C. Amendments to Title III of the 1997 Act Relating to Savings Incentives

1. Conversions of IRAs into Roth IRAs (Sec. 6005(b) of the Bill, Sec. 302 of the 1997 Act, and Secs. 408A and 72(t) of the Code)

Present Law

A taxpayer with adjusted gross income of less than $100,000 may convert a present-law deductible or nondeductible IRA into a Roth IRA at any time. The amount converted is includible in income in the year of the conversion, except that if the conversion occurs in 1998, the amount converted is includible in income ratably over the 4-year period beginning with the year in which the conversion occurs. Amounts includible in income as a result of the conversion are not taken into account in determining whether the $100,000 threshold is exceeded. The 10-percent tax on early withdrawals does not apply to conversions of IRAs into Roth IRAs.

In general, distributions of earnings from a Roth IRA are excludable from income if the individual has had a Roth IRA for at least 5 years and certain other requirements are satisfied. The 5-year holding period with respect to conversion Roth IRAs begins from the year of the conversion. (Distributions that are excludable from income are referred to as qualified distributions.)

Present law does not contain a specific rule addressing what happens if an individual dies during the 4-year spread period for 1998 conversions.

Explanation of Provision

Distributions of converted amounts

Distributions before the end of the 4-year spread

The bill modifies the rules relating to conversions of IRAs into Roth IRAs in order to prevent taxpayers from receiving premature distributions from a Roth conversion IRA while retaining the benefits of 4-year income averaging. In the case of conversions to which the 4-year income inclusion rule applies, income inclusion will be accelerated with respect to any amounts withdrawn before the final year of inclusion. Under this rule, a taxpayer that withdraws converted amounts prior to the last year of the 4-year spread will be required to include in income the amount otherwise includible under the 4-year rule, plus the lesser of (1) the taxable amount of the withdrawal, or (2) the remaining taxable amount of the conversion (i.e., the taxable amount of the conversion not included in income under the 4-year rule in the current or a prior taxable year). In subsequent years (assuming no such further withdrawals), the amount includible in income under the 4-year will be the lesser of (1) the amount otherwise required under the 4-year rule (determined without regard to the withdrawal) or (2) the remaining taxable amount of the conversion.

Under the bill, application of the 4-year spread will be elective. The election will be made in the time and manner prescribed by the Secretary. If no election is made, the 4-year rule will be deemed to be elected. An election, or deemed election, with respect to the 4-year spread cannot be changed after the due date for the return for the first year of the income inclusion (including extensions).

The following example illustrates the application of these rules.

Example: Taxpayer A has a nondeductible IRA with a value of $100 (and no other IRAs). The $100 consists of $75 of contributions and $25 of earnings. A converts the IRA into a Roth IRA in 1998 and elects the 4-year spread. As a result of the conversion, $25 is includible in income ratably over 4 years ($6.25 per year). The 10-percent early withdrawal tax does not apply to the conversion. At the beginning of 1999, the value of the account is $110, and A makes a withdrawal of $10. Under the proposal, the withdrawal would be treated as attributable entirely to amounts that were includible in income due to the conversion. in the year of withdrawal, $16.25 would be includible in income (the $6.25 includible in the year of withdrawal under the 4-year rule, plus $10 ($10 is less than the remaining taxable amount of $12.50 ($25-$12.50)). in the next year, $2.50 would be includible in income under the 4-year rule. No amount would be includible in income in year 4 due to the conversion.

Application of early withdrawal tax to converted amounts

The bill modifies the rules relating to conversions to prevent taxpayers from receiving premature distributions (i.e., within 5 years) while retaining the benefit of the nonpayment of the early withdrawal tax. Under the bill, if converted amounts are withdrawn within the 5-year period beginning with the year of the conversion, then, to the extent attributable to amounts that were includible in income due to the conversion, the amount withdrawn will be subject to the 10-percent early withdrawal tax.

Applying this rule to the example above, the $10 withdrawal would be subject to the 10 percent early withdrawal tax (unless as exception applies).

Application of 5-year holding period

The bill will also eliminate the special rule under which a separate 5-year holding period begins for purposes of determining whether a distribution of amounts attributable to a conversion is a qualified distribution; thus, the 5-year holding rule for Roth IRAs will begin with the year for which a contribution is first made to a Roth IRA. A subsequent conversion will not start the running of a new 5-year period.

Ordering rules

Ordering rules will apply to determine what amounts are withdrawn in the event a Roth IRA contains both conversion amounts (possibly from different years) and other contributions. Under these rules, regular Roth IRA contributions will be deemed to be withdrawn first, then converted amounts (starting with the amounts first converted). Withdrawals of converted amounts will be treated as coming first from converted amounts that were includible in income. As under present law, earnings will be treated as withdrawn after contributions. For purposes of these rules, all Roth IRAs, whether or not maintained in separate accounts, will be considered a single Roth IRA.

Corrections

In order to assist individuals who erroneously convert IRAs into Roth IRAs or otherwise wish to change the nature of an IRA contribution, contributions to an IRA (and earnings thereon) may be transferred in a trustee-to-trustee transfer from any IRA to another IRA by the due date for the taxpayer's return for the year of the contribution (including extensions). Any such transferred contributions will be treated as if contributed to the transferee IRA (and not to the transferor IRA). Trustee-to-trustee transfers include transfers between IRA trustees as well as IRA custodians, apply to transfers from and to IRA accounts and annuities, and apply to transfers between IRA accounts and annuities with the same trustee or custodian.

Effect of death on 4-year spread

Under the bill, in general, any amounts remaining to be included in income as a result of a 1998 conversion will be includible in income on the final return of the taxpayer. If the surviving spouse is the sole beneficiary of the Roth IRA, the spouse may continue the deferral by including the remaining amounts in his or her income over the remainder of the 4-year period.

Calculation of AGI limit for conversions

The bill clarifies the determination of AGI for purposes of applying the $100,000 AGI limit on IRA conversions into Roth IRAs. Under the bill, the conversion amount (to the extent otherwise includible in AGI) is subtracted from AGI as determined under the rules relating to IRAs (Sec. 219) for the year of distribution. Thus, for example, the AGI-based phase out of the exemption from the disallowance for passive activity losses from rental real estate activities (Sec. 469(i)(3)) would be applied taking into account the amount of the conversion that is includible in AGI, and then the amount of the conversion would be subtracted from AGI in determining whether a taxpayer is eligible to convert an IRA into a Roth IRA.

Effective Date

The provision is effective as if included in the 1997 Act, i.e., for taxable years beginning after December 31, 1997.

2. Penalty-free distributions for education expenses and purchase of first homes (Sec. 6005(c) of the Bill, Secs. 203 and 303 of the 1997 Act, and Sec. 402 of the Code)

Present Law

The 10-percent early withdrawal tax does not apply to distributions from an IRA if the distribution is for first-time homebuyer expenses, subject to a $10,000 life-time cap, or for higher education expenses. These exceptions do not apply to distributions from employer-sponsored retirement plans. A distribution from an employer-sponsored retirement plan that is an "eligible rollover distribution" may be rolled over to an IRA. The term "eligible rollover distribution" means any distribution to an employee of all or a portion or the balance to the credit of the employee in a qualified trust, except the term does not include certain periodic distributions, distributions based on life or joint life expectancies and distributions required under the minimum distribution rules. Generally, distributions from cash or deferred arrangements made on account of hardship are eligible rollover distributions. An eligible rollover distribution which is not transferred directly to another retirement plan or an IRA is subject to 20-percent withholding on the distribution.

Explanation of Provision

Under present law, participants in employer-sponsored retirement plans can avoid the early withdrawal tax applicable to such plans by rolling over hardship distributions to an IRA and withdrawing the funds from the IRA. The bill modifies the rules relating to the ability to roll over hardship distributions from employer-sponsored retirement plans (including section 403(b) plans) in order to prevent such avoidance of the 10-percent early withdrawal tax. The bill provides that distributions from cash or deferred arrangements and similar arrangements made on account of hardship of the employee are not eligible rollover distributions. Such distributions will not be subject to the 20-percent withholding applicable to eligible rollover distributions.

Effective Date

The provision is effective for distributions after December 31, 1998.

3. Limits based on modified adjusted gross income (Sec. 6005(b) of the Bill, Sec. 302(a) of the 1997 Act, and Sec. 72(t) of the Code)

Present Law

The $2,000 Roth IRA maximum contribution limit is phased out for individual taxpayers with adjusted gross income ("AGI") between $95,000 and $110,000 and for married taxpayers filing a joint return with AGI between $150,000 and $160,000. The maximum deductible IRA contribution is phased out between $0 and $10,000 of AGI in the case of married couples filing a separate return.

Explanation of Provision

The bill clarifies the phase-out range for the Roth IRA maximum contribution limit for a married individual filing a separate return and conforms it to the range for deductible IRA contributions. Under the bill, the phase-out range for married individuals filing a separate return will be $0 to $10,000 of AGI.

Effective Date

The provision is effective as if included in the 1997 Act, i.e., for taxable years beginning after December 31, 1997.

4. Contribution limit to Roth IRAs (Sec. 6005(b) of the Bill, Sec. 302 of the 1997 Act, and Sec. 408A(c) of the Code)

Present Law

An individual who is an active participant in an employer-sponsored plan may deduct annual IRA contributions up to the lesser of $2,000 or 100 percent of compensation if the individual's adjusted gross income ("AGI") does not exceed certain limits. For 1998, the limit is phased-out over the following ranges of AGI: $30,000 to $40,000 in the case of a single taxpayer and $50,000 to $60,000 in the case of married taxpayers. An individual who is not an active participant in an employer-sponsored retirement plan (and whose spouse is not an active participant) may deduct IRA contributions up to the limits described above without limitation based on income. An individual who is not an active participant in an employer-sponsored retirement plan (and whose spouse is such an active participant) may deduct IRA contributions up to the limits described above if the AGI of the such individuals filing a joint return does not exceed certain limits. The limit is phased for out for such individuals with AGI between $150,000 and $160,000.

An individual may make nondeductible contributions up to the lesser of $2,000 or 100 percent of compensation to a Roth IRA if the individual's AGI does not exceed certain limits. An individual may make nondeductible contributions to an IRA to the extent the individual does not or cannot make deductible contributions to an IRA or contributions to a Roth IRA. Contributions to all an individual's IRAs for a taxable year may not exceed $2,000.

Explanation of Provision

The bill clarifies the intent of the Act that an individual may contribute up to $2,000 a year to all the individual's IRAs. Thus, for example, suppose an individual is not eligible to make deductible IRA contributions because of the phase-out limits, and is eligible to make a $1,000 Roth IRA contribution. The individual could contribute $1,000 to the Roth IRA and $1,000 to a nondeductible IRA.

Effective Date

The provision is effective as if included in the 1997 Act, i.e., for taxable years beginning after December 31, 1997.

5. Contribution limitations for active participants in an IRA (Sec. 6005(a) of the bill, Sec. 301(b) of the 1997 Act, and Sec. 219(g) of the Code)

Present Law

Under present law, if a married individual (filing a joint return) is an active participant in an employer-sponsored retirement plan, the $2,000 IRA deduction limit is phased out over the following levels of adjusted gross income ("AGI"):

Taxable years beginning in:

Phase-out Range

1997 $40,000 to $50,000
1998 $50,000 to $60,000
1999 $51,000 to $61,000
2000 $52,000 to $62,000
2001 $53,000 to $63,000
2002 $54,000 to $64,000
2003 $60,000 to $70,000
2004 $65,000 to $75,000
2005 $70,000 to $80,000
2006 $75,000 to $85,000
2007 $80,000 to $100,000

An individual is not considered an active participant in an employer-sponsored retirement plan merely because the individual's spouse is an active participant. The $2,000 maximum deductible IRA contribution for an individual who is not an active participant, but whose spouse is, is phased out for taxpayers with AGI between $150,000 and $160,000.

Explanation of Provision

The bill clarifies the intent of the Act relating to the AGI phase-out ranges for married individuals who are active participants in employer-sponsored plans and the AGI phase-out range for spouses of such active participants as described above.

Effective Date

The provision is effective as if included in the 1997 Act, i.e., for taxable years beginning after December 31, 1997.