Life and Death Planning for Retirement Benefits

248

Life and Death Planning for Retirement Benefits

If funds are rolled or transferred from a traditional plan or IRA to a Roth IRA before the RMD for the year of the conversion has been distributed out of the traditional plan or IRA, the conversion cannot be a valid Roth conversion to the extent of the RMD. The IRS created a special rule to deal with this situation: The IRS treats the RMD that was improperly “rolled” to the Roth IRA “as if” (1) the RMD had been distributed out of the traditional plan and (2) the recipient then contributed the same amount to the Roth IRA as a “regular contribution” ( ¶ 5.3.02 ). Reg. § 1.408A- 4 , A-6(c). Because of this special IRS rule there will be no penalty for failure to take the RMD ( ¶ 1.9.02 ); the RMD is deemed to have been distributed, and the Roth conversion (to the extent the converted amount exceeded the RMD) is valid. However, the “deemed” regular contribution to the Roth IRA will usually result in an “excess contribution” to the Roth IRA, either because the deemed contribution is larger than the permitted maximum regular contribution ( ¶ 5.3.03 ) or because the person is not eligible to make a regular contribution to a Roth IRA at all. A person who is eligible to convert to a Roth ( ¶ 5.4.02 ) may be ineligible to make a regular contribution to a Roth IRA ( ¶ 5.3.04 ). An excess contribution to the Roth IRA will generate an excess-contribution penalty ( ¶ 5.3.05 ) unless the excess contribution (along with the net income attributable to it) is withdrawn from the Roth IRA prior to the deadline for corrective distributions; see ¶ 2.1.08 . Gideon Example: Gideon, age 78 and retired, converted his $1 million traditional IRA to a Roth IRA in 2010. Unfortunately he failed to take the 2010 RMD from the traditional IRA before doing the conversion. Assume his 2010 RMD was $50,000. The good news is that the $50,000 is treated as if it were distributed to him from the traditional IRA, so he does not have to pay the penalty for failure to take an RMD. The bad news is he has made an excess contribution of $50,000 to the Roth IRA. To avoid a six percent penalty on that excess contribution, he must withdraw the $50,000 (plus net income attributable to it) by October 15, 2011. There is no possibility of treating any part of this improper rollover contribution as a proper “regular” contribution to the Roth IRA; because Gideon is retired, he has no compensation income, and thus is not eligible to make regular contributions to any IRA ( ¶ 5.3.02 ). Compare “Armande Example,” ¶ 2.1.08 (I). “Qualified distributions” from a Roth IRA are income tax-free. It is relatively easy to qualify for “qualified” distributions; see ¶ 5.2.04 – ¶ 5.2.05 . The requirements for a qualified distribution from a designated Roth account (DRAC) are slightly different; see ¶ 5.7.04 . Nonqualified distributions from Roth IRAs may or may not be tax-free; see ¶ 5.2.06 ( ¶ 5.7.05 for nonqualified DRAC distributions). Tax treatment of Roth IRA distributions: Overview A. Qualified vs. nonqualified distributions. Qualified distributions from a Roth IRA are not included in the recipient’s gross income for federal income tax purposes, regardless of whether the recipient is the participant or a beneficiary. § 408A(d)(1) ; Reg. § 1.408A-6 , A- 1(b)(2). Shane Example: Shane has a Roth IRA. He receives qualified distributions from it. These are excluded from his gross income. Shane dies, leaving his Roth IRA half to his son and half to the Shane Family Trust. The son and the trust both take RMDs and other distributions from the Roth IRA, all of which are qualified distributions. These qualified distributions are income tax-free Regarding the tax basis of property distributed from a Roth IRA, see ¶ 8.1.01 .