Roth IRA Planning

 

Roth IRA Planning

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.

Benefits of Roth Assets
Roth IRA assets can have many advantages:

• Similarly to an IRA or qualified plan, the earnings within the account are tax-sheltered.
• Unlike those from a regular IRA or a qualified plan, distributions from a Roth IRA are not included in gross income if certain conditions are met.³
• Roth IRA assets are not subject to required minimum distributions (RMDs). However, assets in a designated Roth account under a qualified cash or deferred arrangement are subject to RMDs.⁴
• Once the original owner of a Roth IRA dies, if the assets transfer to nonspouse beneficiaries, lifetime distributions must begin, but these distributions are tax-free.⁵
• 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.
• Contributions to Roth IRAs can be made at any age, even after age 70½,⁶ assuming that the taxpayer meets the contribution requirements.⁷

Roll Over After-Tax Monies in a Qualified Retirement Plan Directly to a Roth IRA

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.

Example 1: An individual has a $1 million Sec. 401(k) plan balance, of which $100,000 is attributable to after-tax contributions (not designated Roth account contributions). If the individual moved $100,000 directly to a Roth, would it cause an inclusion of $90,000 of taxable income (based on the pro rata rule) or zero taxable income? Until it issued Notice 2014-54, the IRS had argued that the distribution should be considered a pro rata distribution of all pretax and after-tax balances in the plan.⁸

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.

From the Tax Adviser, written by Amanda Lott