by Bob Veres

All of a sudden, it seems like everybody in the financial planning world is talking about Roth IRAs and Roth conversions.  In fact, an article in Financial Planning magazine–one of the trade magazines in our world–recently proclaimed 2010 “The Year of the Roth.”

What’s the big deal?  Roth IRAs are interesting to professionals for several reasons.  With traditional IRAs (and qualified plans like 401(k)s), the money goes in untaxed, and you pay ordinary income taxes whenever you take money out of the account–which might be years in the future.  The Roth reverses this; your contribution is made with after-tax dollars, but then there’s no tax whenever the money is distributed.  If you believe, as many financial professionals do, that tax rates are going to go up in the future, then paying taxes now and eliminating future taxes provides a net gain.

It could get better.  Having money in a Roth account gives you a lot more control over your tax bracket in retirement.  For instance, you might take out just enough from your IRA distributions to fill the 15% bracket, and then take the rest of your living expenses out of your taxable accounts and Roth.  Another version of this kind of planning might help higher-income retirees avoid the brackets where Social Security income is taxed.

Another interesting thing about Roths is that, unlike traditional IRAs, they don’t have any minimum distribution requirements once you turn age 70 1/2.  So long as the money remains in the account, both Roths and traditional IRAs give you the benefits of tax deferral, which eliminates a significant drag on the growth of your money.  If you can afford to keep your money in the Roth account, and take retirement income from other sources, then the deferral can go on longer.

Alas, the Roth account will still be subject to estate taxes, and your heirs (not your spouse) will have to take required distributions each year once they inherit your Roth account.  But they won’t have to pay taxes on the distributions they receive–a nice additional gift for your children or grandchildren.

In the past, the only people who could set up a Roth IRA were those with less than $100,000 in taxable income, which eliminated a lot of the taxpayers who would benefit the most from all these features.  But now, as of January 1, anybody can open up a Roth IRA.  Most of the conversation in professional circles is about Roth conversions; that is, converting the money in your IRA to a Roth or taking a rollover distribution from a company retirement plan directly into a new Roth that you set up.

Should you do this?  Unfortunately, that’s a complicated question, since any money moving from a traditional retirement account to a Roth requires you to pay taxes on the money in the traditional account.  Some of that can be deferred; with any conversion that takes place in 2010, the tax obligation can be split between the 2011 and 2012 tax returns, which represents a (very) short-term loan from the IRS.  So professional advisors are looking at individual situations, looking for portfolio losses that can be used to offset the tax burden, projecting tax brackets over the next three years and a host of other issues, including how long each person will have the money in the Roth account, and where the money to pay the taxes will come from.  (If you have to pay the taxes out of the IRA, then you lose the value of future deferral–not good.)

Another issue is: Do we trust Congress to keep its promise not to tax Roth distributions in the future?  Few of us ever expected to pay taxes on Social Security payments.

Fortunately, the law allows for partial Roth conversions–moving some of the money over, rather than all of it–and also lets you reverse the conversion (professionals call it a recharacterization) any time before October 15 of the year after the conversion.  All of this means that the conversion decision, and the amount to convert, will probably be different for you than it is for the person next door, whose decision will be different from the family down the street.

Meanwhile, you have to wonder how alert are the people who write our tax laws.  Under the current rules, single persons earning more than $105,000, and joint filers over $167,000, are sternly prohibited from making a full contribution to their Roth account.  If you earn more than $120,000 (single) or $177,000 (joint), you’re forbidden to make them at all.

But…  People in these income brackets are perfectly free to make a traditional IRA contribution–and the law says they can immediately turn around and convert the money into a Roth account.  Does that make sense to you?

This is intended to discourage people from invading retirement plans early. And, it generally works.

However, there are occasional cases in which a person simply must begin taking funds from their IRA. There is a way to avoid these penalties. It is known as the SEPP or “Substantially Equal Periodic Payments” plan also identified by the tax code as 72(t). These payments must continue until the person is age 59 1/2 or 5 years, whichever is later. If these payments are modified, all of the prior payments become subject to the penalties. You must be very careful about violating the rules if you embark on this plan.

Here is the story about someone who innocently got stung by “modifying” her payments.

In a recent IRS Private Letter Ruling the rigidity of the rules under IRC § 72(t) by which substantially equal periodic payments are exempt from the 10% early withdrawal tax is illustrated. An individual’s non-taxable transfer of a portion of her individual retirement account to another IRA constituted a prohibited “modification” of the payments, which the IRS ruled could not be corrected by reversing the transfer. The error resulted in the distributions she had taken over the prior seven years all being subject to the 10% early withdrawal tax and interest.¹

Transfer of Only a Portion of the IRA Caused a Modification

In 2008, an individual taxpayer submitted a request to the IRS for a private letter ruling (PLR) after learning that her non-taxable transfer earlier that year of a part of her IRA resulted in a prohibited “modification” of the “substantially equal periodic payments” plan she had been taking from that IRA since 2002. The taxpayer had completed the transfer on the advice of a financial advisor who suggested she invest a portion of the IRA in certificates of deposit, which were not available at the current financial institution, but which were available for IRAs at another institution. After opening another IRA at the other institution, the taxpayer transferred a part of her original IRA. Later the same year, the taxpayer consulted with representatives of a third financial institution about the possible transfer of the remaining IRA assets and was informed that the prior transfer constituted a “modification” of her series of substantially equal periodic payments. In later speaking with her financial advisor she was told that the transfer would cause the imposition of the 10% early withdrawal tax, plus interest, on all amounts that had been withdrawn from the IRA since 2002.

Early Distribution Penalty Applies Retroactively

The taxpayer was age 56, and had begun taking substantially equal periodic payments from the IRA six years earlier at age 50, in 2002. IRC 72(t)(1) imposes a 10% tax on early distributions from qualified plans and IRAs. However, the tax is not imposed if the distributions are part of a series of “substantially equal periodic payments” that are made at least annually over the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and beneficiary. But, if the payments are modified (other than by reason of death or disability) before the individual reaches age 59-1/2, or after the individual reaches age 59-1/2 but before the close of the 5-year period beginning with the first payment, then the taxpayer is obligated to pay the 10% early withdrawal tax that would have been imposed on the earlier payments, plus interest.

“Substantially equal periodic payments” are calculated by using the account balance as of the first valuation date selected. Therefore, as the IRS explained in the letter ruling, a modification occurs if there is any (1) addition to the account balance other than gains or losses, (2) nontaxable transfer of a portion of the account balance to another retirement plan or IRA, or (3) rollover of the amount received so that it results in the distribution not being taxable.

Error Cannot Be Corrected by Reversing the Transfer

As a result, despite the fact that the transfer was made on the basis of erroneous advice from her financial advisor, and the taxpayer had proposed to correct the error by transferring the amount back to the original IRA, the IRS ruled that a “modification” had occurred and could not be corrected by undoing the transfer. Since the modification occurred in 2008, before the taxpayer reached age 59-1/2, she was obligated for that year to pay an additional 10 percent early distribution tax on the distributions she had taken from the IRA since 2002, plus interest.

It seems sort of unfair to the taxpayer since it was the result of incorrect professional advice and since she offered to restore the funds to their original position. This does underscore the importance of good advice before taking action in the more esoteric areas of practice. The rules really are quite clear, but not too many people take action under the SEPP provisions of 72(t) and as a consequence even many advisors are not clear on the rules.
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¹.PLR 200925044 (March 23, 2009)