General Rules Of Individual Retirement Plans

March 13, 2024

3667 / Are fees or commissions paid in connection with an IRA deductible?

<div class="Section1">The IRS has ruled that the payment of administrative or trustee fees incurred in connection with an individual retirement account may be claimed as a miscellaneous itemized deduction (i.e., for the production or collection of income) if such fees are separately billed and paid.<a href="#_ftn1" name="_ftnref1">1</a> However, the 2017 tax reform legislation suspended all miscellaneous itemized deductions subject to the 2 percent floor for 2018-2025. Furthermore, if separately billed and paid, the payment of such fees does not constitute a contribution to the individual retirement account and thus will not be an excess contribution or reduce the amount that may be contributed to the account or, in the case of a traditional IRA, deducted ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3656">3656</a>).<a href="#_ftn2" name="_ftnref2">2</a> Deduction of administrative fees is subject to the 2 percent floor on miscellaneous itemized deductions (prior to 2018).<div class="Section1"> Sales commissions on individual retirement annuities that are billed directly by an insurance agent to the client and paid separately by the client are not separately deductible, but are subject to the overall limits on contributions and deductions.<a href="#_ftn3" name="_ftnref3">3</a> Similarly, broker’s commissions incurred in connection with the purchase of securities on behalf of an IRA are not separately deductible, but are subject to the overall limits.<a href="#_ftn4" name="_ftnref4">4</a> An annual maintenance fee charged for self-directed brokerage accounts that did not vary with the number of transactions, the number of securities involved, or the dollar amount and that was paid to the trustee, not the broker, was not treated as a commission but was separately deductible as an administrative fee.<a href="#_ftn5" name="_ftnref5">5</a> In addition, brokerage account “wrap fees” that were based on a percentage of assets under management, but that did not vary based on the number of trades in the account, were not treated as a commission and were separately deductible as an administrative fee.<a href="#_ftn6" name="_ftnref6">6</a> The IRS has held that the payment of fees associated with flexible premium variable annuity contracts that are paid directly from subaccounts within the contract would not be considered a distribution from the contract. The IRS ruled that assessing expenses against the contract is unrelated to whether or not the participant is currently entitled to benefits under the contract. Therefore, such payments are an expense of the contract and not a distribution.<a href="#_ftn7" name="_ftnref7">7</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Rev. Rul. 84-146, 1984-2 CB 61; Let. Ruls. 9005010, 8951010. <a href="#_ftnref2" name="_ftn2">2</a>.   Let. Ruls. 8432109, 8329058, 8329055, 8329049. <a href="#_ftnref3" name="_ftn3">3</a>.   Let. Rul. 8747072. <a href="#_ftnref4" name="_ftn4">4</a>.   Rev. Rul. 86-142, 1986-2 CB 60; Let. Rul. 8711095. <a href="#_ftnref5" name="_ftn5">5</a>.   Let. Rul. 8835062. <a href="#_ftnref6" name="_ftn6">6</a>.   Let. Rul. 200507021. <a href="#_ftnref7" name="_ftn7">7</a>.   Let. Rul. 9845003. </div></div>

March 13, 2024

3669 / What is the penalty for making excess contributions to an IRA?

<div class="Section1">Editor’s Note: The SECURE Act 2.0 created new statutes of limitations (SOLs) for the penalties that apply to excess IRA contributions and missed RMDs.  The SOLs will now start to run immediately while, under prior law, the clock did not begin until the taxpayer filed Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts (meaning that the IRS often had an unlimited amount of time to act if the taxpayer did not file the form).  However, the Tax Court recently ruled that the new SOL on excess contribution penalties was not retroactive (so did not apply for cases where the penalty was incurred prior to the enactment of SECURE 2.0 on December 29, 2022).<a href="#_ftn1" name="_ftnref1">1</a>  The case serves as a warning for clients with missed RMDs or excess contributions from years prior to 2022 that have not yet been corrected.<div class="Section1"> If contributions are made in excess of the maximum contribution limit for traditional IRAs ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3656">3656</a>) or for Roth IRAs ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3659">3659</a>), the contributing individual is liable for a nondeductible excise tax of six percent of the amount of the excess for every year the excess contribution remains in the IRA (not to exceed six percent of the value of the account or annuity, determined as of the close of the tax year).<a href="#_ftn2" name="_ftnref2">2</a> A contribution by a person ineligible to make the contribution is an excess contribution even if it is made through inadvertence.<a href="#_ftn3" name="_ftnref3">3</a> In the case of an endowment contract described in IRC Section 408(b), the tax does not apply to amounts allocable to life, health, accident, or other insurance.<a href="#_ftn4" name="_ftnref4">4</a> It also does not apply to premiums waived under a disability waiver of premium feature in an individual retirement annuity.<a href="#_ftn5" name="_ftnref5">5</a> The penalty tax does not apply to “rollover” contributions to a traditional IRA or “qualified rollover contributions” to a Roth IRA.<a href="#_ftn6" name="_ftnref6">6</a> It does apply, however, if the “rollover” contribution does not qualify for rollover. The Tax Court did not accept the argument that an IRA created in a failed rollover attempt is not a valid IRA and, thus, the six percent penalty should not apply.<a href="#_ftn7" name="_ftnref7">7</a> Likewise, a failed Roth IRA conversion that is not recharacterized is subject to the six-percent penalty (the right to recharacterize IRA-to-Roth IRA conversions has generally been eliminated for tax years beginning after 2017, although recharacterizations to correct an excess contribution should remain permissible absent further guidance to the contrary).<a href="#_ftn8" name="_ftnref8">8</a> The IRS has ruled that earnings credited to an IRA that are attributable to a non-IRA companion account maintained at the same financial institution (a “super IRA”) are treated as contributions to the IRA; when coupled with a cash contribution, these amounts may represent excess contributions subject to the penalty tax.<a href="#_ftn9" name="_ftnref9">9</a> An interest bonus credited to an individual retirement account, however, is not included in the calculation of an excess contribution.<a href="#_ftn10" name="_ftnref10">10</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Couturier v. Comm., No. 19714-16; 162 TC No. 4 (Feb. 28, 2024). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 4973(a). <a href="#_ftnref3" name="_ftn3">3</a>.   Orzechowski v. Comm., 69 TC 750 (1978), aff’d 79-1 USTC ¶ 9220 (2d Cir. 1979); Tallon v. Comm., TC Memo 1979-423; Johnson v. Comm., 74 TC 1057 (1980). <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 4973(a). <a href="#_ftnref5" name="_ftn5">5</a>.   Let. Rul. 7851087. <a href="#_ftnref6" name="_ftn6">6</a>.   IRC §§ 4973(b)(1)(A), 4973(f)(1)(A). <a href="#_ftnref7" name="_ftn7">7</a>.   Martin v. Comm., TC Memo 1993-399; Michel v. Comm., TC Memo 1989-670. <a href="#_ftnref8" name="_ftn8">8</a>.   SCA 200148051. <a href="#_ftnref9" name="_ftn9">9</a>.   Rev. Rul. 85-62, 1985-1 CB 153. <a href="#_ftnref10" name="_ftn10">10</a>.  Let. Rul. 8722068. </div></div>

March 13, 2024

3668 / Is interest paid on amounts borrowed to fund an IRA deductible?

<div class="Section1">The IRS has ruled that interest paid on amounts borrowed to fund an IRA is not allocable to tax-exempt income ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3652">3652</a>). Therefore, the deduction of such interest is not subject to the general prohibition against deducting interest incurred or carried to purchase tax-exempt assets.<a href="#_ftn1" name="_ftnref1">1</a> Because such interest is “on amounts borrowed to buy or carry property held for investment,” it would seem that it should be classified as “investment interest expense” and the deduction limited.<div class="Section1"> Interest paid on money borrowed to buy property held for investment is investment interest. Such interest is deductible but generally limited to the taxpayer’s net investment income for the year.<a href="#_ftn2" name="_ftnref2">2</a> Generally, interest incurred to produce tax-exempt income is not deductible. Property held for investment includes property that produces interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. It also includes property that produces gain or loss (not derived in the ordinary course of a trade or business) from the sale or trade of property producing these types of income or held for investment (other than an interest in a passive activity). Investment property also includes an interest in a trade or business activity in which the taxpayer did not materially participate (other than a passive activity).<a href="#_ftn3" name="_ftnref3">3</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Let. Rul. 8527082. See IRC §§ 163(a), 265. <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 163(d). <a href="#_ftnref3" name="_ftn3">3</a>.   IRS Publication 550 (2018). </div></div>

March 13, 2024

3670 / When can IRA contributions be withdrawn or reduced?

<div class="Section1">A taxpayer who wants to withdraw or reduce a contribution – whether to correct a problem, such as an excess or impermissible contribution, or merely because the taxpayer has changed his or her mind – generally may do so without recognizing income tax or penalties.<div class="Section1"> If the contribution is withdrawn, together with the net income attributable to such contribution, on or before the due date (including extensions of time) for filing the federal income tax return of the contributing individual, the amount distributed will be treated as if never contributed, regardless of the size of the contribution.<a href="#_ftn1" name="_ftnref1">1</a> Thus, such a distribution is not included in gross income and is not subject to the 10 percent early distribution excise tax. A distribution of an excess contribution also is not subject to the six percent excess contribution excise tax. Moreover, no income tax deduction may be taken for such contribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3669">3669</a>).<a href="#_ftn2" name="_ftnref2">2</a> If there is net income included with the accompanying distribution, such income is includable in income and may be subject to penalty as an early distribution ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3671">3671</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3677">3677</a>).<a href="#_ftn3" name="_ftnref3">3</a> Net income attributable to a contribution is determined by allocating to the contribution a pro-rata portion of the earnings or losses accrued by the IRA during the period the IRA held the contribution. Net income may be a negative amount.<a href="#_ftn4" name="_ftnref4">4</a> Relief may be granted for failure to meet the above deadline if the taxpayer has taken all necessary and reasonable steps, such as properly notifying the financial institution, to comply with the law.<a href="#_ftn5" name="_ftnref5">5</a> Excess amounts that are not withdrawn by this method are subject to the 6 percent excise tax ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3669">3669</a>) in the year of contribution and are carried over and taxed each year until the year the excess is eliminated.<a href="#_ftn6" name="_ftnref6">6</a> By contributing less than the maximum limit in a year, an excess contribution in a previous year may be absorbed up to the unused maximum limit for the year.<a href="#_ftn7" name="_ftnref7">7</a> With respect to traditional IRAs, both the amount contributed and the amount of excess absorbed may be deductible subject to the active participant rules ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3656">3656</a>) and no taxable income or early distribution tax is involved. The deduction must be reduced if the excess was improperly deducted in a year closed to IRS challenge.<a href="#_ftn8" name="_ftnref8">8</a> Where all or a portion of the excess is attributable to an excess “rollover” contribution that resulted from the individual’s reliance on erroneous information supplied by the plan, trust, or institution making the distribution, distribution of the portion of the excess attributable to the erroneous information is not included in income and is not subject to the 10 percent early distribution tax.<a href="#_ftn9" name="_ftnref9">9</a> It is not necessary to withdraw earnings on the excess, but any earnings withdrawn would be taxable income and subject to the 10 percent tax if early. The excess also may be reduced by a distribution includable in income. Such a distribution is subject to the 10 percent excise tax if it is an early distribution, as well as income tax. Where a taxpayer amended his tax return to include an excess contribution in income in the year contributed, the Tax Court ruled that the distribution of the excess in a later year was not includable under the rules of IRC Section 72, that the excess contribution included in income in the prior year constituted an “investment in the contract,” and that as a result it was not taxable a second time on the actual distribution of such excess.<a href="#_ftn10" name="_ftnref10">10</a> The phrase “aggregate amount of * * * consideration paid for the contract” found in IRC Section 72(e)(6) encompassed the excess contribution made by the taxpayer. The contribution was therefore considered to be an amount paid in consideration for an IRA and, thus, an “investment in the contract.” As a consequence, Section 72 would provide a basis for the excess contribution and, upon distribution, such amount would be distributed tax-free.<a href="#_ftn11" name="_ftnref11">11</a> For purposes of the excess contribution rules, if an excess contribution is invested in a time deposit (such as a CD) that is subject to an early withdrawal penalty, the amount reportable as an excess contribution on distribution of the excess is the total amount actually distributed from the plan after the imposition of the early withdrawal penalty.<a href="#_ftn12" name="_ftnref12">12</a> A decline in asset value does not remove an excess contribution.<a href="#_ftn13" name="_ftnref13">13</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 4973(b), 408(d)(4). <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 408(d)(4)(B). <a href="#_ftnref3" name="_ftn3">3</a>.   IRC § 408(d)(4). <a href="#_ftnref4" name="_ftn4">4</a>.   Treas. Reg. § 1.408-11; Notice 2000-39, 2000-2 CB 132. <a href="#_ftnref5" name="_ftn5">5</a>.   Childs v. Comm., TC Memo 1996-267; Thompson v. Comm., TC Memo 1996-266. <a href="#_ftnref6" name="_ftn6">6</a>.   IRC § 4973(a) <a href="#_ftnref7" name="_ftn7">7</a>.   IRC §§ 4973(b)(2), 4973(f)(2). <a href="#_ftnref8" name="_ftn8">8</a>.   IRC § 219(f)(6); Prop. Treas. Reg. § 1.219-1(e). <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 408(d)(5)(B). <a href="#_ftnref10" name="_ftn10">10</a>.   Campbell v. Comm., 108 TC 54 (1997). <a href="#_ftnref11" name="_ftn11">11</a>.   Id. <a href="#_ftnref12" name="_ftn12">12</a>.   Let. Ruls. 8643070, 8642061. <a href="#_ftnref13" name="_ftn13">13</a>.   H. R. Conf. Rep. 93-1280 (ERISA ’74) reprinted in 1974-3 CB 501-502. </div></div>

March 13, 2024

3669 / What is the penalty for making excess contributions to an IRA?

<div class="Section1"> Editor’s Note: The SECURE Act 2.0 created new statutes of limitations (SOLs) for the penalties that apply to excess IRA contributions and missed RMDs. The SOLs will now start to run immediately while, under prior law, the clock did not begin until the taxpayer filed Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts (meaning that the IRS often had an unlimited amount of time to act if the taxpayer did not file the form). However, the Tax Court recently ruled that the new SOL on excess contribution penalties was not retroactive (so did not apply for cases where the penalty was incurred prior to the enactment of SECURE 2.0 on December 29, 2022)<a href="#_ftn1" name="_ftnref1">1</a>. The case serves as a warning for clients with missed RMDs or excess contributions from years prior to 2022 that have not yet been corrected. If contributions are made in excess of the maximum contribution limit for traditional IRAs ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3656">3656</a>) or for Roth IRAs ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3659">3659</a>), the contributing individual is liable for a nondeductible excise tax of six percent of the amount of the excess for every year the excess contribution remains in the IRA (not to exceed six percent of the value of the account or annuity, determined as of the close of the tax year).<a href="#_ftn1" name="_ftnref1">2</a> A contribution by a person ineligible to make the contribution is an excess contribution even if it is made through inadvertence.<a href="#_ftn2" name="_ftnref2">3</a>In the case of an endowment contract described in IRC Section408(b), the tax does not apply to amounts allocable to life, health, accident, or other insurance.<a href="#_ftn3" name="_ftnref3">4</a> It also does not apply to premiums waived under a disability waiver of premium feature in an individual retirement annuity.<a href="#_ftn4" name="_ftnref4">5</a> The penalty tax does not apply to “rollover” contributions to a traditional IRA or “qualified rollover contributions” to a Roth IRA.<a href="#_ftn5" name="_ftnref5">6</a> It does apply, however, if the “rollover” contribution does not qualify for rollover. The Tax Court did not accept the argument that an IRA created in a failed rollover attempt is not a valid IRA and, thus, the six percent penalty should not apply.<a href="#_ftn6" name="_ftnref6">7</a> Likewise, a failed Roth IRA conversion that is not recharacterized is subject to the six-percent penalty (the right to recharacterize IRA-to-Roth IRA conversions has generally been eliminated for tax years beginning after 2017, although recharacterizations to correct an excess contribution should remain permissible absent further guidance to the contrary).<a href="#_ftn7" name="_ftnref7">8</a> The IRS has ruled that earnings credited to an IRA that are attributable to a non-IRA companion account maintained at the same financial institution (a “super IRA”) are treated as contributions to the IRA; when coupled with a cash contribution, these amounts may represent excess contributions subject to the penalty tax.<a href="#_ftn8" name="_ftnref8">9</a> An interest bonus credited to an individual retirement account, however, is not included in the calculation of an excess contribution.<a href="#_ftn9" name="_ftnref9">10</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Couturier v. Comm., No. 19714-16; 162 TC No. 4, (February 28, 2024). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 4973(a). <a href="#_ftnref2" name="_ftn2">3</a>. Orzechowski v. Comm., 69 TC 750 (1978), aff’d 79-1 USTC ¶ 9220 (2d Cir. 1979); Tallon v. Comm., TC Memo 1979-423; Johnson v. Comm., 74 TC 1057 (1980). <a href="#_ftnref3" name="_ftn3">4</a>. IRC § 4973(a). <a href="#_ftnref4" name="_ftn4">5</a>. See Let. Rul. 7851087. <a href="#_ftnref5" name="_ftn5">6</a>. IRC §§ 4973(b)(1)(A), 4973(f)(1)(A). <a href="#_ftnref6" name="_ftn6">7</a>. Martin v. Comm., TC Memo 1993-399; Michel v. Comm., TC Memo 1989-670. <a href="#_ftnref7" name="_ftn7">8</a>. SCA 200148051. <a href="#_ftnref8" name="_ftn8">9</a>. Rev. Rul. 85-62, 1985-1 CB 153. <a href="#_ftnref9" name="_ftn9">10</a>. Let. Rul. 8722068. </div></div>

March 13, 2024

3664 / Can an individual correct a Roth conversion? What is a recharacterization?

<div class="Section1">Editor's Note: The 2017 tax reform legislation eliminated the ability of taxpayers to recharacterize Roth IRA conversions for tax years beginning after 2017. The IRS released a FAQ confirming that taxpayers were entitled to recharacterize 2017 conversions through October 15, 2018.</div> <div class="Section1"> Prior to 2018, if a taxpayer rolled over funds from a traditional IRA or other eligible retirement plan to a Roth IRA during the taxable year, and later discovered that for any reason he or she wanted the transaction undone, the taxpayer generally had until the due date for filing his or her return (including extensions) to correct the conversion without penalty, to the extent all earnings and income allocable to the conversion were also transferred back to the original IRA, and no deduction had been allowed with respect to the original conversion.<a href="#_ftn1" name="_ftnref1">1</a> This "recharacterization" in the form of a trustee-to-trustee transfer resulted in the recharacterized contribution being treated as a contribution made to the transferee IRA, instead of to the transferor IRA.<a href="#_ftn2" name="_ftnref2">2</a> A taxpayer was able to apply to the IRS for relief from the time limit for making a recharacterization.<a href="#_ftn3" name="_ftnref3">3</a> <hr /> Planning Point: After tax reform, if a taxpayer makes a Roth contribution, he or she is permitted to recharacterize the transaction as a contribution to a traditional IRA before the due date for his or her income tax return for the year.<a href="#_ftn4" name="_ftnref4">4</a> <hr /> For purposes of a recharacterized contribution, the net income attributable to a contribution made to an IRA was determined by allocating to the contribution a pro-rata portion of the earnings or losses accrued by the IRA during the period the IRA held the contribution. This allowed the taxpayer to claim any net income that is a negative amount.<a href="#_ftn5" name="_ftnref5">5</a> A time restriction was placed on reconversions (i.e., converting to a Roth IRA a second time after recharacterizing a first conversion). A person could reconvert back to a Roth IRA but only after the later of the beginning of the next year or 30 days after the recharacterization.<a href="#_ftn6" name="_ftnref6">6</a> <hr /> Planning Point: Prior to 2018, where the value of converted property dropped after a conversion to a Roth IRA, it was often useful to recharacterize the contribution back to a traditional IRA and then reconvert to a Roth IRA to reduce the amount taxable on converting to a Roth IRA. The time restriction on reconversions reduced, but did not eliminate, the potential value of this technique. <hr /> Reconversions and recharacterizations had to be reported to the IRS on Form 1099-R and Form 5498. Prior year recharacterizations had to be reported under separate codes. All recharacterized contributions received by an IRA in the same year were permitted to be totaled and reported on a single Form 5498.<a href="#_ftn7" name="_ftnref7">7</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 408A(d)(6); Notice 2008-30, 2008-1 CB 638, A-5. <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.408A-5. <a href="#_ftnref3" name="_ftn3">3</a>. Let. Ruls. 200234073, 200213030. <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 408A(d)(6)(B)(iii). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.408A-5; Notice 2000-39, 2000-2 CB 132. <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 1.408A-5, A-9. <a href="#_ftnref7" name="_ftn7">7</a>. Notice 2000-30, 2000-1 CB 1266. </div>

March 13, 2024

3661 / Can a taxpayer whose income level exceeds the limitations for Roth IRA contributions maintain a Roth IRA?

<div class="Section1">Yes. Despite the fact that a taxpayer whose income level exceeds the Roth IRA contribution limits cannot contribute directly to a Roth IRA, he or she is permitted to maintain a Roth account. In 2025 (projected), the ability to make contributions to a Roth IRA begins to phase out for married taxpayers with income over $236,000 ($150,000 for single taxpayers). In 2024, the ability to make contributions to a Roth IRA begins to phase out for married taxpayers with income over $230,000 ($146,000 for single taxpayers). <a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> In 2025 (projected), Roth contributions are completely disallowed for married taxpayers who earn over $246,000 and single taxpayers who earn over $165,000. In 2024, Roth contributions are completely disallowed for married taxpayers who earn over $240,000 and single taxpayers who earn over $161,000.<a href="#_ftn2" name="_ftnref2">2</a> While contributions cannot be made directly to the Roth IRA if the taxpayer’s income exceeds the annual income threshold, for tax years beginning in 2010 and after, the income limits that applied to prevent high-income taxpayers from making rollovers from traditional IRAs were eliminated.<a href="#_ftn3" name="_ftnref3">3</a> Therefore, many high-income taxpayers may make contributions indirectly to a Roth account, via a series of rollovers from traditional IRAs. The taxpayer must first open a traditional IRA if he or she does not already maintain such an account (in 2025 (projected), each taxpayer can contribute up to $7,000 to an IRA ($8,000 if the taxpayer is 50 or older)). Using the so-called “backdoor” Roth IRA technique, the taxpayer can then roll a portion of the traditional IRA into a Roth IRA account each year, though taxes must be paid on the amounts that are rolled over. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3662">3662</a> for rules regarding rollovers from an IRA to a Roth IRA. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Notice 2023-75. <a href="#_ftnref2" name="_ftn2">2</a>.   Notice 2023-75. <a href="#_ftnref3" name="_ftn3">3</a>.   IRC §§ 408A(c)(3)(B), 408A(e). </div></div>

March 13, 2024

3663 / What should an individual consider when choosing whether to convert retirement funds to a Roth IRA or to a Roth 401(k)?

<div class="Section1">Editor's Note: The 2017 tax reform legislation eliminated the ability of taxpayers to recharacterize Roth IRA conversions for tax years beginning after 2017. Taxpayers were entitled to recharacterize 2017 conversions through October 15, 2018.</div> <div class="Section1"> Prior to 2018, one important characteristic of a Roth IRA conversion was the taxpayer's ability to undo the transaction through a recharacterization transaction that moves the funds back into the traditional account, eliminating the tax liability that the initial conversion created.<a href="#_ftn1" name="_ftnref1">1</a> This option was unavailable if the individual chooses to convert to a Roth 401(k). If the taxpayer's account performed poorly in the months after the conversion took place, or if the taxpayer otherwise found that he or she was unable to pay the tax bill that results from a Roth conversion, the taxpayer had until October 15 of the year following the conversion to recharacterize the funds. The tax reform changes to the recharacterization rules placed Roth IRAs on par with Roth 401(k)s, where once the conversion takes place, the taxpayer is required to pay the associated taxes regardless of any events that occur post-conversion. A taxpayer who converts to a Roth IRA is able to escape the IRS's required minimum distribution (RMD) rules so that the funds in the account are permitted to grow tax-free over a longer period of time. Taxpayers who use Roth 401(k)s are often required to comply with the RMD rules when they turn 73 (72 for 2020-2022, 70½ prior to 2020), possibly reducing the account's growth potential if the taxpayer does not need to access the funds.<a href="#_ftn2" name="_ftnref2">2</a> A taxpayer who plans to use a Roth account as a wealth transfer vehicle may also prefer the Roth IRA because the entire account value can be passed to heirs upon his or her death. Taxpayers who anticipate that they will need access to the funds before retirement should also consider how the application of the "five-year rule" could impact the tax-free availability of these funds. To access the funds, a qualifying event must have occurred and the Roth must be at least five years old before a qualified distribution is permitted. However, if the taxpayer has multiple Roth IRAs, only one of the taxpayer's IRAs must be five years old before a tax-free withdrawal is permitted.<a href="#_ftn3" name="_ftnref3">3</a> With a Roth 401(k), the particular account must be five years old or a penalty tax will apply.<a href="#_ftn4" name="_ftnref4">4</a> Importantly, for high-income taxpayers, post-conversion contributions may be limited or blocked entirely because of the income limits that apply to Roth IRA contributions (but not to Roth 401(k) contributions). In 2025 (projected), the ability to make contributions to a Roth IRA begins to phase out for married taxpayers with income over $236,000 ($150,000 for single filers). In 2025 (projected), Roth IRA contributions are completely blocked for married taxpayers who earn over $246,000 (married) or $165,000 (single) In 2024, the ability to make contributions to a Roth IRA begins to phase out for married taxpayers with income over $230,000 ($146,000 for single filers). In 2024, Roth IRA contributions are completely blocked for married taxpayers who earn over $240,000 (married) or $161,000 (single).<a href="#_ftn5" name="_ftnref5">5</a> Stronger creditor protection rules also apply to Roth 401(k) accounts. While Roth IRAs are protected under state law, the rules that apply in some states offer much less in the way of creditor protection than can be found in others. Roth 401(k)s are always protected by ERISA-mandated federal creditor protection rules regardless of where the taxpayer lives. </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 408A(d)(6). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.401(k)-1(f)(3). <a href="#_ftnref3" name="_ftn3">3</a>. IRC §§ 408A(d). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.402A-1, A-4. <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 408A(c)(3); IR-2014-99 (Oct. 23, 2014), Notice 2023-75. </div>

March 13, 2024

3666 / Who is an "active participant" for purposes of IRA eligibility rules and deduction limits?

<div class="Section1">Suppose an individual is an “active participant” in: <blockquote>(1)   a qualified corporate or Keogh pension, profit sharing, stock bonus, or annuity plan; (2)   a simplified employee pension or SIMPLE IRA; (3)   a Section 403(b) tax sheltered annuity; or (4)   a government plan.</blockquote> In those instances, the individual’s deduction limit for contributions to a traditional IRA may be reduced or eliminated ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>). The limitation applies if the individual or the individual’s spouse was an active participant for any part of the plan year that ended with or within the taxable year.<a href="#_ftn1" name="_ftnref1">1</a> Participation in Social Security, Railroad Retirement (tier I or II), or in an eligible IRC Section 457 deferred compensation plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3581">3581</a>) is not taken into consideration.<a href="#_ftn2" name="_ftnref2">2</a> Federal judges are treated as active participants.<a href="#_ftn3" name="_ftnref3">3</a> Active participants include any individual who is an active participant in a plan established for employees by the United States, a state or political subdivision thereof, or an agency or instrumentality of any of the foregoing.<a href="#_ftn4" name="_ftnref4">4</a> A district court judge in the state of Nebraska who participated in the Nebraska Retirement Fund for Judges was found to be an employee of the state (not an officer of the state) and, thus, was an active participant.<a href="#_ftn5" name="_ftnref5">5</a> Full-time active duty officers in the U.S. Air Force were found to be active participants.<a href="#_ftn6" name="_ftnref6">6</a> Certain members of the armed forces reserves and certain volunteer firemen covered under government plans are not considered active participants.<a href="#_ftn7" name="_ftnref7">7</a> A teacher employed by a municipal school district in Michigan was found to be an active participant in the employment-based, qualified retirement plan provided by the state based upon his being an employee of a state or political subdivision through his employment in the school district.<a href="#_ftn8" name="_ftnref8">8</a> Active participant status for a tax year must be reported by the employer on the employee’s Form W-2. Active participant status is determined without regard to whether such individual’s rights under the plan, trust, or contract are nonforfeitable.<a href="#_ftn9" name="_ftnref9">9</a> Active participant status is further determined under the rules provided in Notice 87-16<a href="#_ftn10" name="_ftnref10">10</a> and Treasury Regulation Section 1.219-2 (active participant rules in effect prior to the Economic Recovery Tax Act of 1981). In the case of a defined benefit plan, an individual who is not excluded under the eligibility provisions of the plan for the plan year ending with or within the individual’s taxable year is an active participant in the plan, regardless of whether such individual has elected to decline participation in the plan, has failed to make a mandatory contribution specified under the plan, or has failed to perform the minimum service required to accrue a benefit under the plan.<a href="#_ftn11" name="_ftnref11">11</a> An individual in a plan under which accruals all have ceased is not an active participant. Where benefits may vary with future compensation, all accruals are not considered to have ceased.<a href="#_ftn12" name="_ftnref12">12</a> In the case of a profit sharing or stock bonus plan, an individual is an active participant if any employer contribution is deemed added or any forfeiture is allocated to the individual’s account during the individual’s taxable year.<a href="#_ftn13" name="_ftnref13">13</a> A contribution is treated as made to an individual’s account on the later of the date the contribution is made or allocated.<a href="#_ftn14" name="_ftnref14">14</a> If the right to an allocation is conditioned on the performance of a specified number of hours (or on the employment of the participant on a specified day) and the individual does not meet the condition for a particular year, the individual is not an active participant with respect to the taxable year within which such plan year ends.<a href="#_ftn15" name="_ftnref15">15</a> Where contributions to a plan are purely discretionary and no amount attributable to forfeitures or contributions has been allocated to an individual’s account by the last day of the plan year, the individual is not an active participant for the taxable year in which the plan year ends. If the employer contributes an amount after the end of the plan year for that prior plan year, however, the individual generally is an active participant for the taxable year in which the contribution is made.<a href="#_ftn16" name="_ftnref16">16</a> An individual is an active participant in a money purchase pension plan if any contribution or forfeiture is required to be allocated to his or her account for the plan year ending with or within his or her taxable year, even if the individual was not employed at any time during the taxable year.<a href="#_ftn17" name="_ftnref17">17</a> An individual is an active participant for any taxable year in which the individual makes a voluntary or a mandatory contribution.<a href="#_ftn18" name="_ftnref18">18</a> The individual is not treated as an active participant if only earnings (rather than contributions or forfeitures) are allocated to his or her account.<a href="#_ftn19" name="_ftnref19">19</a> An individual is not considered an active participant in a plan integrated with Social Security if his or her compensation is less than the minimum needed to accrue a benefit or to be eligible for an allocation in the plan.<a href="#_ftn20" name="_ftnref20">20</a> There is no de minimis rule for active participant status. An individual may be an active participant even if no money is allocated to his or her account.<a href="#_ftn21" name="_ftnref21">21</a> Active participant status is determined without regard to whether the individual is vested in any portion of his or her benefit. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC § 219(g)(1); see Wartes v. Comm., TC Memo 1993-84. <a href="#_ftnref2" name="_ftn2">2</a>.   IRC § 219(g)(5); Notice 87-16, 1987-1 CB 446, A-7; Notice 89-25, 1989-1 CB 662; Notice 98-49, 1998-2 CB 365. <a href="#_ftnref3" name="_ftn3">3</a>.   OBRA ’87, § 10103. <a href="#_ftnref4" name="_ftn4">4</a>.   IRC § 219(g)(5)(A)(iii). <a href="#_ftnref5" name="_ftn5">5</a>.   Fuhrman v. Comm., TC Memo 1997-34. <a href="#_ftnref6" name="_ftn6">6</a>.   Morales-Caban v. Comm., TC Memo 1993-466. <a href="#_ftnref7" name="_ftn7">7</a>.   IRC § 219(g)(6). <a href="#_ftnref8" name="_ftn8">8</a>.   Neumeister v. Comm., TC Memo 2000-41. <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 219(g)(5), flush language; see Nicolai v. Comm., TC Memo 1997-108; Wartes v. Comm., TC Memo 1993-84. <a href="#_ftnref10" name="_ftn10">10</a>.   1987-1 CB 446. <a href="#_ftnref11" name="_ftn11">11</a>.   Notice 87-16, 1987-1 CB 446, A-15; Treas. Reg. § 1.219-2(b)(1); see Nicolai v. Comm., TC Memo 1997-108. <a href="#_ftnref12" name="_ftn12">12</a>.   Notice 87-16, 1987-1 CB 446, A-16; Treas. Reg. § 1.219-2(b)(3); Let. Rul. 8948008. <a href="#_ftnref13" name="_ftn13">13</a>.   Treas. Reg. § 1.219-2(d)(1); see Tolley v. Comm., TC Memo 1997-244. <a href="#_ftnref14" name="_ftn14">14</a>.   Treas. Reg. § 1.219-2(d)(1). <a href="#_ftnref15" name="_ftn15">15</a>.   Notice 87-16, 1987-1 CB 446, A-20; Let. Rul. 8919064. <a href="#_ftnref16" name="_ftn16">16</a>.   Notice 87-16, 1987-1 CB 446; Let. Rul. 9008056. <a href="#_ftnref17" name="_ftn17">17</a>.   Treas. Reg. § 1.219-2(c). <a href="#_ftnref18" name="_ftn18">18</a>.   Treas. Reg. § 1.219-2(e); see Felber v. Comm., TC Memo 1992-418; Wade v. Comm., TC Memo 2001-114. <a href="#_ftnref19" name="_ftn19">19</a>.   Notice 87-16, 1987-1 CB 446, A-16, A-19. <a href="#_ftnref20" name="_ftn20">20</a>.   Notice 87-16, 1987-1 CB 446, A-9. <a href="#_ftnref21" name="_ftn21">21</a>.   Colombell v. Comm., TC Summ. Op. 2006-184. </div></div>

March 13, 2024

3660 / What is the difference between a Roth IRA and a traditional IRA?

The primary difference between a Roth IRA and a traditional IRA is the tax treatment of contributions to, and withdrawals from, the account. "Qualified distributions" (see Q <a href="javascript:void(0)">3673</a>) from a Roth IRA are not includable in gross income. Thus, earnings are tax-free, not tax deferred, as is the case with traditional IRAs. Any nonqualified distribution from a Roth IRA will be includable in income, but only to the extent that the distribution, along with all previous distributions from the Roth IRA, exceeds the aggregate amount of contributions to the Roth IRA. Contributions from a traditional IRA are contributed on a pre-tax basis (i.e., they are deductible up to the annual contribution limit), while Roth IRA contributions are not deductible. Before 2020, contributions to a traditional IRA had to cease when the account owner reached age 70½. The age limitation was eliminated by the SECURE Act.<a href="#_ftn1">1</a> An individual may make both pre-tax and after-tax ( Q <a href="javascript:void(0)">3658</a>) contributions to a traditional IRA, but may only make after-tax contributions to a Roth IRA. <hr></hr> Planning Point: Note that while the SECURE Act eliminated the age restriction for traditional IRA contributions, financial institutions are not required to accept post-age 70½ contributions. In other words, it is up to the specific institution to determine whether to accept these contributions beginning in 2020.<a href="#_ftn2">2</a><hr></hr> Further, amounts accumulated in a traditional IRA or annuity must be distributed in compliance with the minimum distribution requirements (see Q <a href="javascript:void(0)">3682</a>).<a href="#_ftn3">3</a> Roth IRAs are not subject to the lifetime minimum distribution requirements, but are subject to certain after-death distribution requirements ( Q <a href="javascript:void(0)">3687</a>). The chart below summarizes the primary differences between a traditional IRA and a Roth IRA. <table border="1" align="center" id="rte-85ace790-fbbc-11f0-954e-9dd8a2965161"><tr ><td width="184"></td><td width="176">Traditional IRA</td><td width="180">Roth IRA</td></tr><tr ><td width="184">Contribution Limit</td><td width="176">$7,500 + $1,100 catch-up if 50 or older (2026).</td><td width="180">$7,500 + $1,100 catch-up if 50 or older (2026).</td></tr><tr ><td width="184">Taxation of Contributions</td><td width="176">Made with pre-tax dollars</td><td width="180">Made with after-tax dollars.</td></tr><tr ><td width="184">Age Limit for Contributions</td><td width="176">None.</td><td width="180">None.</td></tr><tr ><td width="184">Taxation of Distributions</td><td width="176">Taxed at ordinary income tax rates.</td><td width="180">Tax-free if certain conditions are met.</td></tr><tr ><td width="184">Required Distributions</td><td width="176">Distributions must begin April 1 of the year after the owner turns 73 (72 for 2020-2022, 70 ½ in prior years).</td><td width="180">No lifetime distribution requirements for original account owner.</td></tr></table>For more information on the contribution limit that applies to both traditional IRAs and Roth IRAs, see Q <a href="javascript:void(0)">3656</a> and Q <a href="javascript:void(0)">3659</a>. Also, Q <a href="javascript:void(0)">3659</a> and Q <a href="javascript:void(0)">3661</a> discuss the income limits that apply to Roth IRAs, and Q <a href="javascript:void(0)">3662</a> discusses the rules governing converting traditional IRA funds to Roth accounts. <hr align="left" size="1" width="33%"></hr> <a href="#_ftnref1">1</a>. IRC §§ 408A(c)(1), 408A(c)(4), prior to repeal by the SECURE Act. <a href="#_ftnref2">2</a>. Notice 2020-68. <a href="#_ftnref3">3</a>. IRC §§ 408(a)(6), 408(b)(3), 401(a)(9).