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

1. Conversions of IRAs into Roth IRAs (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.

Description of Proposal

Distributions of Converted Amounts

Distributions before the end of the 4-year spread

The proposal would modify 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to which the 4 year income inclusion rule applies, income inclusion would be accelerated with respect to any amounts withdrawn before the final year of inclusion.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 would 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 proposal, application of the 4-year spread would be elective. The election would be made in the time and manner prescribed by the Secretary. An election with respect to the 4-year spread could not 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 proposed 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 proposal would modify 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 proposal, 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 would 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 proposal would 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 would begin with the year for which a contribution is first made to a Roth IRA. A subsequent conversion would not start the running of a new 5-year period.

Ordering Rules

Ordering rules would 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 would be deemed to be withdrawn first, then converted amounts (starting with the amounts first converted). Withdrawals of converted amounts would be treated as coming first from converted amounts that were includible in income. As under present law, earnings would be treated as withdrawn after contributions. For purposes of these rules, all Roth IRAs would 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 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).

Effect of Death on 4-year Spread

Under the proposal, in general, any amounts remaining to be included in income as a result of a 1998 conversion would be includible in income on the final return of the taxpayer. If the surviving spouse is the beneficiary of the Roth IRA, the spouse could 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 proposal would clarify that, for purposes of applying the $100,000 AGI limit on IRA conversions into Roth IRAs, the conversion amount (to the extent otherwise includible in AGI) is subtracted from AGI as determined under the rules relating to IRAs (Sec. 219). Thus, for example, the AGI-based phase out of the exemption from the disallowance for passive activity losses form 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 and IRA into a Roth IRA.

Effective Date

The provision would be 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 (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. 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.

Description of Proposal

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 proposal would modify the rules relating to the ability to roll over hardship distributions from employer-sponsored retirement plans in order to prevent such avoidance of the 10-percent early withdrawal tax. The proposal would provide 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 would not be subject to the 20-percent withholding applicable to eligible rollover distributions.

Effective Date

The proposal would be effective for distributions after December 31, 1998.

3. Limits based on modified adjusted gross income (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.

Description of Proposal

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

Effective Date

The proposal would be 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. 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.

Description of Proposal

The proposal would clarify 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 proposal would be 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. 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.

Description of Proposal

The proposal would clarify 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 proposal would be effective as if included in the 1997 Act, i.e., for taxable years beginning after December 31, 1997.

D. Amendments to Title III of the 1997 Act Relating to Capital Gains

1. Individual capital gain rate reductions (Sec. 311 of the 1997 Act and Sec. 1(h) of the Code)

Present Law

The 1997 Act provided lower capital gains rates for individuals. Generally, the 1997 Act reduced the maximum capital gains rate from 28 percent to 20 percent and provided a 10-percent rate for capital gains otherwise taxed at a 15-percent rate. The 1997 Act generally retained a 28 percent maximum rate for gain from collectibles, gain included in income from the sale of certain small business stock, net gain properly taken into account before May 7, 1997, and net gain properly taken into account after July 28, 1997, from property held more than one year but not more than 18 months. In addition, a maximum rate of 25 percent is provided for the long-term capital gain attributable to real estate depreciation. Lower rates are also provided in the future for certain property held more than five years.

Under the provisions of the 1997 Act, net short-term capital losses and long-term capital loss carryovers offset gain taxed at a 20-percent rate before offsetting gain taxed at the 25- or 28- percent rates.

Description of Proposal

The proposal would make the following technical corrections to the individual capital gain rate reduction provisions of the 1997 Act:

Collectibles gains and losses, certain small business stock gain included in income, capital gains and losses properly taken into account after July 28, 1997, from the disposition of property held more than one year but not more than 18 months, and long-term capital gains and losses properly taken into account before May 7, 1997, would be placed in one basket ("28-percent rate gain") taxed a maximum rate of 28 percent. All the gains and losses in this basket would be netted for purposes of determining the amount taxed at a maximum 28-percent rate.

Any net short-term capital loss for the taxable year and any long-term capital loss carryover to the taxable year would be placed in the 28-percent rate gain basket. This would allow these capital losses to offset gain taxed at the 28-percent rate before offsetting gain taxed at lower rates. Any net loss in the 28-percent rate gain basket next would offset gain taxed at the 25-percent rate.

Several conforming amendments would be made to coordinate the multiple holding periods with other provisions of the Code. Inherited property and certain patents would be deemed to have a holding period of more than 18 months, thus, allowing the lower 10- and 20-percent rates to apply. The proposal would clarify that long-term capital gain or loss on a section 1256 contract would be treated as gain or loss from property held more than 18 months. Also, the short sale holding period rules of section 1233 and the holding period rules of section 1092(f) would be amended to conform those rules with the new 12-18 month holding period. Amounts treated as ordinary income by reason of section 1231(c) would be allocated among categories of gain in accordance with IRS forms or regulations.

Finally, the proposal would reorder some of the provisions and make other minor technical changes, including a provision to reduce the minimum tax preference on small business stock to 28 percent, beginning in 2006.

Effective Date

The proposal would be effective for taxable years ending after May 6, 1997.

2. Rollover of gain from sale of qualified stock (Sec. 313 of the 1997 Act and Sec. 1045 of the Code)

Present Law

The 1997 Act provided that gain from the sale of qualified small business stock held by an individual for more than 6 months can be "rolled over" tax-free to other qualified small business stock.

Description of Proposal

Under the proposal, a partnership or an S corporation can roll over gain from qualified small business stock held more than 6 months if (and only if) all the interests in the partnership or S corporation are held by individuals, estates, or trusts (other than trusts with corporations as beneficiaries) at all times during the taxable year.

Effective Date

The proposal would be effective on August 5, 1997, the date of enactment of the 1997 Act.

3. Exclusion of gain on the sale of a principal residence owned and used less than two years (Sec. 312(a) of the 1997 Act and Sec. 121 of the Code)

Present Law

Under present law, a taxpayer generally is able to exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. To be eligible for the exclusion, the taxpayer must have owned the residence and used it as a principal residence for at least two of the five years prior to the sale or exchange. A taxpayer who fails to meet these requirements by reason of a change of place of employment, health, or unforeseen circumstances is able to exclude a fraction of the taxpayer's realized gain equal to the fraction of the two years that the requirements are met.

Description of Proposal

The proposal would clarify that an otherwise qualifying taxpayer who fails to satisfy the two-year ownership and use requirements is able to exclude an amount equal to the fraction of the $250,000 ($500,000 if married filing a joint return), not the fraction of the realized gain which is equal to the fraction of the two years that the ownership and use requirements are met. For example, an unmarried taxpayer who owns and uses a principal residence for one year then sells at realized gain of $500,000 may exclude $125,000 of gain (one-half of $250,000) not $250,000 of gain (one-half of the realized gain). Similarly, an unmarried taxpayer who owns and uses a principal residence for one year then sells at a realized gain of $50,000 may exclude the entire $50,000 of gain since it is less than one half of $250,000. The exclusion is not limited to $25,000 (one-half of the $50,000 realized gain).

In addition, the proposal would provide that if a married couple filing a joint return does not qualify for the $500,000 exclusion, the amount of the exclusion claimed by the couple will be the sum of each spouse's exclusion determined on a separate basis.

Effective Date

The proposal would be effective as if included in section 312 of the 1997 Act.

4. Effective date of the exclusion of gain on the sale of a principal residence (Sec. 312(d)(2) of the 1997 Act and Sec. 121 of the Code)

Present Law

The exclusion for gain on sale of a principal residence under the 1997 Act generally applies to sales or exchanges occurring after May 6, 1997. A taxpayer may elect, however, to apply prior law to a sale or exchange (1) made before the date of enactment of the Act, (2) made after the date of enactment pursuant to a binding contract in effect on such date, or (3) where a replacement residence was acquired on or before the date of enactment (or pursuant to a binding contract in effect on the date of enactment) and the prior-law rollover provision would apply.

Description of Proposal

The proposal would clarify that a taxpayer may elect to apply prior law with respect to a sale or exchange on the date of enactment of section 312 of the 1997 Act.

Effective Date

The proposal would be effective as if included in section 312 of the 1997 Act.