use of the tax brackets. Suppose a taxpayer decides that a conversion is warranted only to the extent that the income from the conversion will be taxed in the 15% bracket. Such a taxpayer can do the conversion, and then at the time the tax return is prepared, transfer any amount that would cause taxation at 28% back into the traditional IRA. This same technique could be used at the higher brackets, for example, making sure that no income is taxed at the 31% bracket.
The Author:
Barry C. Picker is a Certified Public Accountant with the Personal Financial Specialist
designation, and is a Certified Financial Planner licensee. He runs his own accounting and
financial planning firm located in Brooklyn, NY, and is also a member of the NYS Society
of CPAs Estate Planning Committee. He has taught seminars and written articles on tax
topics, and has been quoted in various publications. In addition, he is part of a panel
that answers tax questions on America Online at keyword:TaxLogic. He can be reached at
(718) 934-4300, or via E-Mail at BPickerCPA@cs.com.