Taxation of Roth Rollover;  Roth Holding Period Rules; and Gifts to College-age Grandchildren

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, February 8,  1998.

Copyright 1998 Robert L. Sommers, all rights reserved.

Question: I’m age 69 and am considering rolling over my $94,000 IRA into a Roth on or before December 31 of this year to take advantage of the four-year tax averaging opportunity. (Note: if a Roth conversion occurs during 1998, the resulting taxes will be due in four equal annual installments.) What happens if I die before the four-year period ends. At my age, is a Roth rollover a good idea?

Answer: If a taxpayer dies during the four-year period, all taxes owed from the rollover become payable on the taxpayer’s last tax return, unless the Roth beneficiary is the decedent’s spouse. In that case, the four-year averaging continues.

Whether you should convert to a Roth depends on your health, tax bracket and your finances. If you are healthy, in a high tax bracket and do not need the funds immediately, consider the rollover. If, however, you must pay the tax with money from your IRA, you’ll wind up with less money invested in your Roth -- a distinct disadvantage.

Remember, an IRA has mandatory distributions (commencing on April 1 of the year after age 70) and once the IRA distributions begin, the pay-out period becomes fixed. In other words, the IRA becomes a depleting resource.

In contrast, the Roth does not have mandatory distributions during the owner’s life. Therefore, if you lived another twenty years, and allowed your Roth to accumulate, it could double or triple in value, while during that same time period, your IRA may have been drained. Also, you may make annual contributions to a Roth after age 70. You would also have the flexibility to withdraw funds from the Roth without tax or penalty, once you have satisfied the initial five-year holding requirement (discussed below).

Question: I’m age 62 and would like to rollover my present IRA to a new Roth and then make annual contributions to the Roth thereafter. What happens if I exceed the $100,000 adjusted gross income (AGI) limit for rollovers and how does the five-year holding requirement apply to my subsequent contributions?

Answer: Many taxpayers who convert to a Roth won’t know whether their AGI exceed $100,000 until after December 31, 1998. Relief rules will allow the taxpayer to convert the Roth back to an IRA so that the rollover, in effect, never happened. If this conversion is completed before the due date for filing the 1998 tax return, excluding extensions, then there will be no penalties for the attempted rollover.

In general, distributions are tax-free if they occur after age 59 and the contributions, including rollovers, have remained in the Roth for at least five years. The five-year period begins with the first tax year the taxpayer (or taxpayer’s spouse) made the contribution. As with traditional IRAs, a taxpayer must make the annual contribution (maximum $2,000 for individuals, $4,000 for couples) on or before the due date for filing the tax return, including extensions. For example, if the taxpayer makes a $2,000 contribution for tax year 1998 on February 15, 1999, the first year of the holding period is actually 1998.

Each annual contribution is subject to the five-year holding period. If this requirement is violated, earnings generated from the contributions are taxable. Also, if the taxpayer is under age 59 , there is an additional 10% penalty for early withdrawal. To mitigate this unfavorable result, taxpayers are treated as receiving distributions of their contributions until the amount distributed exceeds the total of all contributions. Thus, none of the distributions are attributable to earnings -- and subject to tax and penalties -- until the total amount of distributions exceed the amount of contributions.

For instance, if a taxpayer makes 10 annual $2,000 contributions (total contributions of $20,000), the first $20,000 will be considered a return of contributions, thus not subject to the five-year rule.

Question: I want to give money to my college-age grandchildren. What are the gift rules?

Answer: You may use your annual gift-tax exclusion to shelter gifts of $10,000 per year per beneficiary. Husbands and wives may make annual gifts of $20,000 per beneficiary. You may exceed these limits for "qualified transfers" of tuition payments to educational organizations and for medical care. (The relationship between the donor (giver) and donee (recipient) is irrelevant.)

Payments must be made to the educational or medical organization and not as reimbursements to parents, students or patients who made the payments directly. Also, gifts in trust for educational or medical payments do not qualify. The educational-expense exception applies only to tuition for education or training (books, supplies, room and board are excluded). Medical care payments are restricted to those activities qualifying for the medical-expense deduction.

In your situation, consider making direct tuition payments to the school and then using the $10,000 portion ($20,000 for married couples) of your annual exclusion for gifts to your grandchild. If the student is in the 15% tax bracket, consider gifting appreciated assets (stocks, bonds), then having the donee sell them. Remember, the donee receives a carryover basis (your basis becomes the donee’s basis) and will pay tax on the gain if the asset is sold for a profit.


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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**