Legal ruling 1998-4

Recharcterization of Roth IRA Contributions

Introduction

Advice has been requested regarding the California personal income tax treatment of a trustee-to-trustee transfer from a Roth IRA to a traditional IRA. Under federal tax law, as amended by the Internal Revenue Service Restructuring and Reform Act of 1998 (P.L. 105-206, 112 Stat. 685), certain contributions to a Roth IRA are treated as having been made to a traditional IRA rather than the Roth IRA. Consequently, amounts otherwise includible in gross income as a result of a contribution to a Roth IRA, i.e., any qualified rollover contribution from a traditional IRA to a Roth IRA, are not includible in gross income for federal tax purposes. However, since California did not conform to the federal amendments that statutorily authorize disregarding a transfer, due to the veto of AB 1469 (1998), questions have arisen as to the proper treatment of such transfers for California personal income tax purposes.

Issue

What is the California personal income tax treatment of a trustee-to-trustee transfer from a Roth IRA to a traditional IRA that results in the recharacterization of the contributions to the Roth IRA for federal income tax purposes?

Facts

Situation 1

A taxpayer makes a rollover contribution from traditional IRA #1 to a Roth IRA during 1998. The taxpayer is not a married individual filing a separat return and the taxpayer's adjusted gross income for 1998 exceeds $100,000. On or before the due date of the return for the year of the contribution (including extensions), the taxpayer makes a trustee-to-trustee transfer from the Roth IRA to traditional IRA #3 of contributions received by the Roth IRA from traditional IRA #1.

Situation 2

Same as situation 1 except the taxpayer's adjusted gross income for the taxable year does not exceed $100,000. The value of traditional IRA #1 at the time of the qualified rollover contribution to the Roth IRA was $300. After the trustee-to-trustee transfer, the taxpayer makes a qualified rollover contribution from IRA #3 to a Roth IRA. At the time of the subsequent qualified rollover contribution from IRA #3 to the Roth IRA, the value of IRA #3 has declined to $200.

Law and Analysis

Section 408A of the Internal Revenue Code establishes the Roth IRA as a new type of individual retirement plan, effective for taxable years beginning on or after January 1, 1998. Unlike a traditional IRA, contributions to a Roth IRA are not deductible and qualified distributions from a Roth IRA are not includible in gross income. The ability to make a contribution to a Roth IRA is limited by a taxpayer's adjusted gross income.

Section 408A allows a qualified rollover contribution from a traditional IRA to a Roth IRA if the adjusted gross income of a taxpayer (other than a married individual filing a separate return) for a taxable year does not exceed $100,000. (A married individual filing a separate return is not allowed to make a qualified rollover contribution from a traditional IRA to a Roth IRA.) Except for previous nondeductible contributions, a qualified rollover contribution of a traditional IRA to a Roth IRA is includible in gross income. Any qualified rollover contribution to a Roth IRA in 1998 is includible in gross income ratably over the 4-taxable year period beginning with the taxable year in which the payment or distribution is made. A distribution from a traditional IRA that is part of a qualified rollover contribution to a Roth IRA is exempt from the 10 percent federal tax on early withdrawals from an IRA. A qualified rollover contribution from a traditional IRA to a Roth IRA is considered a distribution from the traditional IRA without regard to the manner in which the rollover contribution is actually accomplished. In addition, a qualified rollover contribution is disregarded for purposes of the rule under Section 408(d)(3) that limits an eligible rollover to one per year.

If a taxpayer makes a transfer from a traditional IRA to a Roth IRA and the transfer is not eligible for treatment as a qualified rollover contribution (such as in the case where a taxpayer's adjusted gross income exceeds $100,000), the amounts transferred (other than amounts attributable to nondeductible contributions) are includible in gross income and subject to the 10 percent tax on early withdrawals. In addition, to the extent the contribution to the Roth IRA exceeds the limit on regular contributions to a Roth IRA ($2,000 per year), the excess is subject to the federal excise tax on excess contributions. See, generally, Notice of Proposed Rulemaking and Notice of Public Hearing, Roth IRAs, REG-115393-98, Internal Revenue Service Bulletin 1998-39, pp. 34 - 49.

Section 408A of the Internal Revenue Code was amended by the Internal Revenue Service Restructuring and Reform Act of 1998 (P.L. 105-206, 112 Stat. 685). These amendments authorize a taxpayer to elect out of the 4-taxable year ratable inclusion in income resulting from a qualified rollover contribution made to a Roth IRA in 1998. These amendments also included provisions to alleviate difficulties resulting from a rollover contribution from a traditional IRA to a Roth IRA where the taxpayer is not eligible to make a qualified rollover contribution. A taxpayer is permitted to recharacterize contributions to a Roth IRA. In particular, Section 408A, as amended by the 1998 Act, provides that a contribution to a Roth IRA that is transferred to a traditional IRA in a trustee-to-trustee transfer shall be treated as made to the traditional IRA and not the Roth IRA (a recharacterization). A recharacterization must be done by a trustee-to-trustee transfer and the transfer must be made on or before the due date (including extensions) for the federal income tax return for the taxable year of the contribution.

Pursuant to Section 17501 of the Revenue and Taxation Code, Section 408A of the Internal Revenue Code is applicable for California personal income tax purposes. Under the authority of Section 17024.5 of the Revenue and Taxation Code, as amended by Stat. 1998, Ch. 322 (AB 2797), the reference to Section 408A of the Internal Revenue Code means Section 408A of the Internal Revenue Code, as in effect January 1, 1998.

Legislation to conform California law to the amendments made to Section 408A by the Internal Revenue Service Restructuring and Reform Act of 1998 for California purposes, AB 1469, (1998) was vetoed on September 29, 1998. Consequently, Section 408A of the Internal Revenue Code, for California purposes, does not include amendments enacted in 1998. For example, under California law a taxpayer that makes a qualified rollover contribution from a traditional IRA to a Roth IRA before January 1, 1999, may not elect out of the 4-taxable year ratable inclusion in gross income.

However, the 1998 federal law did not amend Section 408A(b). That section grants to the Secretary of the Treasury authority to prescribe the manner for designating an individual retirement plan as a Roth IRA. Section 17024.5 of the Revenue and Taxation Code provides that, when applying any section of the Internal Revenue Code, "Franchise Tax Board" shall be substituted for Secretary when appropriate. As a result, Section 408A(b) of the Internal Revenue Code, as applicable for California purposes, authorizes the Franchise Tax Board to prescribe the manner for designating an individual retirement plan as a Roth IRA.

Pursuant to this authority, with regard to the 1998 taxable year, if a taxpayer makes a trustee-to-trustee transfer from a federally designated Roth IRA to a traditional IRA that results in a recharacterization of contributions to the Roth IRA for federal purposes, such trustee-to-trustee transfer shall be treated, for California purposes, as revoking the designation of the individual retirement plan from which such amounts were transferred as a Roth IRA with regard to amounts so transferred. This revocation is not applicable for purposes of applying the limitations of Section 408(d)(3)(B). The individual retirement plan is an individual retirement plan under Section 7701(a)(37) of the Internal Revenue Code, as applicable, for California purposes.

Situation 1

The taxpayer described in situation 1 is not eligible to make qualified rollover contribution to a Roth IRA because the taxpayer's adjusted gross income exceeds $100,000. The distribution from traditional IRA #1 will be treated as an early withdrawal, subject to the federal 10 percent penalty on early withdrawals. The contribution to the Roth IRA will be treated as an excess contribution, subject to the federal excise tax on excess contributions. To avoid this result, the taxpayer makes a timely trustee-to-trustee transfer from the Roth IRA of contributions received from traditional IRA #1 to traditional IRA #3.

For federal income tax purposes, amounts transferred are treated as a contribution to traditional IRA #3, rather than a contribution to a Roth IRA. The contribution to the Roth IRA is ignored for federal tax purposes. Consequently, there is no income recognition resulting from the contribution of the traditional IRA to the Roth IRA. In addition, there is no distribution from traditional IRA #1 subject to the penalty on early withdrawals, and no excess contributions to the Roth IRA subject to the federal excise tax.

For California personal income tax purposes, the taxpayer described in situation 1 is treated as having made an eligible rollover contribution from traditional IRA #1 to another traditional IRA, IRA #2, and a trustee-to-trustee transfer from traditional IRA #2 to traditional IRA #3. An eligible rollover contribution from a traditional IRA to another traditional IRA is notincludible in gross income in the year of the rollover contribution. Similarly, amounts transferred in a trustee-to-trustee transfer from a traditional IRA to another traditional IRA are not includible in gross income in the year of the transfer. The qualified rollover contribution from IRA #1 to IRA #2, the previously designated Roth IRA, is disregarded for purposes of applying the one-year rule on eligible rollover contributions.

Situation 2

Although not required to do so, the taxpayer in situation 2 chooses to make a trustee-to-trustee transfer to traditional IRA #3 of amounts contributed to the Roth IRA from traditional IRA #1. As in situation 1, contributions made to the Roth IRA are treated as contributed to traditional IRA #3 and not contributed to the Roth IRA for federal income tax purposes. Consequently, there is no income recognition resulting from the qualified rollover contribution from traditional IRA #1 to the Roth IRA. As in situation 1, for California purposes, the taxpayer is treated as having made an eligible rollover contribution from traditional IRA #1 to another traditional IRA, IRA #2, and a trustee-to-trustee transfer from traditional IRA #2 to traditional IRA #3. The eligible rollover contribution from traditional IRA #1 to IRA #2, the previously designated Roth IRA, is disregarded for purposes of applying the one-year rule.

The taxpayer in situation 2 is eligible to make another qualified rollover contribution from traditional IRA #3 to a Roth IRA under federal law and California law. Assuming no subsequent trustee-to-trustee transfer is made, this second qualified rollover contribution to a Roth IRA requires recognition of income as a result of the contribution under federal income tax law and California personal income tax law. However, the amount includible in gross income under federal law and California law would be based on the value of traditional IRA #3 at the time of the qualified rollover contribution to a Roth IRA, i.e., $200, rather than the value of traditional IRA #1 at the time of the initial qualified rollover contribution to a Roth IRA, i.e., $300.

If the second qualified rollover contribution from traditional IRA #3 to a Roth IRA is made before January 1, 1999, the income is includible ratably over the 4-taxable year period beginning with the taxable year of the distribution. Federal law permits a taxpayer to elect out of the ratable inclusion. California law does not.

Holding

With respect to the 1998 taxable year, if a taxpayer makes a trustee-to-trustee transfer from a federally designated Roth IRA that recharacterizes contributions to the Roth IRA for federal purposes, such transfer shall be treated, for California purposes, as revoking the designation of the individual retirement plan from which such amounts were transferred as a Roth IRA with regard to amounts so transferred. This revocation is not applicable for purposes of applying the one-year rule on rollover contributions to an IRA. The individual retirement plan is an individual retirement plan under Section 7701(a)(37) of the Internal Revenue Code, as applicable, for California purposes. In all other circumstances, a traditional IRA effectively designated, as a Roth IRA for federal tax purposes, shall be a Roth IRA for California purposes.

Drafting Information

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