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Recent IRA Developments

January 1, 1999
Since the passage of technical corrections relating to the Roth Individual Retirement Accounts and Annuities (IRAs) in August in the IRS Restructuring and Reform Act of 1998 (1998 Act), the Internal Revenue Service (IRS) has issued proposed Roth IRA regulations, released guidance clarifying the application of the Roth IRA rules, announced the opening of its Roth IRA prototype program, and encouraged employers to facilitate the establishment of IRAs by their employees. We summarized both the changes made in the 1998 Act and the proposed regulations in a prior bulletin; this bulletin discusses the other guidance recently issued by the IRS with respect to IRAs.

Roth IRA Developments

"Reconversions." The 1998 Act modified Internal Revenue Code (Code) section 408A to allow a taxpayer to elect, at any time before the due date (with extensions) for filing the taxpayer's federal income tax return, to "recharacterize" a contribution made to one IRA as a contribution to another IRA. The IRS issued Notice 98-50, 1998-44 I.R.B. 10 (Nov. 2, 1998) to address the situation in which a taxpayer (1) converts from a Traditional IRA to a Roth IRA, (2) transfers the amount back to the Traditional IRA in a recharacterization, and (3) then converts the same amount back to a Roth IRA again (this last step is called a "reconversion" by the IRS). The IRS may have been concerned about the potential for abuse of the ability to reconvert by any taxpayers who initially made his or her taxable conversion at a time when the equity markets were highly valued, but then made a recharacterization and reconversion at a later time in the same year when market values had declined in order to incur tax on a lower conversion amount.

The notice essentially permits taxpayers to reconvert a given amount once per year, starting November 1, 1998. For example, an amount that has been converted once in 1998 can be recharacterized and reconverted once between November 1, 1998 and December 31, 1998, and once again between January 1, 1999 and December 31, 1999. Similarly, an amount converted in 1999 can be reconverted once in 1999. If a reconversion is determined to be improperly made, it is deemed an excess reconversion, and it will be taxed on the same basis as the initial conversion (unless the taxpayer chooses to recharacterize it as a Traditional IRA contribution). The guidance applies to the 1998 and 1999 tax years, but the IRS states that for future years it is considering a variety of approaches for limiting reconversions, including permitting only a single conversion per year or requiring a 30- or 60-day holding period for recharacterizations before reconversion.

Roth IRA Reporting. In Notice 98-49, 1998-38 I.R.B. 5 (Sept. 21, 1998) the IRS specifies the tax reporting rules for Roth IRA recharacterization transactions. The notice requires Roth IRA trustees, custodians, and issuers to issue Forms 1099-R and 5498 for each leg of a recharacterization transaction (i.e. for the initial distribution/contribution, and then for the recharacterization distribution/contribution), as well as for any subsequent reconversion, which would have required IRA providers to issue multiple tax reporting forms for individual owners, something that many providers do not have adequate systems to accommodate. The IRS addressed this problem in Announcement 99-5, 1999-3 I.R.B. 16 (Jan. 19, 1999), in which it states that a trustee, custodian, or issuer will satisfy the reporting requirements if it "reports the results of these recharacterizations and reconversions on the appropriate forms using a reasonable alternative method . . . ," but only for recharacterizations and reconversions that occur with the same trustee, custodian, or issuer.

The announcement appears to contemplate that a single Form 1099-R or 5498 showing the aggregate results of the IRA transactions could be issued for a given year as an alternative method of reporting. However, the announcement goes on to require that an IRA provider using an alternate method of reporting must provide instructions to the IRA owner on how to use the information on the forms to properly report the recharacterization or reconversion for Federal income tax purposes. It is unclear what level of detail is required in the instructions to the taxpayer. Finally, the IRS provides in Announcement 98-113, 1998-51 I.R.B. 48 (Dec. 21, 1998) that the codes on the 1998 Form 1099-R regarding whether distributions from Roth IRAs occurred during certain five-year periods are no longer appropriate as a result of the 1998 Act changes (i.e., for all Roth IRAs, the five-year period now dates from the first contribution to any Roth IRA and not separately from the date of conversion for a conversion Roth IRA). Thus, all distributions for 1998 can (and for 1999, must) be reported simply as Roth IRA distributions.

Prototype Program. Effective November 30, 1998, the IRS announced the opening of its Roth IRA prototype program in Rev. Proc. 98-59, 1998-50 I.R.B. 8 (Dec. 14, 1998). The revenue procedure generally refers to the traditional IRA prototype program for the various procedural requirements, applicable forms, user fees, and other details. The IRS notes that a "dual-purpose IRA," i.e. one that can be used as either a Traditional IRA or a Roth IRA, can receive an opinion letter if it requires the owner to clearly designate which type of IRA it is upon establishment and Roth and Traditional IRA funds are maintained separately. In connection with the prototype program, on December 7, 1998, the IRS also released sample language (often referred to as the Listing of Required Modifications, or "LRMs") that it finds acceptable for Roth IRAs. The LRMs contain more detail than the Roth IRA model forms (Forms 5305-R,-RA, and -RB), including a detailed definition of compensation, additional information on the calculation of life expectancies for minimum required distributions upon death, and language regarding the impermissibility of SIMPLE IRA contributions and the penalty for SIMPLE IRA transfers in the first two years of the SIMPLE IRA.

Rev. Proc. 98-59 also generally grants transition relief to Roth IRA providers if, before June 30, 1999, a provider (1) used a document to establish a Roth IRA and the document or other materials clearly indicated the IRA was a Roth IRA at the time of establishment; (2) operated the Roth IRA in compliance with applicable laws and regulations; and (3) applies for IRS approval of the document and adopts the approved document within a specified time frame. In these circumstances, the Roth IRA will be deemed to be retroactively IRS-approved as of the date of its establishment.

Payroll Deduction IRA Contributions

In Announcement 99-2, 1999-2 I.R.B. 44 (Jan. 11, 1999), the IRS encouraged employers to permit employees to make IRA contributions through payroll deductions. The announcement states that employees may, under some circumstances, be able to reduce their withholding to take IRA contributions into account, resulting in an immediate benefit from the IRA contribution. The Department of Labor has indicated that it plans to publish an interpretive bulletin encouraging payroll deduction IRA contributions and providing some information on whether such a program would constitute an employee pension benefit plan subject to the requirements of Title I of the Employee Retirement Income Security Act.

This article is intended to provide the reader with general information and should not be considered a substitute for specific legal advice or opinion. Readers are advised not to act upon this information without seeking professional counsel.

For further information please contact:

George H. Bostick
Sutherland Asbill & Brennan LLP
1275 Pennsylvania Avenue, NW
Washington, DC 20004-2415

W. Mark Smith
Sutherland Asbill & Brennan LLP
1275 Pennsylvania Avenue, NW
Washington, DC 20004-2415

Carol A. Weiser
Sutherland Asbill & Brennan LLP
1275 Pennsylvania Avenue, NW
Washington, DC 20004-2415

Walter H. Wingfield
Sutherland Asbill & Brennan LLP
999 Peachtree Street, NE
Atlanta, GA 30309-3996
Phone 404.853.8161
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