Legal ruling 1998-3

Taxation of IRA Distributions Rolled Over to a Roth IRA Followed by a Change of Residence Status

Issue

What portion of a distribution from a regular individual retirement account (IRA) rolled over to a Roth IRA during 1998 is subject to California tax upon a change of residence status?

Law

Revenue and Taxation Code (Rev. and Tax. Code) section 17507.6 added by Ch. 612, Laws 1997, applicable to taxable years beginning on or after January 1, 1998, generally conforms to the Roth IRA provisions of Internal Revenue Code (Int. Rev. Code) section 408A, added by P.L. 105-34 applicable to taxable years beginning after December 31, 1997.

Pursuant to Rev. and Tax. Code section 17507.6(c)(3)(B), an individual whose federal adjusted gross income does not exceed $100,000 and who does not file a separate return as a married individual may make a rollover contribution from a regular IRA to a Roth IRA. The rollover contribution is deemed to be a distribution from a regular IRA and included in gross income under the rules otherwise applicable to regular IRAs. (Rev. and Tax. Code section 17507.6(d)(3)(C).)

If an eligible individual makes a rollover contribution from a regular IRA to a Roth IRA before January 1, 1999, the amount required to be included in gross income must be included in income ratably over four taxable years beginning in the taxable year in which the distribution occurs.[1] (Rev. and Tax Code section 17507.6 (d)(3)(A)(iii).)

This notice addresses concerns that arise (1) when a nonresident individual makes a rollover contribution from a regular IRA to a Roth IRA before January 1, 1999, and during the following four-year period becomes a California resident (inbound taxpayer), and (2) when a resident of California makes a rollover contribution from a regular IRA to a Roth IRA before January 1, 1999, and during the following four year period becomes a nonresident (outbound taxpayer).

Analysis

Inbound Taxpayers

Inbound taxpayers must include in gross income the ratable portions of the taxable distribution reportable under the four-year rule after they become California residents.

Rev. and Tax. Code section 17041 imposes tax on the entire taxable income of every resident of this state. Taxable income is defined to include gross income from regular IRAs, which are rolled over to Roth IRAs (Rev. and Tax. Code section 17507.6) An individual who makes a rollover contribution from a regular IRA to a Roth IRA before January 1, 1999, is required to include one fourth of the taxable portion of the IRA distribution in gross income in each of four consecutive years beginning with the year of distribution. (Ibid.) Because residents are subject to tax on their entire taxable income, and because taxable income includes gross income from an IRA rollover in the situation described, an individual must include in gross income the ratable portions reportable under the four-year rule after he or she becomes a California resident.

Rev. and Tax. Code section 17554, the accrual provision, does not prevent California from assessing tax on the portions reportable after the individual becomes a resident. Section 17554 states, in general, that California may not impose tax on income from sources outside this state if the income accrued when the individual was a nonresident, even though the income is recognized after the taxpayer becomes a California resident. Section 17554 comes into play, however, if and only if, two conditions are satisfied:

1. California’s sole basis for imposing tax is residency, and
2. Taxation would differ depending on whether the taxpayer uses the cash or accrual method of accounting. (Appeal of Virgil M. and Jeanne P. Money, Cal. St. Bd. of Equal., December 13, 1983.)

The purpose of section 17554 is to prevent discriminatory taxation following a change of residency based on whether the taxpayer uses the cash or accrual method of accounting. (Supra.)

In the situation where California is attempting to tax an individual who becomes a resident after making a rollover contribution from a regular IRA to a Roth IRA before January 1, 1999, the first condition is satisfied. The sole basis for imposing tax is that the individual has become a California resident during the four-year period the income is recognized. However, the second condition is not satisfied. All taxpayers, cash and accrual alike, must report the taxable distribution ratably over four years. Thus, there exists no possibility of discriminatory taxation following a change of residency based upon the use of different accounting methods. Accordingly, section 17554 is never applied. All taxpayers must include the ratable share of the taxable distribution in gross income after they become California residents.

Outbound Taxpayers

Outbound taxpayers must include in gross income only those portions of the taxable distribution reportable under the four-year rule before they become nonresidents.

As discussed above, Rev. and Tax. Code sections 17041 and 17507.6 require residents of California to include in gross income the taxable portions of regular IRAs rolled over to Roth IRAs before January 1, 1999, over a four-year period.

Rev. and Tax. Code section 17952.5, however, prevents California from imposing tax on the portions of the IRA distribution recognized after the individual becomes a nonresident. Section 17952.5 states that gross income of a nonresident does not include qualified retirement income, including income from an IRA, received on or after January 1, 1996. In the case of a rollover from a regular IRA to a Roth IRA subject to the four-year rule, the distribution is deemed to have been received during 1998. Accordingly, any amount included in gross income under the four-year rule after the individual becomes a nonresident falls squarely within the exemption from gross income provided by section 17952.5.

Year One Proration

An individual who makes a rollover contribution from a regular IRA to a Roth IRA before

January 1, 1999, and thereafter during the same taxable year changes residency, must include in California adjusted gross income one fourth of the taxable portion of the distribution multiplied by a fraction, the denominator of which is the number of days from the date of the distribution until the end of the taxable year in which the distribution occurs and the numerator of which is the number of days in the denominator in which the individual is a resident of California.

If a taxpayer changes residency during the second, third, or fourth year, the amount included in California adjusted gross income for the year of the change in residency is one fourth of the taxable distribution multiplied by a fraction, the denominator of which is the total number of days in the taxable year and the numerator of which is the number of days in the year in which the individual is a California resident.

Long-standing administrative practice apportions fungible items of income and deductions to periods of residency based upon the amount of time an individual is a resident of California. Thus, the time approach is the required method for apportioning the taxable distribution required to be included in gross income under the four-year rule in the circumstance when a change of residency occurs during the four taxable year period following the distribution.

Drafting Information

The principal author of this notice is Richard Gould of the Franchise Tax Board, Legal Branch. For further information regarding this ruling, contact Mr. Gould at the Franchise Tax Board, Legal Branch, P.O. Box 1720, Rancho Cordova, CA 95741-1720.

Footnotes

1. As of the date of this notice, California has not conformed to provisions of P.L. 105-206 which allow a taxpayer to elect to include the taxable distribution in gross income in the year the distribution occurs.↵Return to reference