Source: https://www.thetaxadviser.com/issues/2016/mar/roth-ira-planning.html
Timestamp: 2019-04-23 12:32:14+00:00

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Advantages of Roth IRAs include nontaxable qualified distributions, lack of required minimum distributions, and that contributions can be made at any age.
Partial rollovers of qualified retirement plan assets into a Roth IRA, a recently approved option, can accommodate tax-free transfers if, after rolling after-tax proceeds into the Roth account, individuals then roll pretax monies into another plan or traditional IRA. Similarly, they can roll pretax monies in a traditional IRA into a qualified plan and convert the remaining after-tax funds into a Roth IRA.
Roth IRA contribution limits are similar to those for traditional IRAs, but designated Roth account contributions are subject to higher limits for qualified plans. While the latter are subject to required minimum distributions after age 70½, these may be avoided with an in-service distribution or rollover to a Roth IRA.
Converting assets from a traditional IRA or qualified plan to a Roth IRA is no longer limited by modified adjusted gross income, opening this option to more individuals. Pretax retirement accounts can be converted to designated Roth accounts within a qualified plan, with many former restrictions removed in recent years. Income recognition on conversion should be assessed for its effects on taxes and other income-based criteria.
Bankruptcy protection limits, beneficiaries, investment allocations, and risk from adverse law changes should also help guide planning decisions regarding IRAs.
In 1997, Congress created the Roth IRA.1 While a taxpayer cannot take an upfront deduction for contributions, qualified distributions are not taxable. In addition to Roth contributions, individuals may make qualified rollovers of traditional IRA and qualified plan assets into Roth IRAs, commonly referred to as conversions. Converted assets are included in gross income, subject to a few exceptions.2 The opportunity to get more assets into Roth vehicles via various means has evolved over the last several years, most recently with the promulgation of Notice 2014-54. This was a huge taxpayer win, allowing rollovers of after-tax dollars in retirement plans directly to Roth IRAs to potentially be completely tax-free.
Similarly to an IRA or qualified plan, the earnings within the account are tax-sheltered.
Owners who will be in a higher tax bracket in the future could benefit from tax rate arbitrage by paying taxes on contributed monies at their current, lower rate.
An important recent development in Roth planning is the promulgation of Notice 2014-54 in September 2014. Previously, opinions had differed regarding the treatment of after-tax portions that a taxpayer rolled from a qualified retirement plan to a Roth IRA.
Under Notice 2009-68, the IRS stated that if an individual made a partial rollover to another plan or IRA and a distribution to himself or herself, this is treated as two separate distributions, to each of which the "cream-in-the-coffee" rule9 would apply. If it is deemed to be one distribution, then an exception could apply,10 which would make any after-tax amounts kept by the individual not subject to the cream-in-the-coffee rule. This exception states that in a partial rollover from a qualified retirement plan, the pretax monies are deemed to be rolled over first. Therefore, in Example 1 above, if the individual had $1 million distributed to him and, within 60 days, he deposited $900,000 to an IRA, 100% of the dollars in the IRA would be considered pretax. The dollars remaining outside would be considered 100% after-tax. This would bypass the cream-in-the-coffee rule and effectively distribute $100,000 to the individual with no income tax ramifications.
In Notice 2014-54, the IRS declared that pretax and after-tax amounts distributed to multiple destinations at the same time should be treated as a single distribution, which allows the exception to apply. Therefore, an individual can effectively move after-tax proceeds directly to a Roth IRA without causing an income tax liability if all of the pretax monies are simultaneously rolled to another plan or a traditional IRA. This was a huge win for taxpayers and presents an opportunity to accumulate more in Roth assets if coordinated correctly.
If an individual has an IRA that contains both pretax and after-tax amounts and does a conversion, the pro rata rule would apply. If the taxpayer has a $100,000 IRA with $60,000 of after-tax contributions and $40,000 of earnings (i.e., pretax), any dollar converted would result in 40 cents of taxable income.
This assumes that the $60,000 in the IRA was the only IRA account that the individual had. If he had others (whether SIMPLE, SEP, or traditional), they would be factored into the calculation to determine the taxability of converting the $60,000. When a taxpayer can do a Roth conversion with no tax liability, it makes deciding whether to convert much easier.
The most direct way to build Roth assets is through contributions, either to a Roth IRA or to a designated Roth account.
Individuals who are young, with many years of compounding power in front of them.
Individuals who are likely in a lower tax bracket today than they will be when they withdraw the assets.
Individuals who have more assets than they will need for retirement. Roth IRAs can be excellent estate planning tools because the beneficiary can make distributions over his or her lifetime and continue the tax-free compounding, potentially over many decades.14 This applies if the ultimate beneficiaries of the individual's estate are individuals. If the ultimate beneficiaries are charitable beneficiaries, which are not subject to income tax,it would be fruitless for the IRA owner to pay the tax upfront that could be avoided altogether.
Individuals who are seeking tax diversification of assets. As Roth IRAs and designated Roth accounts are relatively new, many individuals who have been working and saving for retirement for many years have more in taxable and pretax retirement funds. Individuals can hedge against future tax changes by building up assets in multiple tax "buckets."
Roth IRAs also can be useful savings vehicles for children and grandchildren, who may be unable from an income standpoint to amass cash. Family members can make Roth IRA contributions on their behalf, assuming that the children or grandchildren are eligible, based on earned income and MAGI. While this could be more income-tax beneficial than setting up a trust for the benefit of the same beneficiary, it does give beneficiaries more control over the assets—which could be a negative aspect, depending on the beneficiaries' maturity level (and that of their spouse or significant other).
Beginning in 2006, if a plan allowed it, participants had an additional option to choose from. Instead of deferring the income tax that was attributable to the compensation set aside into the retirement plan, they could pay income tax on the monies set aside and contribute them to a designated Roth account within the employer's plan.16 Distributions from the designated Roth account later would not be taxable.
The two main differences between designated Roth accounts and Roth IRAs are that designated Roth account contributions are not limited to taxpayers under certain income levels, and the contribution limits are higher (in 2015 and 2016, for those under age 50, $18,000, versus $5,500 for Roth IRAs, and $24,000 versus $6,500 for those age 50 and over). If Warren Buffett had access to a designated Roth account through his employer, he would be eligible to contribute up to $24,000 of his earned income to it.
Unlike a Roth IRA, a designated Roth account is subject to the same lifetime distribution rules as other qualified plans.19 This means that employees could be subject to RMDs beginning at age 70½ unless they are still working and own less than 5% of the company.20 Participants would be wise to consider an in-service distribution if they would be subject to RMDs from their employer's designated Roth account. If they rolled the designated Roth account assets into a Roth IRA, which, as stated earlier, is not subject to RMDs,they could keep the assets in a Roth vehicle to continue tax-free compounded investment growth. Otherwise, a distribution would have to be made, and although it would be tax-free, all future growth would forever be outside the preferential Roth environment.
Prior to 2010, married taxpayers filing jointly were permitted to do a conversion only if their MAGI was less than $100,000.23 This income cap has since been removed.
The taxpayer has ample assets outside the traditional IRA or retirement plan funds to pay the resulting income tax liability due upon the conversion. Having to pay the income tax liability from the retirement funds diminishes the benefit, as fewer assets remain in the Roth to grow tax-free.
The individual anticipates having a higher tax rate in the future than now. Many observers believe that tax rates for upper-middle-income and high-income individuals will trend higher in future years, as marginal ordinary income tax rates are currently low when considered from a historical perspective.
Individuals who retire prior to age 70½, when RMDs must begin from traditional IRA assets,24 may be in a lower tax bracket than in the future. By doing small Roth conversions during the years prior to age 70½, taxpayers can potentially maximize the after-tax value of their wealth and reduce future RMDs that will be subject to ordinary income tax.
Individuals who will need the assets for their living expenses in a retirement that is still a number of years away could be good candidates for a conversion. This allows additional tax-free compounding of growth and diminishes the relative cost of the upfront income tax costs of conversion.
The Small Business Jobs Act of 2010, P.L. 111-240, added a provision that allows any Sec. 401(k), Sec. 403(b), or governmental Sec. 457(b) plan that provides for both traditional and designated Roth account contributions to offer the ability to do a conversion within the plan itself.27 A plan is not required by law to offer this feature to its participants, even if it does allow its participants to participate in a designated Roth account within the plan. Initially, the ability to do an in-plan conversion required participants to be entitled to a distribution from the pretax plan, which meant that they had to meet certain age or qualifying event requirements. This limited the availability of conversions of qualified plan assets for many individuals.
However, the American Taxpayer Relief Act of 2012removed many of these restrictions and permitted individuals to convert balances in an employer-sponsored tax-deferred retirement plan into a designated Roth account beginning in tax years after Dec. 31, 2012, if the plan allows it.28 The tax consequences are the same as if the money had been rolled over to an IRA and then converted to a Roth IRA, meaning that any amounts not attributed to after-tax contributions are taxed as ordinary income.
For example, a conversion by a taxpayer in the 35% marginal federal income tax bracket of $500,000 within the plan, assuming that the amount converted consisted entirely of pretax contributions and earnings attributable to them, would trigger $175,000 of additional income tax, besides any additional taxes the taxpayer might incur due to a higher total income (e.g., net investment income tax, limitation of itemized deductions, etc.).
One drawback of doing a conversion within the employer-sponsored plan, as opposed to from an IRA, is that the taxpayer cannot recharacterize the conversion later. This can be particularly costly if the assets' value sharply declines between the time of the conversion and when the account could have been recharacterized had the conversion taken place in an IRA.
With these rollovers, individuals are not required to withhold 20% income tax that typically applies to distributions from a qualified plan. Tax withholding can be applied electively,31 but if the individual has other assets, they would be a preferable source from which to pay the resulting income tax liability due to the conversion. This keeps the amount within the Roth as large as possible.
Due to the income limits applicable to Roth IRA contributions and the deductibility of regular IRA contributions, taxpayers with higher incomes may think that they cannot participate in Roth IRAs. This is not necessarily the case.
Individuals, regardless of income levels, are allowed to make contributions to regular IRAs. If the individual's income level exceeds certain thresholds, the contributions will be deemed nondeductible, meaning that the contributions are considered made with after-tax dollars. Then the individual can convert these assets within the traditional IRA to a Roth IRA. Upon the conversion, he or she will have to include in gross income only the amount that is attributable to any earnings on the contributions. If the conversion takes place relatively soon after the contribution, this amount would likely be very small, if anything.
There is a major caveat to this planning opportunity. If the individual has other IRA assets that are pretax dollars, calculating the amount included in taxable income is more complex. The cream-in-the-coffee rule32 would apply. All IRAs are aggregated to determine the amount that is considered includible in the taxpayer's income. This is reported on Form 8606, Nondeductible IRAs, with the taxpayer's Form 1040, U.S. Individual Income Tax Return. Essentially, the calculation multiplies all distributions from the individual's IRAs for the year by a fraction to determine how much is taxable and how much is a recovery of basis. The numerator is the total basis that the taxpayer has in his or her IRAs, and the denominator of the fraction is the total balance of all IRA assets as of Dec. 31 of the tax year, plus any amounts that were distributed throughout the year.
Example 3:If an individual who has $100,000 in IRA assets, of which $5,000 is from after-tax contributions, converts $5,000 from his IRA to a Roth IRA, the amount that would be taxed as ordinary income is calculated as follows: $5,000 − ($5,000 × [$5,000 ÷ ($95,000 + $5,000)]) = $5,000 − $250 = $4,750 of taxable income.
This means that only 5% of the conversion was nontaxable, with the remaining 95% taxable. This can make Roth conversions for individuals with significant pretax IRA assets not nearly as efficient as for those who have minimal pretax assets.
Those who have most or all of their pretax retirement dollars in an employer-sponsored plan, as these dollars are not factored into the calculation to determine the taxability of a conversion from an IRA to a Roth IRA.
Assuming that an individual has nothing in any IRAs prior to any nondeductible contribution to an IRA and subsequent conversion to a Roth, a Roth conversion can be tax-neutral. For example, if he or she makes a $5,500 nondeductible contribution to an IRA (due to income thresholds) and subsequently converts that $5,500 to a Roth IRA, the formula to determine the amount considered taxable would be: $5,500 − ($5,500 × [$5,500 ÷ ($0 + $5,500)]) = $5,500 − $5,500 = $0 taxable income.
A conversion to a Roth IRA is tied to the traditional monies that are being rolled over. Therefore, a conversion for 2015 must be tied to a distribution that occurs by Dec. 31, 2015. An individual must contribute a distribution from a traditional plan to a Roth IRA within 60 calendar days after the distribution date.37 Therefore, an individual could have a distribution from his or her IRA on Dec. 31, 2015, and as long as the monies are contributed to a Roth IRA within 60 calendar days, the conversion will be considered complete in 2015.
As stated earlier, any qualified distribution from a Roth IRA is not includible in gross income. A distribution is qualified if it meets the qualified purpose and qualified distribution period tests.
For a first-time home purchase, limited to $10,000.
While the exemption is unlimited for retirement plans such as Sec. 401(k)s and Sec. 403(b)s, IRAs (including Roth IRAs) have an exemption of only $1 million. This is adjusted triennially for cost of living and is now $1,245,475.46 If a qualified retirement plan is rolled over to an IRA (whether pretax or Roth), it is not subject to the exemption cap.47 Individuals and their financial advisers would be wise to consider segregating IRA assets that are due to qualified plan rollovers versus IRA contributions, to avoid any confusion down the line.
A recent Supreme Court case clarified that inherited IRAs are not afforded any protection under federal bankruptcy laws.54 However, if the individual's state specifies otherwise, inherited IRA assets could be protected.
The above comments are with respect to bankruptcy proceedings. For general creditor proceedings, individuals must look to their state's law to determine what protections are afforded to IRA assets.
In addition to being financially responsible to avoid bankruptcy proceedings, individuals should look to secure umbrella liability insurance for protection against civil lawsuit liabilities.
If a plan is fully subject to the Retirement Equity Act of 1984,55 then, generally, the plan must distribute any benefits to a married employee in the form of a qualified joint and survivor annuity, unless the employee has waived that form of benefit and the employee's spouse consents to the waiver. While qualified plans such as designated Roth accounts are subject to this requirement, Roth IRAs are not.
Individuals who have multiple tax buckets (pretax, Roth, and taxable) should pay attention to asset location. For example, if an individual invests 60% in stocks and 40% in bonds, it would not be ideal to have the bonds in the Roth IRA account, given its tax-free compounding ability and subsequent tax-free qualified distributions. An individual may maximize overall wealth by strategically locating higher-growth assets in the tax-preferred Roth accounts.
Limitation of financial aid for higher education: Although the Free Application for Federal Student Aid (FAFSA) does not require retirement assets to be reported, a conversion will increase the total income that must be reported. Therefore, doing a Roth conversion on Jan. 1, 2016, instead of Dec. 31, 2015, for example, could minimize the impact on any potential financial aid that could be awarded to a student based on the parents' income for 2015.
Net investment income tax: Since 2013, the 3.8% net investment income tax is imposed on net investment income exceeding specified amounts.59 Increasing a taxpayer's income with Roth conversions could subject some or all of the taxpayer's net investment income to this additional tax.
Increased rate on capital gains and dividends: Also since 2013, adjusted net capital gains that, if ordinary income, would be taxed at a rate of 39.6% are subject to a federal tax of 20% instead of 15%.60 Increasing a taxpayer's income with Roth conversions could thereby increase the tax rate applied to long-term capital gains or qualified dividends.
Require minimum distributions from Roth IRAs.
One would hope that any legislative changes would apply prospectively, not retroactively. The fact that individuals who have been able to take advantage of Roth conversions and contributions and designated Roth accounts are likely to be more affluent and more influential with Congress may impede any changes from being applied retroactively.
Roth assets can be valuable as part of strategies for overall tax diversification, wealth transfer, or retirement income. While potentially valuable to some, they could be inappropriate for others, depending on their estate planning goals, the likelihood of lower tax brackets in retirement or lower tax brackets of beneficiaries compared with those of the current owners, and a lack of ability to pay the resulting income tax liability from assets outside retirement assets.
Regular Roth IRA contributions are limited to a relatively small annual dollar amount, but continued over many years, compounding of investments can be powerful. The same is true for nondeductible IRA contributions and subsequent Roth conversions. Designated Roth accounts allow taxpayers to save almost four times as much as can be contributed to a Roth IRA.
Individuals can also convert assets to Roth IRAs, choosing to pay income tax now on the converted amounts to have future growth occur in the preferential Roth environment. The different conversion methods available include converting assets from a traditional IRA to a Roth IRA, converting assets within a qualified retirement plan to a designated Roth account within the plan, and converting assets directly from a qualified retirement plan to a Roth IRA. The law has evolved over the past several years to increase taxpayers' ability to move assets into Roth IRAs via conversion.
An individual with both an IRA and a qualified retirement plan has additional strategies available. He or she can directly roll any after-tax monies in the qualified plan to a Roth IRA to avoid the cream-in-the-coffee rule and get assets into Roth vehicles with potentially no corresponding income tax liability. If an individual has an IRA with both pretax and after-tax dollars, he or she can roll the pretax dollars into the qualified retirement plan and then convert the remaining dollars in the IRA, which, if done correctly, results in no income tax liability.
Other considerations in deciding whether to put additional assets into Roth vehicles include asset location, ripple effects due to higher taxable income, and the lower amount of credit protection afforded to contributory IRAs, compared with qualified retirement plans or segregated IRA rollover plans. The elephant in the room is the potential legislative risk. Individuals should work closely with their professional advisers, including accountants, attorneys, and financial advisers, to review the overall risks in the context of the client's individual situation.
1Taxpayer Relief Act of 1997, P.L. 105-34.
4Sec. 408A(c)(5); Regs. Sec. 1.401(k)-1(f)(4)(i).
8Secs. 72(e)(8)(A), 72(e)(8)(B), and 72(e)(5)(D).
9The rule that an individual who receives a distribution from an account that contains both pretax and after-tax contributions must recognize in income a pro rata portion of each.
11Sec. 408(d)(3)(H); Secs. 402(c)(8)(B)(iii), (iv), (v), and (vi).
13Secs. 408A(c) and 219(g)(7)(A); Notice 2015-75.
14Regs. Sec. 1.408A-6, A-14(b); Sec. 408(a)(6).
23Sec. 408A(c)(3)(B)(i), before amendment by the Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222; Regs. Sec. 1.408A-4, Q&A 2.
27Sec. 402A(c)(4) and Notice 2010-84.
28American Taxpayer Relief Act of 2012, P.L. 112-240.
29Notice 2008-30, A-6; Notice 2009-75.
30Secs. 408A(e), 402(c)(8)(B), and 457(e)(1)(B).
32Secs. 72 and 408(d)(2); Regs. Sec. 1.408A-4, A-7(a).
34Instructions to Form 8606, Nondeductible IRAs.
35Regs. Sec. 1.408A-3, A-2(b); Sec. 219(f)(3).
36Because Emancipation Day, April 16, falls on a Saturday in 2016, it will be observed on April 15, thus deferring filing deadlines otherwise on that date to the following Monday, April 18, except for taxpayers residing in Massachusetts and Maine, for whom that Monday is Patriot's Day, further deferring their deadline to April 19. See Sec. 7503 and Rev. Rul. 2015-13.
37Regs. Sec. 1.408A-4, A-1(b)(1); Secs. 402(c)(3)(A) and 408(d)(3).
41Sec. 72(t); Regs. Sec. 1.408A-6, A-5(a). For more on the exceptions to the 10% penalty, see Poyzer and Yoder, "How to Avoid the 10% Additional Tax on Early Retirement Distributions," 221-1 Journal of Accountancy 46 (January 2016).
44Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, P.L. 109-8.
46To be readjusted effective April 1, 2016. 11 U.S.C. §522(n) and 11 U.S.C. §104.
4911 U.S.C. §522(b)(3)(C) and Hamlin, 465 B.R. 863 (B.A.P. 9th Cir. 2012).
50Gladwell v. Reinhart, No. 09-4028 (10th Cir. 4/24/12).
51Employee Retirement Income Security Act of 1974.
5211 U.S.C. §§522(b)(4)(A) and (B).
53Patterson v. Shumate, 504 U.S. 753 (1992), and 29 C.F.R. §§2510.3-3(b) and (c)(1).
54Clark v. Rameker, 134 S. Ct. 2242 (2014).
55Retirement Equity Act of 1984, P.L. 98-397.
56Centers for Medicare & Medicaid Services, "Part B Costs," available at www.medicare.gov.
61Office of Management and Budget, Analytical Perspectives, Budget of the United States Government, Fiscal Year 2016.
Amanda Lott is a partner and wealth adviser with RegentAtlantic Capital LLC in Morristown, N.J. For more information about this column, contact Ms. Lott at alott@regentatlantic.com.

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