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Blogging from Heckerling: Post Seven

Doth Thou Roth?

One of the featured sessions on the last day of the Heckerling Institute was presented by Natalie B. Choate, Esq. of the law firm Nutter McClennen & Fish on the topic of Roth Individual Retirement Accounts.

Ms. Choate began by emphasizing that Roth IRAs provide tax-free income/appreciation build up and are not subject to the mandatory distribution rules at age 70½ that pertain to traditional IRAs – all of which make Roth IRAs powerful wealth building and tax planning tools.  The longer the assets are kept in a Roth IRA and given the opportunity to earn compounded tax-free investment returns within the account, the greater the Roth IRA may grow.  Distributions from Roth IRAs held more than five years provide tax-free income to over-age 59½ retirees and could result in a lower tax bracket for the taxpayer’s other income.  Ms. Choate jested that significant tax-free distributions from a large Roth IRA could allow a retiree to not have to file a tax return and to qualify for other benefits including welfare.

Estate planners should consider stretching the retention of the assets within the Roth IRA upon the death of the Roth IRA owner to qualify for life expectancy payouts to the decedent’s beneficiaries.  A good estate plan may bequeath/specifically designate the inheritance of the Roth IRA to a young beneficiary such as a grandchild.  If the client has a concern that the young beneficiary will recklessly spend the Roth IRA assets, a properly drafted see-through trust could protect the assets in the Roth IRA and still qualify for lengthy life expectancy payouts.

Ms. Choate stated that a better choice for the beneficiary of a Roth IRA could be the surviving spouse who could then rollover the Roth IRA into their own Roth IRA.  The surviving spouse will also not be subject to the mandatory distribution rules, unlike if the Roth IRA is transferred to any other beneficiary upon the death of the Roth IRA owner.  Leaving the Roth IRA to a surviving spouse will also allow the continued tax-free build-up of the assets that do not need to be withdrawn from the Roth IRA for the remainder of the surviving spouse’s life.  Upon the surviving spouse’s death, the surviving spouse could then leave the Roth IRA to a young beneficiary and obtain a long life-expectancy distribution payout to the beneficiary.  It is not a good idea to designate a trust for the surviving spouse to inherit the Roth IRA because the spouse will not be eligible to rollover the Roth IRA to their own Roth IRA.  A Roth IRA held by a trust for the surviving spouse and other beneficiaries will have to be distributed based upon the surviving spouse’s (i.e. the oldest trust beneficiary) life expectancy, which could exhaust the Roth IRA if the surviving spouse lives to their mid to late 80s.

In order to acquire a Roth IRA, a taxpayer can make annual contributions of up to $5,500 ($6,500 if over the age of 50) limited by the taxpayer’s earned compensation if it is less than the aforementioned maximum annual contribution amount.  Additionally, there are income limitations that may make taxpayers ineligible to make contributions directly to a Roth IRA.  For the 2018 tax year, married filing jointly taxpayers that earn more than $199,000 or single taxpayers earning more than $135,000 cannot contribute directly to a Roth IRA because of these modified adjusted gross income limitations.  However, Roth IRA conversions from traditional IRAs are not subject to the aforementioned income limitations.  Ms. Choate stated that, using a technique that is supported by a footnote included in the Joint Committee of Taxation conference committee report on the recently enacted Tax Cuts and Jobs Act of 2017, higher income taxpayers who are under age 70½ can make “back door” Roth IRA annual contributions by making annual contributions to their traditional IRAs and then convert the contributions to a Roth IRA from the traditional IRA.  The “back door” IRA annual contributions/conversions will not be tax deductible.

Taxpayers can make traditional IRA-to-Roth IRA conversions of any amount from the assets held by their traditional IRAs.  The amount of pre-tax money converted from a traditional IRA to a Roth IRA will then be included in the taxpayer’s taxable income as an IRA distribution for the tax year of the conversion(s).  A taxpayer can possibly achieve a tax-free conversion if the taxpayer has available non-passive business losses to offset the taxable income from the IRA conversion.

Additionally, Ms. Choate mentioned that another technique when a taxpayer can achieve a tax-free Roth IRA conversion is if they have both the following attributes:

1) The taxpayer is a participant in a qualified retirement plan such as a 401(k) plan. 2)  The taxpayer has after-tax contributions in a qualified retirement plan or traditional IRA.

If the taxpayer has both the above-mentioned attributes, the taxpayer can do an “upstream” direct rollover of all of their pre-tax money in all their traditional IRA accounts to a qualified retirement plan if the plan administrator will accept the upstream rollover.  After-tax money cannot be rolled over to a qualified plan.  Thereafter, the taxpayer can perform a direct tax-free rollover of the remaining after-tax money to a Roth IRA and the conversion will not be includible in the taxpayer’s taxable income.

Ms. Choate explained that the “cream-in-the-coffee” rule aggregates all the traditional IRAs held by a taxpayer when a distribution or Roth IRA conversion is made from a traditional IRA.  Therefore, a distribution or Roth IRA conversion from a traditional IRA will be treated as a pro-rata distribution of both the taxable pre-tax money and the non-taxable after-tax money held by all the taxpayer’s IRA accounts.  A taxpayer can simultaneously perform a direct upstream rollover of all their pre-tax money to a qualified retirement plan and a direct tax-free rollover of the remaining after-tax money to a Roth IRA if the contributions are appropriately designated and certified by the taxpayer as pre-tax money and after-tax money upon the direct transfer of the assets to the qualified plan and Roth IRA, respectively.

Toward the end of the session, Ms. Choate mentioned that the Tax Cuts and Jobs Act of 2017 eliminated taxpayers’ ability to re-characterize or reverse a traditional IRA to a Roth IRA conversion.  Therefore, beginning with 2018 conversions, taxpayers cannot re-characterize a taxable conversion from a traditional IRA to a Roth IRA.  However, Ms. Choate stated that the Internal Revenue Service posted on its website their interpretation of the new tax legislation that prior taxable conversions performed during 2017 can be successfully re-characterized and reversed prior to the 2017 tax return due date, including extensions, up to the latest date of October 15, 2018.

 Blogging from Heckerling 2018

Kurt Peterson Tax Director provides a wide range of tax services including financial planning, income tax planning, estate planning, complex estate plan structures, retirement planning, and risk management insurance.

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