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Sorting out the timing rules for traditional and Roth IRAs – Part II

This blog article sorts out the Roth IRA timing rules for regular contributions, rollovers, trustee-to-trustee transfers, conversions, recharacterizations, and reconversions, and offers practical suggestions on how to keep the complications to a minimum. It’s the second of a two-part series – the first covering timing rules for traditional IRAs.

Regular contributions to Roth IRAs. The deadline for establishing and making a contribution to a Roth IRA is the unextended tax return due date for the tax year to which the contributions relate. (Reg. § 1.408A-3 Q&A-2(b))

Tax-free rollover between Roth IRAs. Tax-free rollovers between Roth IRA – the withdrawal from one Roth IRA and rollover into another Roth IRA – generally are subject to the same rules that apply to traditional IRAs. (Code Sec. 408(d)(3), Code Sec. 408A(a) , IRS Publication 590, 2013, pg. 69) That means tax-free rollovers between Roth IRAs are subject to both the Code Sec. 408(d)(3)(I) 60-day timing rule and the 1-year wait period that apply to traditional IRAs. In Bobrow, TC Memo 2014-21TC Memo, contrary to long-established IRS rules, the Tax Court said that the 1-year wait period applies to a taxpayer’s traditional IRAs on an aggregate basis, rather than on an individual basis. Since Roth IRA rollovers generally are subject the same rules as traditional IRA rollovers, this means an individual can’t make a Roth-IRA-to-Roth-IRA rollover if he or she made such a rollover involving any of the individual’s Roth IRAs in the preceding 1-year period. In Ann. 2014-15, 2014-16 IRB, IRS said it agrees with the Tax Court but won’t apply the Bobrow interpretation of Code Sec. 408(d)(3)(B) to any rollover that involves an IRA distribution occurring before Jan. 1, 2015.

Note: In general online guidance ( irs.gov/Retirement-Plans/IRA-One-Rollover-Per-Year-Rule ), IRS has said that it also won’t apply the Bobrow interpretation of Code Sec. 408(d)(3)(B) (see discussion above) to any rollover that involves a Roth IRA distribution occurring before Jan. 1, 2015.

Trustee-to-trustee transfer between Roth IRAs. These transactions generally are subject to the same rules that apply to trustee-to-trustee transfers between traditional IRAs. (Code Sec. 408A(a)) There are no timing restrictions on these transfers.

Conversion from traditional IRA to Roth IRA. An otherwise allowable conversion from a traditional IRA to a Roth IRA may be made at any time. Since the conversion is taxable, the one-year waiting period that limits successive tax-free rollovers between traditional IRAs does not apply.

The conversion can be made via:

  • Rollover (withdrawal from the traditional IRA and contribution to a Roth IRA within sixty days after the withdrawal);
  • Direct trustee-to-trustee transfer; or
  • Redesignation of the account if the traditional IRA and Roth IRA have the same trustee). (Reg. § 1.408A-4 Q&A-1(b); IRS Publication 590, 2013, pg. 68)

The income resulting from the conversion is included on the return for the tax year in which funds are transferred or withdrawn from the traditional IRA. However the 10% premature distribution penalty doesn’t apply.

Conversion from employer retirement plan to Roth IRA. An eligible rollover distribution from an eligible retirement plan (e.g., an employer-sponsored profit-sharing plan) may be converted into a Roth IRA. (Code Sec. 408A(e)(1)) The conversion may take the form of a distribution from the plan followed by a rollover to the Roth IRA within 60 days, or it may take the form of a trustee-to-trustee transfer. (IRS Publication 590, 2013, pg. 69) Either way, the conversion is a taxable event.

Note: A distribution from the plan followed by a timely rollover to a Roth IRA will be subject to mandatory 20% withholding under Code Sec. 3405(c), but a trustee-to-trustee transfer will escape withholding.

IRS has said that a taxpayer who asked his employer sponsored plan to transfer money to a traditional IRA can change his mind after the transfer is completed and shift the funds to a Roth IRA through a conversion. The conversion is accomplished by a withdrawal from the traditional IRA and subsequent contribution to the Roth IRA within 60 days. Alternatively, it may be accomplished by a direct transfer from the regular IRA to a Roth IRA. ( irs.gov/pub/irs-tege/rne_spr09.pdf )

Recharacterization of contribution or conversion to Roth IRA. There are three possible types of recharacterizations:

    1. A contribution to a Roth IRA may be recharacterized as a contribution to a traditional IRA.2. A contribution to a traditional IRA may be recharacterized as a contribution to a Roth IRA.3. A conversion from a traditional IRA to a Roth IRA – i.e., a taxable distribution from the traditional IRA followed by a timely rollover to the Roth IRA – may be recharacterized (that is, reversed or cancelled out). (Code Sec. 408A(d)(6), Reg. § 1.408A-5 , IRS Publication 590, 2013, pg. 30)
Note: A conversion can help a taxpayer improve his tax situation. For example, a taxpayer who made a contribution to a Roth IRA may realize that a deductible contribution to a traditional IRA is a better alternative (e.g., keep him out of a higher tax bracket and/or avoid the loss of deductions geared to adjusted gross income). Or a taxpayer that received an unexpected, large bonus after converting a hefty sum in a traditional IRA to a Roth IRA may want to back out of the conversion to avoid being propelled into a higher tax bracket.

The recharacterization is made via a trustee-to-trustee transfer directly between financial institutions or within the same financial institution. Any recharacterized conversion or Roth IRA rollover from a traditional IRA will be treated as though the conversion or rollover had not occurred. Any recharacterized contribution will be treated as having been originally contributed to the second IRA, not the first IRA. The amount transferred must include related earnings or be reduced by any loss. (Instructions to Form 8606, Nondeductible IRAs, (2013), p. 3)

For recharacterization purposes, a distribution from a traditional IRA that’s received in one year and timely rolled over to a Roth IRA in the next year is treated as a contribution to the Roth IRA in the year of the distribution from the traditional IRA. (IRS Publication 590, 2013, pg. 30)

A distribution from an employer-sponsored qualified plan that was rolled over into a Roth IRA also may be undone via a recharaterization. (Instructions to Form 8606, Nondeductible IRAs, (2013), p. 3) However, the taxpayer can only recharacterize amounts rolled into a Roth IRA from an employer-sponsored retirement plan by transferring them to a new or existing traditional IRA, and not back into the plan from which they were distributed. ( irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-IRAs-Recharacterization-of-Roth-Rollovers-and-Conversions )

Timing. Ideally, a recharacterization should be made by the due date (plus extensions) of the taxpayer’s return for the affected year, and reflected on the return for that year.

However, a taxpayer can make a recharacterization even after he has filed his return for the year for which a traditional or Roth IRA contribution or conversion to a Roth IRA was made. He can make the recharacterization within six months of the unextended due date of his return for the year in which he made the traditional or Roth IRA contribution or conversion to a Roth IRA. Thus, for example, a contribution to a traditional IRA in 2013 may be recharacterized as a contribution to a Roth IRA as late as Oct. 15, 2014. A taxpayer that wants to make a recharacterization after he has filed the return for the affected year must file an amended return reflecting the transfer, and write “Filed pursuant to section 301.9100-2” on the amended return. (Instructions to Form 8606, Nondeductible IRAs, (2013), p. 3)

Reconversions. A person who converted an amount from a traditional IRA to a Roth IRA may not only transfer the amount back to a traditional IRA in a recharacterization, but may later reconvert that amount from the traditional IRA to a Roth IRA, and, under certain circumstances, have his resulting income fixed at the time of the reconversion.

Timing. A taxpayer who converts or has converted an amount from a traditional IRA to a Roth IRA and then transfers that amount back to a traditional IRA by way of a recharacterization can’t reconvert that amount from the traditional IRA to a Roth IRA before the beginning of the tax year following the tax year in which the amount was converted to a Roth IRA or, if later, the end of the 30-day period beginning on the day on which the IRA owner transfers the amount from the Roth IRA back to a traditional IRA by way of a recharacterization. This timing rule applies regardless of whether the recharacterization occurs during the tax year in which the amount was converted to a Roth IRA or the following tax year. (Reg. § 1.408A-5, Q&A 9(a)(1))

Note: This rule prevents a taxpayer from recharacterizing a Roth IRA as a traditional IRA if the market value of the IRA has been substantially reduced, e.g., because of a sharp decline in the market value of stocks held in the IRA, and then immediately reconverting to a Roth IRA to take advantage of the lower market value in determining the income to be reported from the conversion.

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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