New Roth IRA Conversion Rules

Taxpayers with earned income have until April 15, 1999, to open a Roth IRA and have it count as starting on January 1, 1998.

Taxpayers who already have a traditional IRA can convert part or all of it to a Roth IRA if their adjusted gross income doesnt exceed $100,000. The converted amount would be included in their current income.

The taxable conversion is reported on Form 8606, Nondeductible IRAs , and attached to form 1040. These conversions are especially attractive for taxpayers who would like to leave their IRAs to their heirs and who have non-IRA money available to pay the taxes due on the conversion.

In 1998, in an attempt to save taxes, some taxpayers engaged in sequential conversions and reconversions. For example, assume that in 1998, a taxpayer converted a traditional IRA to a Roth IRA when the account was valued at $400,000. Then the stock market dropped, and the account value fell to $250,000. The taxpayer transferred the balance back to a traditional IRA and subsequently reconverted the funds into another Roth. As a result, the taxpayer was able to save taxes in 1998 by being taxed on only $250,000 instead of $400,000.

To close this loophole, the IRS issued Notice 98-50 (1998-44 IRB). The new rule limits reconversions to one on or after November 1, 1998, but on or before December 31, 1998. In addition, the rule permits only one reconversion in 1999.

If a taxpayer ended 1998 with a Roth IRA and the stock market takes a dive in the early part of 1999, he or she has until April 15, 1999, to close out the Roth and establish a traditional IRA.

A taxpayer who ended 1998 with a Roth and then discovered that his or her 1998 adjusted gross income was more than $100,000 has until April 15, 1999 (plus extensions), to recharacterize the Roth as a traditional IRA and then reconvert to a Roth. Under the law, this recharacterization would not be treated as a conversion.

If the market plunges later in 1999, that taxpayer is allowed to reconvert once.

If the taxpayer discovers after filing a timely return that his or her adjusted gross income for 1998 is above the $100,000 limit, the conversion may be treated as a regular contribution to a Roth IRA. The account value in excess of $2,000 is subject to a 6% excise tax under IRC section 4973 and an additional 10% tax under IRC section 72(t). The four-year payout period that was allowed for qualified 1998 conversions would no longer be available to a taxpayer in this situation. The four-year payout is only allowed on IRAs converted before December 31, 1998.

Observation: A Roth IRA is not for every taxpayer. If the individual will be in a low tax bracket at retirement or must use IRA money to pay the taxes on the conversion, he or she should think twice before converting to a Roth.

Michael Lynch, CPA, Esq., associate
professor of tax accounting at Bryant
College, Smithfield, Rhode Island.