Chapter 8
IRAs

There are several types of IRAs: Traditional IRAs, Roth IRAs, SIMPLE IRAs, and SEPs. You may personally set up a traditional or Roth IRA with your bank or broker. SIMPLE IRAs (8.18) and SEPs (8.15) are available only if your employer offers such plans. For 2017, the contribution limit for both traditional (8.2) and Roth IRAs (8.20) is $5,500, or $6,500 for individuals who are age 50 or older at the end of the year. There is no deduction for Roth IRA contributions, which are allowed only if you have earned income and only if your modified adjusted gross income (MAGI) is within specified limits. If you have earnings, you may make traditional IRA contributions, which are either fully deductible, partly deductible, or not deductible at all, depending on whether you (and your spouse) have retirement coverage where you work and if so, whether your MAGI subjects you to the deduction phaseout rules (8.4).

Traditional IRA distributions are generally fully taxable and, if made before age 59½, subject to a penalty; see 8.12 for penalty exceptions. Minimum annual distributions from a traditional IRA must begin after you reach age 70½ (8.13).

Although contributions to a Roth IRA are not deductible, the Roth IRA has a major tax advantage: tax-free withdrawals of earnings may be made after a five-year waiting period if you are over age 59½ (8.24). Tax-free withdrawals of contributions may be made at any time. A traditional IRA may also be converted to a Roth IRA; conversions are taxable. After a conversion, a Roth IRA may be recharacterized back to a traditional IRA, and subsequently reconverted to a Roth IRA. See the discussion of annual Roth IRA contributions (8.20), conversions (8.22), and recharacterizations and reconversions (8.23).

Low-to-moderate-income taxpayers may be able to claim a tax credit on Form 8880 for contributions to a traditional IRA, Roth IRA, SIMPLE IRA, or salary-reduction SEP (25.11).

8.1 Starting a Traditional IRA

If you have earnings, you may contribute to a traditional IRA up to an annual limit (8.2). The contribution may be deductible (8.4) or nondeductible (8.6). Earnings within the IRA accumulate tax free until withdrawals are made (8.8).

You also may set up a traditional IRA by rolling over a distribution received from a qualified employer plan. For example, if you receive a lump-sum payment from a qualified employer plan upon retirement, changing jobs, or becoming totally disabled, you may make a tax-free rollover to a traditional IRA (7.8). If you have a traditional IRA, you can roll it over or make a direct transfer to a different traditional IRA (8.10).

Your employer can set up a “deemed IRA” as a separate account under a qualified retirement plan. As long as the separate account otherwise meets IRA requirements, you can make voluntary employee contributions that will be treated as IRA contributions subject to the regular IRA rules. The separate account can be treated as a traditional IRA or Roth IRA (8.19).

Roth IRAs. Annual contributions to a Roth IRA and conversions of traditional IRAs to Roth IRAs are discussed at 8.19–8.22.

Restrictions on traditional IRAs. You may not freely withdraw IRA funds until the date you reach age 59½ or become disabled. If you take money out before that time, you are subject to a penalty (8.12). Pledging the account as collateral is treated as a taxable distribution from the account (8.8). In the year you reach age 70½, you may no longer make traditional IRA contributions (8.2), and you must start to withdraw (8.13) from the account. All traditional IRA withdrawals are fully taxable except for amounts allocable to nondeductible contributions (8.8 – 8.9). Special averaging for lump-sum distributions (7.4) does not apply to IRA distributions. Excess contributions (8.7) are penalized.

If your IRA loses value because of poor investments, you may not deduct the loss. A loss is allowed only if you make nondeductible contributions that you have not recovered when the account is depleted (8.9).

Types of traditional IRAs. You may set up an IRA as:

1. An individual retirement account with a bank, savings and loan association, federally insured credit union, or other qualified person as trustee or custodian. An individual retirement account is technically a trust or custodial account. Your contribution may be invested in vehicles such as certificates of deposit, mutual funds, and certain limited partnerships.
2. An individual retirement annuity by purchasing an annuity contract (including a joint and survivor contract for the benefit of you and your spouse) issued by an insurance company; no trustee or custodian is required. The contract, endorsed to meet the terms of an IRA, is all that is required. It must provide for flexible premiums up to the annual contribution limit, so that if your compensation changes, your payment may also change. As borrowing or pledging of the contract is not allowed under an IRA, the contracts will not contain loan provisions. Endowment contracts that provide life insurance protection may not be used as individual retirement annuities.

You may set up one type of IRA one year and choose another form the next year. You also may split your contribution between two or more investment vehicles. For example, you are eligible to contribute $5,500 for 2017 if under age 50. You may choose to put $2,750 into an individual retirement annuity and $2,750 into an individual retirement account with a bank, mutual fund, or brokerage firm.

You do not have to file any forms with your tax return when you set up or make contributions to a deductible IRA. Form 8606 must be attached to Form 1040 or Form 1040A if you make nondeductible IRA contributions (8.6). The trustee or issuer of your IRA will report your contribution to the IRS on Form 5498, and you should receive a copy.

Self-directed IRA. If you wish to take a more active role in managing your IRA investments, you may set up a “self-directed” IRA using an IRS model form. The model trust (Form 5305) and the model custodial account agreement (Form 5305-A) meet the requirements of an exempt individual retirement account and so do not require a ruling or determination letter approving the exemption of the account and the deductibility of contributions made to the account. If you use this method, you still have to find a bank or other institution or trustee to handle your account or investment. Investments in a self-directed IRA are subject to restrictions; see the Caution in 8.1.

SIMPLE IRA. If you work for a company with 100 or fewer workers, your employer may set up a SIMPLE IRA to which you may make salary-reduction contributions (8.17).

Contributions allowed up until filing due date. To make deductible or nondeductible IRA contributions for a year, you have until the regular filing due date (without extensions) of the return for that year. Since the deadline for 2017 returns is April 17, 2018 (page 6), you have until the April 17 due date to make your contribution for 2017. For a contribution to count as a 2017 contribution, it must be made by the April 17 due date, even if you get an extension to file your 2017 return (46.3). If you make a contribution between January 1 and April 17, 2018, make sure the IRA trustee or custodian designates it as a 2017 contribution (and not a 2018 contribution) if that is what you intend. If you are short of cash, you may borrow the funds to make the contribution without jeopardizing a deduction (8.2). If an IRA deduction entitles you to a refund, you can file your return early, claim the IRA deduction, and if you receive the refund in time, apply it towards an IRA contribution before the due date.

8.2 Traditional IRA Contributions Must Be Based on Earnings

You may make contributions to a traditional IRA for 2017 of up to $5,500, $6,500 if you are age 50 or older at the end of 2017, provided that (1) you have at least $5,500/$6,500 of wages, salary, or net self-employment earnings in 2017, and (2) you have not reached age 70½ by the end of the year. If your earned income is less than $5,500 ($6,500 if age 50 or older), the contribution limit is 100% of your pay or net earned income if self-employed. If you have more than one traditional IRA, the limit applies to total contributions to all of the IRAs for the year. Contributions for 2017 may be made up to the filing deadline of April 17, 2018; this is the deadline even if you obtain a filing extension for your 2017 return.

If you are married filing jointly, you may each contribute up to $5,500 (or $6,500 if age 50 or older) to an IRA for 2017, as long as your combined compensation covers the contributions (8.3)

Deductibility. Contributions up to the $5,500 or $6,500 limit are fully deductible on your 2017 return if neither you nor your spouse is an active participant in an employer or self-employed retirement plan. Deductions for active plan participants are phased out for single persons with 2017 modified adjusted gross income over $62,000. The phaseout threshold on a joint return is generally $99,000 for 2017 (8.3), but a more favorable $186,000 phaseout threshold applies to a jointly filing spouse who is not a plan participant (8.4).

Contribution limit increased by $1,000 if age 50 or older. If you are age 50 or older by the end of 2017, an additional contribution of up to $1,000 may be made for 2017, increasing your contribution limit to the lesser of $6,500 (up from the general limit of $5,500) or your taxable compensation. If you are an active participant in an employer retirement plan, the $6,500 limit is subject to the phaseout rule (8.4).

Taxable compensation. Traditional IRA contributions, whether deductible or nondeductible, must be based on taxable compensation received for rendering personal services, such as salary, wages, commissions, tips, fees, bonuses, jury fees, or net earnings from self-employment (less retirement plan contributions on behalf of the self-employed). An IRA contribution (deductible or nondeductible) may not be based upon:

1. Investment income such as interest, dividends, or profits from sales of property;
2. Deferred compensation, pensions, or annuities; or
3. Income earned abroad for which the foreign earned income exclusion is claimed.

If you live in a community property state, the fact that one-half of your spouse’s income is considered your income does not entitle you to make contributions to an IRA. Your contribution must either be based on pay earned through your services or, if you file jointly, it must be allowed under the spousal IRA rules (8.3).

Working for spouse. If you work for your spouse, you may make an IRA contribution provided you actually perform services and receive an actual payment of wages. A wife who worked as a receptionist and assistant to her husband, a veterinarian, failed to meet the second test. Her husband did not pay her a salary. Instead, he deposited all income from his business into a joint bank account held with his wife. In addition, no federal income tax was withheld from her wages. In a ruling, the IRS held that the wife could not set up her own IRA, even though she performed services; she failed to receive actual payment. Depositing business income into a joint account is neither actual nor constructive payment of the wife’s salary. Furthermore, any deduction claimed for the wife’s wages was disallowed.

Self-employed may make IRA contributions. IRA contributions may be based on net self-employment earnings (45.1). For IRA purposes, net earnings from Schedule C are reduced by deductible contributions made on your behalf to qualified plans and SEPs (41.5) and by the deduction for one-half of self-employment tax liability (45.3). If you have a net loss for the year, you may not make an IRA contribution unless you also have wages.

If you have more than one self-employed activity, you must aggregate profits and losses from all of your self-employed businesses to determine if you have net income on which to base an IRA contribution. For example, if one self-employed business produces a net profit of $15,000 but another a net loss of $20,000, you may not make an IRA contribution based on the net profit of $15,000 since you have an overall loss. This netting rule does not apply to salary or wage income. If you are an employee who also has an unprofitable business, you may make an IRA contribution based on your salary.

If you have a self-employed retirement plan from your business, you are considered an active participant in a retirement plan for purposes of the adjusted gross income phaseout rules (8.4).

Taxable alimony treated as compensation. A divorced spouse with little or no earnings may treat taxable alimony as compensation, giving a basis for deductible IRA contributions. If you are divorced, you generally may make an IRA contribution for 2017 equal to 100% of the taxable alimony you received, up to the $5,500 limit ($6,500 if age 50 or older). However, if you are an active participant in an employer plan and your adjusted gross income exceeds the $62,000 threshold for unmarried individuals, see 8.4 for the phaseout of the deduction limit. Taxable alimony is alimony paid under a decree of divorce or legal separation, or a written agreement incident to such a decree; see Chapter 37. It does not include alimony payments made under a written agreement that is not incident to such a decree.

No contributions to traditional IRA allowed for those age 70½. Even if you still have earnings, you may not make contributions to a traditional IRA for the year in which you reach age 70½, or any later year. For example, if you were born in the last six months of 1946 or the first six months of 1947, you reach age 70½ during 2017 and therefore may not make any traditional IRA contributions (deductible or nondeductible) for 2017 or for any later year.

If you have a nonworking spouse under age 70½, you may contribute to his or her IRA, even though no contribution may be made to your own traditional IRA because you have reached age 70½ (8.3).

Qualified reservist repayments. If you were called to active duty as a member of the reserves for over 179 days, or indefinitely, and took a distribution from your IRA during your active duty period, the distribution may be repaid to an IRA within the two-year period beginning on the day after the end of the active duty period. The repayment is allowed regardless of the regular IRA contribution limit for the year of repayment. The repaid amount is not deductible. The qualified reservist repayment must be reported as a nondeductible IRA contribution (8.6) on Line 1 of Form 8606.

8.3 Contributions to a Traditional IRA If You Are Married

If both you and your spouse earned compensation in 2017 of at least $5,500 and are under age 50 at the end of the year, each of you may make a contribution of up to $5,500 to a traditional IRA for 2017 by April 17, 2018. Under the spousal IRA rule, the $5,500 per spouse contribution limit applies even if only one of you works, provided you file jointly and your combined taxable compensation is at least $11,000. An additional contribution of up to $1,000 can be made for each spouse who is age 50 or older by the end of the year so long as there is compensation to cover it and the spouse is under age 70½; no IRA contribution is allowed for an individual who is age 70½ or older at the end of the year.

Contributions for 2017 are fully deductible up to the $5,500 limit ($6,500, if applicable) if neither you nor your spouse was covered by an employer retirement plan during the year. If either of you was an active plan participant (8.5), you are both considered active participants, and a deduction may be limited or disallowed (8.4) depending on your modified adjusted gross income (MAGI). However, if you file jointly and only one of you was an active plan participant, a more favorable MAGI phaseout rule applies to the nonparticipant spouse, so that the spouse without coverage may be able to claim a deduction even if the participant spouse may not. The deduction phaseout rules are discussed below.

Spousal IRA contribution on joint return for nonworking or low-earning spouse. If you file a joint return for 2017, and you and your spouse are both under age 50 at the end of the year, you may each contribute up to $5,500 to a traditional IRA as long as your combined compensation is at least $11,000. If you are both age 50 or older by the end of 2017, the contribution limit for each of you is raised to $6,500, so long as your combined compensation is at least $13,000. If one spouse is under age 50 and one is age 50 or older at the end of 2017, the total contribution limit is $12,000 ($5,500 for spouse under age 50 plus $6,500 for spouse age 50 or more), provided your combined compensation is at least $12,000. This spousal IRA rule allows a spouse with minimal earnings to “borrow” compensation from his or her spouse in order to reach the maximum contribution limit. In figuring a couple’s combined compensation for purposes of the “borrowing” rule, the higher earning spouse’s compensation is reduced by his or her deductible IRA contribution and by any regular contributions made by the higher earning spouse to a Roth IRA for the year.

Deduction phaseout rule for spouses filing jointly for 2017. If either you or your spouse was an active participant (8.4) in an employer retirement plan during 2017, the phaseout rule may limit or completely disallow an IRA deduction. However, even if one or both of you were active participants in an employer plan, the phaseout rule does not apply and you may each deduct contributions up to the $5,500 limit ($6,500 if age 50 or older) if your 2017 joint return modified adjusted gross income (MAGI) (8.4) is $99,000 or less.

If both of you were active plan participants for 2017, the deduction limit begins to phase out if your joint return MAGI is more than $99,000 and no deduction is allowed for either of you if your 2017 joint return MAGI is $119,000 or more.

If you were not an active plan participant in 2017 but your spouse was, a different phaseout rule applies to each of you. Your spouse, as an active plan participant, is subject to the deduction phaseout if MAGI on the joint return is between $99,000 and $119,000; no deduction is allowed if MAGI is $119,000 or more. However, as the nonparticipant spouse, your deduction limit is not subject to phaseout unless MAGI on the joint return is over $186,000. Your deduction is phased out if joint MAGI is between $186,000 and $196,000, and no deduction is allowed if MAGI is $196,000 or more.

See 8.4 for an example of how the reduced deduction limit is figured if MAGI is within the above phaseout ranges.

Deduction phaseout rule for married persons filing separately for 2017. If you are married, live together at any time during 2017, file separately for 2017, and either of you was an active participant in an employer plan, the other spouse is also considered an active participant. Both of you are subject to the $0 to $10,000 MAGI deduction phaseout range (8.4).

If you live apart for all of 2017, you each figure IRA deductions as if single. Thus, the more favorable deduction phaseout range of $62,000 to $72,000 applies if you are covered by an employer retirement plan (8.4). If you are not covered, you may claim a full deduction on your separate return.

Contribution for nonworking or low-earning spouse under age 70½. If in 2017 you were age 70½ or over and had taxable compensation, and your spouse is under age 70½ at the end of the year, you may contribute to a spousal IRA for 2017 if you file a joint return and your spouse had little or no compensation; see the spousal IRA rules above. The entire contribution must be allocated to your nonworking spouse. No contribution may be made to your own traditional IRA for the year in which you reach age 70½, or any later year. However, you may contribute to a Roth IRA even if you are over age 70½, provided your compensation is within the Roth IRA limits (8.20).

8.4 IRA Deduction Restrictions for Active Participants in Employer Plan

If you are covered by an employer retirement plan, including a self-employed plan, you may be unable to make deductible IRA contributions to a traditional IRA. When you have coverage, your right to claim a full deduction, a limited deduction, or no deduction at all depends on your modified adjusted gross income (MAGI). If you are married, and your spouse has employer plan coverage for 2017 you are also considered to have coverage in most cases. However, if you file jointly and do not individually have employer plan coverage, a special MAGI phaseout rule may allow you to deduct IRA contributions even if a deduction for your spouse is limited or barred.

The deduction phaseout rules do not apply, regardless of your income, if you are unmarried and do not have employer plan coverage, or if you are married and neither of you has coverage. An IRA deduction of up to $5,500 ($6,500 if age 50 or older at end of year) for 2017 is allowed as long as you have compensation of at least $5,500 ($6,500 if age 50 or older) and you have not reached age 70½ by the end of the year.

Are you an active plan participant? Generally, you are considered to be “covered” by a retirement plan if you are an active participant in the plan for any part of the plan year ending within your taxable year. If you are an employee, your Form W-2 for 2017 should indicate whether you are covered for the year; if you are, the “Retirement plan” box within Box 13 of Form W-2 should be checked. Active participation (8.5) in a self-employed qualified plan or SEP (Chapter 41) is treated as employer plan coverage for purposes of the IRA deduction phaseout rules.

You are not an active plan participant but your spouse is. Even if you were not an active participant in an employer retirement plan at any time in 2017, your IRA deduction limit for 2017 may be phased out because of your spouse’s coverage. However, if you file jointly, your own deduction is not limited unless modified adjusted gross income (MAGI) on the 2017 joint return exceeds $186,000. For your spouse who has employer plan coverage, the rule is different: the phaseout threshold for his or her 2017 deduction is joint MAGI of $99,000, assuming you file jointly.

As a nonparticipant, you are not allowed any deduction if MAGI on your joint return is $196,000 or more. A deduction for your spouse as an active participant is completely phased out if joint return MAGI for 2017 is $119,000 or more.

Stricter phaseout rules apply to married persons filing separately if they live together at any time during the year. If you lived with your spouse at any time during 2017 and either of you was an active plan participant in 2017, you are both subject to the $0 – $10,000 MAGI phaseout range on separate returns. Neither of you may claim an IRA deduction if the MAGI on your separate return is $10,000 or more.

If you are married filing separately and you lived apart for all of 2017, your spouse’s plan participation does not affect your IRA deduction. Take into account only your own participation, if any, and if you are an active participant, your IRA deduction under the phaseout rules is figured as if you were single. If you are not an active participant, you may claim the full $5,500 deduction limit for 2017 ($6,500 if age 50 or older).

Modified adjusted gross income (MAGI) determines your deduction limit if you or your spouse is an active plan participant. If either you or your spouse is an active plan participant, you still may be allowed a full or limited 2017 deduction, but this will depend on whether your 2017 modified adjusted gross income (MAGI) is within the phaseout range that applies to you as shown below.

For purposes of figuring your IRA deduction limit, MAGI may be higher than the actual AGI reported on your return because certain deductions and exclusions are not taken into account. To get MAGI, you ignore IRA contributions and must add back to AGI:

• deduction claimed for student loan interest (33.13);
• deduction claimed for qualified college tuition and fees (33.12);
• deduction claimed for domestic production activities (40.23);
• exclusion claimed for employer-provided adoption assistance (3.6) ;
• exclusion claimed for interest on U.S. Savings Bonds used for tuition (33.4);
• exclusion claimed for foreign earned income (36.1), or a foreign housing exclusion or deduction (36.4).

Figuring Your 2017 IRA Deduction Under the Phaseout Rules

If you are an active plan participant for 2017, or you file a joint return for 2017 and your spouse was an active participant, the full $5,500 deduction limit (or $6,500 if age 50 or older by the end of the year) is available to you only if your modified adjusted gross income (MAGI) does not exceed the applicable phaseout threshold shown below. If you are an active plan participant, the deduction limit is phased out over the first $10,000 of MAGI exceeding the threshold unless you are married filing jointly or a qualifying widow/widower, in which case the phaseout range doubles to $20,000.

Phaseout threshold for 2017 returns. On your 2017 return, the $5,500 deduction limit (or $6,500 if age 50 or older by the end of the year) is phased out if modified adjusted gross income exceeds:

• $62,000 if you are single or head of household;
• $62,000 if you are married filing separately, you lived apart from your spouse for all of 2017, and you were an active plan participant during 2017. If you lived apart the entire year and you were not an active participant, you qualify for the full deduction limit; the phaseout rule is inapplicable to you even if your spouse was an active plan participant;
• $99,000 if you are married filing jointly and both you and your spouse were active plan participants during 2017, or you are a qualifying widow or widower and were an active plan participant during 2017;
• $99,000 if you are married filing jointly and you are an active plan participant during 2017 but your spouse was not. You use the $99,000 threshold; your spouse uses the $186,000 threshold;
• $186,000 if you are married filing jointly and you were not an active plan participant at any time during 2017 but your spouse was. You use the $186,000 threshold; your spouse uses the $99,000 threshold; and
• $0 if you are married filing separately, you lived with your spouse at any time in 2017, and either you or your spouse was an active plan participant during 2017. You and your spouse are both subject to the “0” threshold on your separate 2017 returns so long as you lived together at any time in 2017 and either of you was an active plan participant during the year.

Compute the deduction limit under the phaseout rule. If your MAGI is within the phaseout range shown in the middle column of Table 8-1, you are allowed a portion of the deduction limit. You can figure the limit in your case by applying the four steps of Worksheet 8-1 below. If you are married and both you and your spouse are contributing to traditional IRAs for 2017, you should separately figure your deduction limits, as each spouse may have a different phaseout threshold. The following Examples illustrate the computation.

Nondeductible contributions. Any contributions exceeding the amount allowed under the above rules may be treated as nondeductible IRA contributions (8.6). Alternatively, the excess may be contributed to a Roth IRA if allowed under the Roth IRA rules (8.20).

Figuring your IRA deduction if you receive Social Security benefits. If you or your spouse (8.3) is an active participant in an employer plan and either of you receives Social Security benefits, you need to make an extra computation before you can figure whether an IRA deduction is allowed. First follow the rules discussed in 34.3 to determine if part of your Social Security benefits would be subject to tax, assuming no IRA deduction were claimed. If none of your benefits would be taxable, you follow the regular rules above for determining IRA deductions. If part of your Social Security benefits would be taxable, MAGI for IRA purposes is increased by the taxable benefits. The allowable IRA deduction is then taken into account to determine the actual amount of taxable Social Security. IRS Publication 590-A has worksheets for making these computations.

8.5 Active Participation in Employer Plan

Active participants in an employer retirement plan are subject to the phaseout rules for deducting contributions (8.4). When a married couple files jointly and only one of the spouses was an active plan participant for the taxable year, a more favorable phaseout range applies to the non-participant spouse than to the spouse who was an active participant (8.4).

An employer retirement plan means:

1. A qualified pension, profit-sharing, or stock bonus plan, including a qualified self-employed retirement plan, SIMPLE IRA, or simplified employee pension (SEP) plan;
2. A qualified annuity plan;
3. A tax-sheltered annuity; and
4. A plan established for its employees by the United States, by a state or political subdivision, or by any agency or instrumentality of the United States or a state or political subdivision, but not eligible state Section 457 plans.

Form W-2. If your employer checks the “Retirement plan” box within Box 13 of your 2016 Form W-2, this indicates that you were an active participant in your employer’s retirement plan during the year. If you want to make a contribution before you receive your Form W-2, check the following guidelines and consult your plan administrator for your status.

Type of plan. Under any type of plan, if you are considered an active participant for any part of the plan year ending with or within your taxable year, you are treated as an active participant for the entire taxable year. Because of this plan year rule, you may be treated as an active participant even if you worked for the employer only part of the year. Under IRS guidelines, it is possible to be treated as an active participant in the year of retirement and even in the year after retirement if your employer maintains a fiscal year plan.

The plan year rule works differently for defined benefit pension plans than for defined contribution plans such as profit-sharing plans, 401(k) plans, money purchase pension plans, and stock bonus plans. These rules are discussed below.

If you are married, and either you or your spouse is treated as an active participant for 2016, see 8.3 for the effect on the other spouse.

Defined benefit pension plans. You are treated as an active participant in a defined benefit pension plan if, for the plan year ending with or within your taxable year, you are eligible to participate in the plan. Under this rule, as long as you are eligible, you are treated as an active participant, even if you decline participation in the plan or you fail to make a mandatory contribution specified in the plan. Furthermore, you are treated as an active participant even if your rights to benefits are not vested.

Defined contribution plan. For a defined contribution plan, you are generally considered an active participant if “with respect to” the plan year ending with or within your taxable year (1) you make elective deferrals to the plan; (2) your employer contributes to your account; or (3) forfeitures are allocated to your account. If any of these events occur, you are treated as an active participant for that taxable year, even if you do not have a vested right to receive benefits from your account.

8.6 Nondeductible Contributions to Traditional IRAs

If you are not allowed to deduct any IRA contributions for 2017 because of the phaseout rule (8.4), you may make nondeductible contributions of up to $5,500 ($6,500 if age 50 or over at the end of 2017) where you have compensation of at least that much and are not age 70½ older by the end of the year. If the deduction limit is reduced under the phaseout rules (8.4), you may make a nondeductible contribution to the extent the maximum contribution limit of $5,500 (or $6,500) exceeds the reduced deductible limit(8.4).

If you make contributions to a traditional IRA during the year, you may not know whether your active participation status (8.5) and modified adjusted gross income (MAGI) will permit you to claim a deduction under the phaseout rules in 8.4. You can make your contribution and wait until you file your return to determine if you are eligible for a deduction. Assume that you make a contribution and after the end of the year you determine that you are eligible for only a portion of the deductible amount under the phaseout rule (8.4). In that case, you can leave the nondeductible portion in a nondeductible traditional IRA (reporting it on Form 8606), or you may recharacterize (8.21) the nondeductible contribution as a Roth IRA contribution assuming you qualify to contribute to a Roth IRA (8.20). On the other hand, you may decide to withdraw the nondeductible contribution as discussed below.

Roth IRA alternative. If you are not barred from making Roth IRA contributions (8.20) because of your income level, the Roth IRA has advantages over the nondeductible traditional IRA. Although both types of plans allow earnings to accumulate tax free until withdrawal, the Roth IRA has advantages at withdrawal. After a five-year period, completely tax-free withdrawals of earnings as well as contributions may be made from a Roth IRA if you are age 59½ or older, you are disabled, or you withdraw no more than $10,000 for first-time home-buyer expenses (8.24). Even within the first five-year period, contributions (but not earnings) may be withdrawn tax free from a Roth IRA. On the other hand, withdrawals from a nondeductible traditional IRA are partially taxed if any deductible contributions to any traditional IRA were previously made. Even if only nondeductible contributions had been made, earnings from traditional IRAs are taxed at withdrawal. Furthermore, contributions after age 70½ may be made only to a Roth IRA, and mandatory required minimum distributions are not required from a Roth IRA, as they are from a traditional IRA. See the discussion of Roth IRAs in this chapter (8.19–8.25).

Form 8606. If you made a nondeductible contribution to a traditional IRA for 2017, you must report it on Form 8606 unless you withdraw the contribution as discussed below. You must list on Form 8606 the value of all of your IRAs as of the end of the year, including amounts based on deductible contributions. If you are married and you and your spouse both make nondeductible contributions, you must each file a separate Form 8606. A $50 penalty may be imposed for not filing Form 8606 unless there is reasonable cause. Furthermore, if you overstate the amount of designated nondeductible contributions made for any taxable year, you are subject to a $100 penalty for each such overstatement unless you can demonstrate that the overstatement was due to reasonable cause. You may file an amended return for a taxable year and change the designation of IRA contributions from deductible to nondeductible or nondeductible to deductible.

Withdrawing nondeductible contributions. If you make a contribution to a traditional IRA contribution for 2017 and later realize it is not deductible, you may recharacterize the contribution by transferring it (plus allocable income if any) to a Roth IRA, assuming your income is within the annual Roth IRA contribution limit (8.21).

If you do not want (or are ineligible) to recharacterize the traditional IRA contribution to a Roth IRA, you may make a tax-free withdrawal of the contribution by the filing due date (plus extensions), instead of designating the contribution as nondeductible on Form 8606. To do this, you must also withdraw the earnings allocable to the withdrawn contribution and include the earnings as income on your 2017 return. You might want to make the withdrawal if you incorrectly determined that a contribution would be deductible and you do not want to leave nondeductible contributions in your account. However, making the withdrawal could subject you to bank penalties for premature withdrawals, or other withdrawal penalties imposed by the IRA trustee. Furthermore, if you are under age 59½, the 10% premature withdrawal penalty applies to the withdrawn earnings unless one of the exceptions (8.12) is available.

8.7 Penalty for Excess Contributions to Traditional IRAs

If you contribute more than the allowable amount to a traditional IRA, whether deductible or nondeductible, the excess contribution may be subject to a penalty tax of 6%. The penalty tax is cumulative. That is, unless you correct the excess, you will be subject to another penalty on the excess contribution in the following year. The penalty tax is not deductible. The penalty is figured in Part III of Form 5329, which must be attached to Form 1040.

The 6% penalty may be avoided by withdrawing the excess contribution by the due date for your return, including extensions, plus any income earned on it. The withdrawn excess contribution is not taxable provided no deduction was allowed for it. The withdrawn earnings must be reported as income on your return for the year in which the excess contribution was made. The earnings should be reported to you as a taxable distribution on Form 1099-R. If you are under age 59½ (and not disabled) when you receive the income, the 10% premature withdrawal penalty applies to the income. Similar rules apply to withdrawals of excess employer contributions to a simplified employee pension plan (8.15) made by the due date for your return.

If an excess contribution for 2017 is not withdrawn by the due date (plus extensions) for your 2017 return, but you filed by the due date (with extensions), the IRS allows the withdrawal to be made no later than October 15, 2018, provided the related earnings are reported on an amended return that explains the withdrawal; see the Form 5329 instructions for details. If the withdrawal is not made, the 6% penalty will apply to your 2017 return but it may be avoided for 2018 by withdrawing the excess by the end of 2018. Instead of withdrawing the excess contribution during 2018, you may also avoid or at least reduce a penalty for 2018 by making an IRA contribution for 2018 that is less than the maximum allowable amount. That is, you reduce the 2018 IRA contribution by the excess contribution for the prior year; see IRS Publication 590-A and Form 5329 for details.

If you deducted an excess contribution in an earlier year for which total contributions were no more than the maximum deductible amount for that year, you may make a tax-free withdrawal of the excess by filing an amended return by the deadline (47.2) to correct the excess deduction. However, the 6% penalty tax applies for each year that the excess was still in the account at the end of the year.

See IRS Publication 590-A for further information on correcting excess contributions made in a prior year.

Roth IRAs. A similar 6% penalty applies on Form 5329 to excess contributions to a Roth IRA; see Form 5329 and IRS Publication 590-A for further details.

8.8 Distributions From Traditional IRAs

If all of your contributions to all of your traditional IRAs were deductible, any distribution from any of your traditional IRAs will be taxable unless you roll it over or redeposit it within 60 days (8.10). If you made both deductible and nondeductible contributions to your traditional IRAs (any of them), withdrawals allocable to the deductible contributions plus earnings are taxable and the balance allocable to the nondeductible contributions is tax free (8.9).

However, if you are age 70½ or older and you tell your IRA trustee to directly transfer up to $100,000 of deductible contributions and earnings from your IRA to a qualified charitable organization, this is treated as a qualified charitable distribution (QCD) that is not taxable to you and it offsets the required minimum distribution (8.13) you must receive for the year; see below for QCD details.

In addition to regular income tax, taxable distributions are also subject to these age-related restrictions:

• Distributions before age 59½ are subject to a 10% tax penalty, unless you are totally disabled, meet exceptions for paying medical costs, receive annual payments under an annuity-type schedule or you qualify for another exception (8.12).
• After you reach age 70½, you must start to receive annual distributions from your traditional IRAs under a life-expectancy calculation. The required starting date is the April 1 of the year after the year in which you reach age 70½. For example, if you reach age 70½ during 2017, you must start taking IRA distributions no later than April 1, 2018. Failure to take the annual required minimum distribution could result in penalties (8.13).

Conversion to Roth IRA. A conversion of a traditional IRA to a Roth IRA is generally treated as a fully taxed distribution from the traditional IRA (8.22).

Loan treated as distribution. If you borrow from your IRA account or use it as security for a loan, you generally are considered to have received your entire interest. Borrowing will subject the account or the fair market value of the contract to tax at ordinary income rates as of the first day of the taxable year of the borrowing. Your IRA account loses its tax-exempt status. If you use the account or part of it as security for a loan, the portion that is pledged is treated as a distribution. However, under the rollover rules, a short-term loan may be made by withdrawing IRA funds and redepositing them in an IRA within 60 days, subject to the once-a-year rollover rule (8.10).

IRS seizure of IRA treated as distribution. The Tax Court has held that an IRS levy of an IRA to cover back taxes is a taxable distribution to the account owner, even though the funds are transferred directly from the account to the IRS and not actually received by the owner. Where the owner is under age 59½, the 10% penalty for early withdrawals (8.12) does not apply to involuntary distributions attributable to an IRS levy.

How to report IRA distributions on your 2017 return. All IRA distributions are reported to you and to the IRS on Form 1099-R (7.1). Form 1099-R must be attached to your return only if federal tax has been withheld. You can avoid withholding by instructing the payer not to withhold using Form W-4P or a substitute form.

If you have never made nondeductible contributions, your IRA withdrawals are fully taxable and should be reported on Line 15b of Form 1040 or Line 11b of Form 1040A. If you have made deductible and nondeductible contributions, complete Form 8606 to figure the nontaxable and taxable portions (8.9). Then you report the total IRA withdrawal on Line 15a of Form 1040 or Line 11a of Form 1040A and enter only the taxable portion on Line 15b or Line 11b, respectively.

If you have an individual retirement annuity, your investment in the contract is treated as zero so all payments are fully taxable. Distributions from an endowment policy due to death are taxed as ordinary income to the extent allocable to retirement savings; to the extent allocable to life insurance, they are considered insurance proceeds.

Proceeds from U.S. retirement bonds (which were issued by the Treasury before May 1982) are taxable in the year the bonds are redeemed. However, you must report the full proceeds in the year you reach age 70½ even if you do not redeem the bonds.

See below for reporting qualified charitable distributions (QCDs).

Qualified Charitable Distribution by IRA Owner Age 70½ or Older

If you are at least age 70½, you can avoid tax on transfers made directly from your traditional IRA to an eligible charity, up to an annual exclusion limit of $100,000. To be a qualified charitable distribution (QCD) eligible for the exclusion, the transfer must be made directly by the trustee of your traditional IRA to a qualifying charity that is eligible to receive tax-deductible donations (this excludes a “supporting organization” or donor-advised fund). The QCD rules apply only to traditional IRAs, and not to distributions from SIMPLE IRAs, qualified employer plans, or SEPs (including salary-reduction SEPs set up before 1997). If your spouse is also at least age 70½ and instructs the trustee of his or her traditional IRA to make a qualifying direct transfer, you can each claim the up-to-$100,000 exclusion; thus, on a joint return, up to $200,000 is potentially excludable.

Because a QCD is not included in adjusted gross income (up to the $100,00 limit), the exclusion may help you limit the taxability of Social Security benefits (34.3), limit exposure to the 3.8% tax on net investment income (28.3), increase deductibility of unreimbursed medical expenses (17.1), and preserve eligibility for the $25,000 loss allowance under the passive loss rules (10.2).

A QCD counts towards the required minimum distribution (8.13) that you must otherwise receive from your IRAs for the year. You cannot claim a charitable deduction for the amount of the QCD excluded from income.

Make sure that you get a timely written acknowledgment from the charity. You need the same type of acknowledgment that you have to get to substantiate a donation exceeding $250 under the charitable contribution deduction rules (14.14).

If you authorize a QCD and there were any nondeductible contributions to any of your traditional IRAs, the QCD is deemed to come first out of the part of the distribution that otherwise would be taxable (without the QCD rules)—that is, the amount equal to your deductible contributions plus earnings. The part of the distribution equal to the deductible contributions plus earnings is the amount eligible for the QCD exclusion, up to the $100,000 limit. Any balance of the transfer is deemed to be a transfer of nondeductible contributions and is nontaxable. You must file Form 8606 (8.9) to report a distribution of nondeductible contributions and to figure your remaining basis in the IRAs: your pre-distribution basis is reduced by the portion of the distribution that is not considered part of the QCD because it is allocable to nondeductible contributions.

How to report a QCD. A QCD must be reported as an IRA distribution on Line 15 of Form 1040 or Line 11 of Form 1040A. The total transfer is shown on Line 15a (or Line 11a). If the entire QCD is excludable from income, enter “0” on Line 15b (or Line 11b) as the taxable amount. Also enter “QCD” next to Line 15b (or 11b). If part of the QCD was allocable to nondeductible contributions reported on Form 8606, that part is not taxable and is not entered on Line 15b (or Line 11b).

If you itemize deductions on Schedule A (Form 1040), any portion of the transfer allocable to nondeductible contributions can be claimed as a charitable contribution. No charitable deduction is allowed for the excludable part of the QCD (deductible contributions plus earnings).

8.9 Partially Tax-Free Traditional IRA Distributions Allocable to Nondeductible Contributions

If you ever made a nondeductible contribution to a traditional IRA, you must file Form 8606 to report a 2017 distribution from any of your traditional IRAs, even if the distribution is from an IRA to which only nondeductible contributions were made. All of your traditional IRAs are treated as one contract. If you receive distributions from more than one traditional IRA in the same year, they are combined for reporting purposes on Form 8606.

When you have made nondeductible as well as deductible contributions to traditional IRAs, any distribution from any of the traditional IRAs will be treated partly as a tax-free return of cost basis in the nondeductible contributions, and partly as a taxable distribution of deductible contributions and earnings. In other words, the part of your withdrawal that is allocable to your nondeductible contributions is tax-free; any balance is taxable. You may not claim that you are withdrawing only your tax-free contributions, even if your withdrawal is less than your nondeductible contributions. The six steps below reflect the IRS method used on Form 8606 to figure the nontaxable and taxable portions of the IRA distributions.

The rule requiring you to combine nondeductible and deductible IRAs when making IRA withdrawals does not apply to withdrawals from a Roth IRA; do not combine your traditional and Roth IRAs. Roth IRAs are treated separately. After a five-year period, withdrawals after age 59½ from a Roth IRA are completely tax-free (8.23).

A bank or other payer of a distribution from a traditional IRA will not indicate on Form 1099-R whether any part of a distribution is a tax-free return of basis allocable to nondeductible contributions. It is up to you to keep records that show the nondeductible contributions you have made. IRS instructions require you to keep copies of all Forms 8606 on which nondeductible contributions have been designated, as well as copies of (1) your tax returns for years you made nondeductible contributions to traditional IRAs; (2) Forms 5498 showing all IRA contributions and showing the value of your IRAs for each year you received a distribution; and (3) Form 1099-R (or previously used Form W-2P) showing IRA distributions. According to the IRS, you should keep such records until you have withdrawn all IRA funds.

Figuring the taxable portion of a traditional IRA distribution. If you received a distribution from a traditional IRA in 2017 and have ever made nondeductible contributions to any of your traditional IRAs, follow Steps 1–6 to determine the tax-free and taxable portions of the 2017 distribution. These steps assume that you did not convert a traditional IRA to a Roth IRA during 2017. If you did convert a traditional IRA to a Roth IRA, follow the instructions to Form 8606.

Deductible IRA loss based on unrecovered nondeductible contributions. According to the IRS, a loss is allowed if all IRA funds have been distributed and you have not recovered your basis in nondeductible contributions. However, the loss must be claimed as a miscellaneous itemized deduction subject to the 2% of adjusted gross income floor on Schedule A, Form 1040.

8.10 Tax-Free Direct Transfer or Rollover From One Traditional IRA to Another

You may switch how your traditional IRA funds are invested without incurring tax on a distribution by rolling over a distribution to another IRA within 60 days of receiving it, although another option, a direct transfer, is a more advantageous way of changing IRA investments, as discussed below.

Distributions from inherited IRAs are subject to separate rules. A surviving spouse beneficiary who withdraws funds from an inherited IRA can do a 60-day rollover (see below), but a nonspouse beneficiary cannot roll over a withdrawal. However, a nonspouse beneficiary as well as a surviving spouse beneficiary can make a direct trustee-to-trustee transfer to another traditional IRA (8.14).

Direct transfer from one IRA to another. A direct transfer is made by instructing the trustee (or custodian) of a traditional IRA to transfer all or part of your account to another IRA trustee (or custodian). Direct transfers are tax free because you do not receive the funds. With a direct transfer, there is no risk of missing the 60-day deadline for rolling over a withdrawal into a new IRA. There is also no need to worry about making multiple transfers within the same 12-month period if you use direct transfers. The tax law does not require a waiting period between direct transfers, whereas rollovers are subject to a once-a-year limitation, as discussed below.

For example, assume you have a traditional IRA at Bank “A” and decide to switch your account to Mutual Fund “ABC.” The mutual fund will provide you with transfer request forms that you complete and return to the fund, which will then forward the forms to the bank; the bank will process the request and then transfer the funds to the fund to complete the direct transfer. The transfer from the bank to the mutual fund is tax free. Because the IRA funds were not paid to you, the transfer is not considered a rollover subject to the once-a-year rollover limitation. This means that if within one year you become unhappy with the performance of Mutual Fund “ABC,” you may make another tax-free direct transfer of your IRA to Fund “XYZ” or to Bank “B.”

Rollover within 60 days. If you withdraw funds from your traditional IRA, you have 60 days to make a tax-free rollover to another traditional IRA. The amount you receive from your old IRA must be transferred to the new plan by the 60th day after the day you received it. Amounts not rolled over within the 60-day period must be treated as a taxable distribution for the year you received the distribution (not the year in which the 60-day period expired, if that is later) unless the IRS waives the 60-day deadline (see below). If the distribution is taxed and you were under age 59½ when the distribution was made, the 10% penalty for an “early” distribution applies unless a penalty exception (8.12) is available.

The IRS may waive the 60-day rollover deadline on equitable grounds if a distribution cannot be rolled over on time because of events beyond your reasonable control, such as illness, natural disaster, or a financial institution’s error; see the IRS waiver guidelines below.

There are two other possible grounds for an extension of the 60-day rollover deadline. An extension is allowed if your distribution is “frozen” and cannot be withdrawn from an insolvent or bankrupt financial institution.The deadline is extended to 120 days if a distribution is taken to buy or build a qualifying “first home” and the deal falls through. These extensions are discussed below.

Caution: Once you complete a rollover between traditional IRAs, you must wait one year before you can make another tax-free rollover; see below.

IRS may waive 60-day rollover deadline on equitable grounds. You may be able to obtain a waiver of the 60-day rollover deadline in one of three ways:

1. You qualify for an automatic waiver. The IRS will automatically waive the deadline if: (a) you deposited the rollover funds with a financial institution within the 60-day period, (b) you followed all of the institution’s rollover procedures but the rollover account was not established on time solely because of the institution’s error, and (c) the funds were actually deposited in a valid rollover account within one year of the start of the 60-day period.
2. You use the self-certification procedure for a waiver where you missed the 60-day deadline because of one or more of 11 reasons recognized by the IRS, as described below.
3. You apply for a waiver by requesting a private letter ruling and showing that your failure to meet the 60-day deadline was due to reasons beyond your reasonable control. However, a $10,000 user fee must be submitted with the ruling request.

Self-certification procedure for getting waiver of 60-day deadline. The IRS has provided rules (Revenue Procedure 2016-47) that extend the time for completing a rollover if you “self-certify” that you meet specified conditions. The IRS could later question your eligibility, but the procedure allows you and the IRA trustee that receives your transfer after the 60-day period to treat it as a valid rollover.

Conditions for self-certification. You can use this procedure if you give a written certification (see below) to the IRA trustee that you meet all of the following three conditions:

1. You were not previously denied a waiver request for a rollover of this distribution by the IRS.
2. You have a good reason for missing the 60-day deadline. There are 11 acceptable reasons:
   1. An error was made by the financial institution making the distribution or receiving the rollover transfer.
   2. You misplaced and never cashed the distribution check.
   3. You deposited the distribution in an account you mistakenly thought was an eligible retirement plan.
   4. Your principal residence was severely damaged.
   5. A member of your family died.
   6. You or a member of your family was seriously ill.
   7. You were incarcerated.
   8. You were subject to restrictions imposed by a foreign country.
   9. There was a postal error.
   10. The distribution was made on account of an IRS levy and the proceeds have been returned to you.
   11. The party making the distribution delayed providing information required by the receiving IRA despite your efforts to obtain it.
3. You completed the rollover as soon as practicable. This test is considered met if you satisfy a 30-day safe harbor, which applies when the funds are rolled over within 30 days after you are no longer subject to the condition that prevented a timely rollover.

Written self-certification required. To make the self-certification, you must give the IRA trustee (the trustee of the IRA to which you are making the late transfer) a signed letter stating that you intended to make the rollover within 60 days of receiving the distribution but were unable to do so because of one or more of the 11 reasons shown above (condition 2), and that conditions 1 and 3 were also met. You can use the model letter in the Appendix to Rev. Proc. 2016-47, or a letter that is substantially similar. Keep a copy of the certification with your records.

Unless the IRA trustee has actual knowledge that you are not eligible for the self-certification, the trustee may rely on your written notification for purposes of accepting the late transfer as a timely rollover and reporting it as a rollover on Form 5498 (“IRA Contribution Information”). On Form 5498, the IRA trustee will report the amount of the late rollover for which self-certification was made in Box 13a (“Postponed Contribution”), and in Box 13c (“Code”), code “SC” will be entered.

Caution: the IRS may question your self-certification. This self-certification process does not require you to provide documentation to the IRA trustee about the circumstance that made you eligible for the waiver. You may report the transfer on your return as a valid rollover (therefore not taxable) unless the IRS has informed you otherwise. However, if you are audited and the IRS questions the waiver, then it is up to you to prove that you met the conditions for the self-certification.

Note that even if you do not self-certify, the IRS could grant a waiver for equitable reasons on an audit of your return.

Frozen deposits in insolvent financial institutions. The 60-day limit for completing a rollover is extended if the funds are “frozen” and may not be withdrawn from a bankrupt or insolvent financial institution. The 60-day period is extended while the account is frozen and you have a minimum of 10 days after the release of the funds to complete the rollover.

If a government agency takes control of an insolvent bank, you might receive an “involuntary” distribution of your IRA account from the agency. According to the IRS and Tax Court, such a payment is subject to the regular IRA distribution rules. For example, a couple received payment for their $11,000 IRA balance from the Maryland Deposit Insurance Fund after the bank in which the funds were invested became insolvent. The Tax Court held that the payment was taxable, even though the distribution was from a state insurance fund and not from the bank itself. Furthermore, since they were under age 59½, the 10% penalty for early distributions (8.12) was imposed, even though the distribution was involuntary. The tax and penalty could have been avoided by making a rollover of the distribution within 60 days, but this was not done.

120-day rollover period after failure to acquire “first-time” home. A “first-time” homebuyer may be able to limit or avoid a 10% penalty for a distribution before age 59½ by using the funds within 120 days to help buy, build, or rebuild a principal residence (8.12). If the requirements of the exception cannot be met because the planned purchase or construction of the home falls through, the law allows the taxpayer to return the distribution to an IRA within 120 days after receiving the distribution. The recontribution is not taken into account for purposes of the once-a-year rollover limit discussed above. The extension of the tax-free rollover period from 60 days to 120 days is automatic if the requirements are met; a waiver of the 60-day deadline (as discussed above) from the IRS is not required. For example, a taxpayer withdrew IRA funds to buy a home and would have qualified as a “first-time” homebuyer, but his offer was rejected by the seller and approximately 72 days after the IRA withdrawal he put the amount of the distribution back into his IRA. The IRS in a private ruling held that the recontribution to the IRA was timely under the special 120-day rollover rule.

Only One IRA Rollover is Allowed Within Any 12-Month Period

If you receive an IRA distribution and within 60 days of receiving it you rolled it over to the same IRA or to another IRA, you cannot roll over another distribution from any of your IRAs within the 12-month period starting on the date you received the first distribution. A second tax-free rollover within the 12-month period is not allowed even if the proceeds of the second distribution are redeposited into the same IRA from which the distribution was made. Note that if you receive a distribution and roll it over at a later date within the 60-day rollover period, the 12-month period begins on the date that the distribution was received, not the later rollover date.

For purposes of the one-rollover-per year limitation, all of your traditional IRAs, Roth IRAs, SEP,s and SIMPLE IRAs are aggregated as if they were one IRA. Only one rollover from any of these accounts is allowed within a 12-month period. Thus, if you make a rollover from one traditional IRA to another, you cannot make a rollover between Roth IRAs within the same 12-month period. Similarly, if a rollover is made from one Roth IRA to another, you cannot make a rollover from one traditional IRA to another within the same 12-month period. However, conversions from a traditional IRA to a Roth IRA are not limited; see below.

If within 12 months of making an IRA-to-IRA rollover you receive an IRA distribution and attempt to roll it over, the distribution will be taxable to the extent it is allocable to pre-tax contributions plus earnings (there is no tax on any portion allocable to after-tax contributions), and if you are under age 59½, the 10% early distribution penalty will apply unless you qualify for a penalty exception (8.12). Furthermore, the failed rollover will be treated as an excess contribution subject to a 6% penalty unless it is withdrawn (8.7).

Conversions to Roth IRA are not limited. A rollover or a direct transfer from a traditional IRA to a Roth IRA is treated as a taxable distribution (8.22) and thus it is not subject to the one-per-year limit on tax-free rollovers. Within the same 12-month period, you can make one or several taxable conversions of traditional IRAs to Roth IRAs and still make one tax-free IRA rollover.

Direct transfers are not limited. You can make a trustee-to-trustee from one IRA to another in order to change your IRA investment as often as you would like without limitation. Since the funds do not pass through your hands, a trustee-to-trustee transfer is not a “rollover” and therefore is not subject to the one-rollover-per year limitation. If you receive a check for a distribution from the transferring IRA trustee that is payable to the receiving IRA trustee (not to you) and you deliver the check to the new trustee, this is considered a trustee-to-trustee transfer.

Recharacterizations not counted as rollovers. If you make a timely recharacterization of a traditional IRA contribution to a Roth IRA, or a Roth IRA contribution to a traditional IRA, the recharacterization is not treated as a rollover for purposes of the one-rollover-a-year limit (8.21).

8.11 Transfer of Traditional IRA to Spouse at Divorce

If you receive your former spouse’s IRA pursuant to a divorce decree or written instrument incident to the decree, the transfer is not taxable to either of you. From the date of transfer the account is treated as your IRA. If you are legally separated, a transfer of your spouse’s IRA to you is tax free if made under a decree of separate maintenance or written instrument incident to the decree. The transferred account is then treated as your IRA.

How to make a divorce-related transfer. If you are required to transfer IRA assets from your account to your spouse or former spouse by a decree of divorce or separate maintenance, or a written instrument incident to such a decree, use one of these transfer methods to avoid being taxed on the transfer: (1) change the name on the IRA from your name to the name of your spouse or former spouse if you are transferring your entire interest in the IRA, or (2) direct your IRA trustee to transfer the IRA assets directly to the trustee of a new or existing IRA in the name of your spouse or former spouse.

If you simply withdraw money from your IRA and pay it to your spouse, you will be treated as having received a taxable distribution from your IRA. If you are under age 59½, you will be subject to the 10% early distribution penalty (unless an exception applies; see 8.12) as well as regular tax on the withdrawal.

QDRO transfer of spouse’s employer plan benefits to your IRA. If you receive your share of your spouse’s or former spouse’s benefits from an employer plan under a qualified domestic relations order (QDRO), you can make a tax-free rollover to a traditional IRA or another eligible retirement plan so long as it would have been eligible for rollover had your spouse received it (7.12). If you roll over only part of a qualifying QDRO distribution, you figure the tax on the retained portion by taking into account a prorated share of your former spouse’s cost investment.

8.12 Penalty for Traditional IRA Withdrawals Before Age 59½

If you receive a taxable distribution from a traditional IRA (8.8) before you are age 59½, you have to pay a 10% penalty in addition to regular tax on the distribution, unless you qualify for a penalty exception specified in the tax law. There is no general exception for financial hardship. Although you may be forced in tough economic times to tap your IRA to cover living expenses, or you face a family emergency, you will be able to avoid the early distribution penalty only if you fit within one of the designated penalty exceptions, such as for disability, paying substantial medical expenses, or higher education expenses.

Here is the list of allowable penalty exceptions: (1) you take the distribution because you are totally disabled, (2) you pay medical expenses exceeding 10% (or 7½ %; see 17.1) of adjusted gross income, (3) you receive unemployment compensation for at least 12 consecutive weeks and pay medical insurance premiums, (4) you pay qualified higher education expenses, (5) the distribution is $10,000 or less and used for qualified first-time home-buyer expenses, (6) you receive a qualified reservist distribution, (7) the distribution is one of a series of payments being made under one of several annuity-type methods, (8) the distributions are made to you as a beneficiary of a deceased IRA owner, or (9) the distribution was due to an IRS levy on your IRA. These exceptions are further discussed below.

Also note that a qualifying rollover (8.10) of an IRA distribution is not subject to tax and therefore not subject to the 10% penalty even if you are under age 59½.

The penalty is 10% of the taxable IRA distribution. For example, if before age 59½ you withdraw $3,000 from your traditional IRA, you must include the $3,000 as part of your taxable income and, in addition, pay a $300 penalty tax. If part of a pre-59½ distribution is tax free because it is allocable to nondeductible contributions (8.9) or rolled over to another IRA (8.10), the 10% penalty applies only to the taxable portion of the distribution.

If you do not owe the penalty because you qualify for an exception, you may have to file Form 5329, depending on whether the payer of the distribution correctly marked the exception in Box 7 of Form 1099-R. If you qualify for the annuity-method exception and the payer correctly indicated that exception by marking Code 2 in Box 7, you do not have to file Form 5329. Similarly, if you are the beneficiary of a deceased IRA owner and the payer has correctly noted that with Code 4 in Box 7, you do not have to file Form 5329 to claim the exception.

If you qualify for the disability exception, the medical expenses exception, or the higher education expenses exception (see below), it is unlikely that the payer will know of that fact and thus the penalty exception code will probably not be marked in Box 7 of Form 1099-R (Code 3 for disability exception, Code 5 for medical expenses, Code 8 for higher education expenses). In that case, you must file Form 5329 to claim the exception. You also must file Form 5329 if the annuity method or beneficiary exception applies but it is not coded in Box 7 of Form 1099-R.

If part of your distribution is eligible for a penalty exception, you must enter the exception code on Form 5329 and figure the 10% penalty on the nonqualifying part. The penalty is entered on Line 59 of Form 1040 (“Additional Tax on IRAs, Other Qualified Plans, etc.”).

Beneficiaries. Beneficiaries are exempt from the pre–age 59½ penalty. If the IRA owner was not your spouse and you liquidate the account and receive the proceeds, or if you receive annual payments as a beneficiary under the inherited IRA rules (8.14), any distributions you receive before age 59½ are not subject to the early distribution penalty, although they are subject to regular income tax.

If you inherit an IRA from your deceased spouse and elect to treat it as your own IRA as discussed in 8.14, you are not eligible for the beneficiary exception; distributions from the account before you reach age 59½ will be subject to the penalty unless another exception applies. The beneficiary exception applies if the account is maintained in the name of your deceased spouse and you are receiving the distribution according to the rules for a spousal beneficiary (8.14).

Disability exception. To qualify for the disability exception, you must be able to show that you have a physical or mental condition that can be expected to last indefinitely or result in death and that prevents you from engaging in “substantial gainful activity” similar to the type of work you were doing before the condition arose.

In one case, a 53-year-old stockbroker claimed that his IRA withdrawal of over $200,000 should be exempt from the 10% penalty because he suffered from mental depression. However, the Tax Court upheld the IRS imposition of the penalty because he continued to work as a stockbroker.

Medical expense exception. If you withdraw IRA funds in a year in which you pay deductible medical costs (17.1), part of the distribution may avoid the pre–age 59½ penalty. The penalty does not apply to the part of the distribution equal to the expenses over your AGI floor (17.1)). The distribution must be received in the same year that the medical expenses are paid. The medical costs must be eligible for the itemized medical deduction (17.2), but the IRA penalty exception applies whether you itemize or claim the standard deduction.

Unemployed person’s medical insurance exceptions. There is no general penalty exception for being unemployed. However, if you are unemployed and received unemployment benefits under Federal or state law for at least 12 consecutive weeks, you may make penalty-free IRA withdrawals to the extent of medical insurance premiums paid during the year for you, your spouse, and your dependents. The withdrawals may be made in the year the 12-week unemployment test is met, or in the following year. However, the penalty exception does not apply to distributions made more than 60 days after you return to the work force.

Self-employed persons who are ineligible by law for unemployment benefits may be treated as meeting the 12-week test, and thus eligible for the exception, under regulations to be issued by the IRS.

Higher education expenses exception. A penalty exception is allowed for IRA distributions that do not exceed higher education expenses, including graduate school costs, for you, your spouse, your or your spouse’s children, or your or your spouse’s grandchildren that you paid during the year of the IRA distribution. Eligible expenses include tuition, fees, books, supplies, and equipment that are required for enrollment or attendance, plus room and board for a person who is at least a half-time student.

The penalty exception applies only if the withdrawal from the IRA and the payment of the qualified higher education expenses occur within the same year. For example, in one case, a taxpayer under age 59½ took IRA distributions in 2001 to pay credit card debt incurred in 1999 and 2000 to pay qualified higher education expenses for those years. Another taxpayer under age 59½ took IRA distributions in 2002 and used them to pay qualified expenses incurred in 2003 and 2004. In both cases, the Tax Court agreed with the IRS that the penalty exception was not available because the IRA withdrawals were not made in the same year that the qualified higher education expenses were incurred.

First-time home-buyer expense exception. A penalty exception is allowed for up to $10,000 of qualifying “first-time” home-buyer expenses. You are a qualifying first-time home-buyer if you did not have a present ownership interest in a principal residence in the two-year period ending on the acquisition date of the new home. If you are married, your spouse also must have had no such ownership interest within the two-year period. The penalty does not apply to IRA distributions that are used within 120 days to buy, construct, or reconstruct a principal residence for you, your spouse, child, grandchild, or ancestor of you or your spouse. Qualifying home acquisition costs include reasonable settlement, financing, or other closing costs. If you qualify, the exception applies only for $10,000 of home-buyer expenses. This is a lifetime cap per IRA owner and not an annual limit.

If you take a distribution, intending to use it for home acquisition costs that would qualify for the first-time buyer exception, but the transaction falls through, you have 120 days from the date you receive the distribution to roll it back to an IRA (8.10).

IRS levy. The 10% penalty does not apply to an “involuntary” distribution due to an IRS levy on your IRA.

Qualified reservist distribution. If you are a member of the reserves called to active military duty for over 179 days, or indefinitely, distributions received during the active duty period are not subject to the early distribution penalty. Furthermore, a qualified reservist distribution may be recontributed to the plan within two years after the end of your active duty period without regard to the regular limits on IRA contributions (8.2). A recontribution is not deductible.

Annuity Schedule Payments Avoid 10% Penalty

You may avoid the penalty if you are willing to receive annual distributions under one of the three IRS-approved annuity-type methods discussed in this section. Before arranging an annuity-type schedule, consider these points: all of the payments will be taxable (unless allocable to nondeductible contributions (8.9)), and if you do not continue the payments for a minimum number of years, the IRS will impose the 10% penalty for all taxable payments received before age 59½, plus interest charges. The minimum payout period rules do not apply to totally disabled individuals or to beneficiaries of deceased IRA owners.

The payments must continue for at least five years, or until you reach age 59½, whichever period is longer. Thus, if you are in your 40s, you would have to continue the scheduled payments until you are age 59½. If you are in your mid-50s, the minimum payout period is not as serious a burden, as you only need to continue the scheduled payments for at least five years, starting with the date of the first distribution, provided that the period ends after you reach age 59½.

During this minimum period, the arranged annuity-type schedule generally may not be changed unless you become disabled. For example, taking a lump-sum distribution of your account balance before the end of the minimum payout period would trigger the retroactive penalty, plus interest charges. The penalty is triggered even if the change in distribution methods is made after you reach age 59½. However, the IRS may allow a reduction in payments during the minimum period, such as where part of an IRA has been transferred to an ex-spouse following a divorce. Also, as discussed below, the IRS allows a one-time irrevocable switch from the fixed amortization method or fixed annuitization method to the required minimum distribution method. After the minimum payout period, you can discontinue the payments or change the method without penalty.

Three approved payment methods. If you would like to take advantage of this penalty exception, you may apply one of the following three payout methods that have been approved by the IRS. With each method, you must receive at least one distribution annually. Under Method 1, the payment changes annually based on the value of the account. Under Methods 2 and 3 the annual payment is generally fixed when the payments begin, but in private rulings the IRS has approved payment schedules that from inception recalculate the amount to be withdrawn each year. Methods 2 and 3 require the assistance of a tax professional and financial advisor to plan the series of payments. The IRS allows taxpayers receiving payments under Method 2 or 3 to reduce the required annual amount without penalty by switching to Method 1.

1. Required minimum distribution method. This is the easiest method to figure but provides smaller annual payments than the other methods. Figure the annual withdrawal by dividing your account balance by your life expectancy or by the joint life and last survivor expectancy of you and your beneficiary.

   For example, assume that in 2018 you will be age 50 and need to begin receiving distributions from your IRA, which has a balance of $100,000 at the beginning of the year. If you use your single life expectancy, you may take a penalty-free payment of $2,924 in 2018 ($100,000 account balance ÷ 34.2 life expectancy). Single life expectancy is shown in Table 8-5, Beneficiary’s Single-Life Expectancy Table (8.14).

   If instead of using your single life expectancy you used the joint life and last survivor expectancy of you and your beneficiary, the annual penalty-free amount would be smaller given the longer joint life expectancy. For example, if your beneficiary was age 45, your joint life and last survivor life expectancy would be 43.2 years (using ages 50 and 45), and the penalty-free withdrawal $2,315 ($100,000 account balance ÷ 43.2). See Table 8-2 for a sample section of the IRS joint life and last survivor life expectancy table. The full IRS table showing joint life and last survivor life expectancy is in IRS Publication 590-B and can also be obtained from your IRA trustee.

2. Fixed amortization method. Under this method, you amortize your IRA account balance like a mortgage, using the same life expectancy as under Method 1 (your single life expectancy or the joint life and last survivor expectancy of you and your beneficiary). The interest rate used must be no more than 120% of the federal mid-term rate for either of the two months immediately preceding the month in which distributions begin. In private rulings, the IRS has approved proposed payment schedules that annually recalculate the payments to be received under the fixed amortization method. See Revenue Ruling 2002-62 for further details on this method.
3. Fixed annuitization method. This method is similar to the fixed amortization method, but an annuity factor from a mortality table is used. Revenue Ruling 2002-62 provides the mortality table to be used. The maximum interest rate used cannot exceed 120% of the federal mid-term rate for either of the two months immediately preceding the month in which distributions begin. In private rulings, the IRS has approved proposed payment schedules that annually recalculate the payments to be received under the fixed annuitization method.

8.13 Mandatory Distributions From a Traditional IRA After Age 70½

The tax law requires that by April 1 of the year following the year in which you reach age 70½, you have to start receiving on an annual basis minimum distributions from your traditional IRAs under a schedule that meets IRS tests. The distributions will be fully taxable unless some of your IRA contributions were nondeductible (8.8). You cannot avoid tax on a required minimum distribution (RMD) by rolling it over to another account. However, by authorizing a qualified charitable distribution (QCD), you can satisfy your RMD requirement while avoiding tax on the distribution (8.8).

If you do not receive the required minimum amount, a penalty tax of 50% applies (unless the IRS waives it) to the difference between the amount that should have been received and the amount you did receive. Assume that, under the rules discussed below, your RMD is $3,818, but you do not receive it. You would be subject to a penalty of $1,909 (50% of $3,818), assuming the IRS does not waive it. If you received only $3,000, you would have to pay a penalty of $409, 50% of the $818 shortfall, unless the IRS waives the penalty.

If you are subject to a penalty, you should figure it on Form 5329, which must be attached to Form 1040. You can request a waiver of the penalty on Form 5329 if the failure to receive the proper amount was due to a reasonable error and you have or have or will make up for the shortfall; follow the Form 5329 instructions.

IRA owners and beneficiaries figure required minimum distributions (RMDs) differently. The RMD rules for account owners of traditional IRAs are discussed in this section (8.13). Beneficiaries of traditional IRAs also must receive annual RMDs unless their entire share of the account is received by the end of the year after the year of the owner’s death. However, beneficiaries must use different rules to figure their RMDs (8.14).

Roth IRA owners (8.19) are not subject to RMD rules, but beneficiaries of Roth IRAs are (8.24).

Deadline for receiving your first required minimum distribution (RMD). Your “required beginning date,” the date by which you must receive your first RMD, is April 1 of the year following the year in which you reach age 70½. Thus, if you reached age 70½ in 2017, you must take your first RMD from your traditional IRA (the RMD for 2017) by April 1, 2018, assuming you did not receive the RMD during 2017. The April 1 deadline applies only to your first RMD. This means that if you reached age 70½ in 2017, your second RMD, the RMD for 2018, will have to be received by December 31, 2018, so if you delay your first RMD until early 2018 (but no later than April 1), you will have to take two distributions in 2018, one by April 1 (the RMD for 2017) and the other by December 31 (the RMD for 2018). This could substantially increase your 2018 taxable income. The RMD for each later year must be received by December 31 of that year.

Figuring Your Required Minimum Distribution (RMD)

The trustee or custodian of your traditional IRA must calculate the amount of your required minimum distribution or offer to do so. If you are required to receive a required minimum distribution (RMD) for 2017, the trustee or custodian should have reported the amount to you by February 1, 2017, or offered to calculate it upon your request. If you are required to receive an RMD for 2018, the IRA trustee or custodian must tell you what your RMD is by January 31, 2018, or offer to calculate it for you upon your request. The calculation is based on final IRS regulations.

To calculate the RMD for yourself, you can use Steps 1–3 below, which are based on the final IRS regulations.

If the IRA trustee or custodian calculates the RMD, the calculation may be based on the Uniform Lifetime Table (Table 8-3 below), which assumes that your beneficiary is 10 years younger than you are. However, if your sole beneficiary is your spouse who is more than 10 years younger than you, your RMD can be reduced by using the Joint Life and Last Survivor Expectancy Table (see Table 8-4). If this more-than-10-years-younger spousal exception applies and your IRA trustee or custodian does not use the Joint Life and Last Survivor Expectancy Table in calculating your RMD, you can do so yourself by calculating the RMD under Steps 1–3 below.

* This is a sample of the Joint Life and Last Survivor Expectancy Table shown in IRS Publication 590-B. Use this table to figure your required minimum distribution only if your spouse is your sole beneficiary and he or she is more than 10 years younger than you are; see “Exception for younger spouses” in 8.13. Find your age (as of your birthday for the year you are making the computation) on the horizontal line and your spousal beneficiary’s age in the vertical column. For example, if you are age 74 and your spousal beneficiary is 63, the life expectancy factor is 24.5 years. If your age or your spouse’s age is not shown here, refer to IRS Publication 590-B.

Steps for figuring your required minimum distribution (RMD). For each of your traditional IRAs, figure the required minimum distribution (RMD) you must receive using the following steps. Keep in mind that once you have separately determined the RMD for each IRA, the IRS allows you to withdraw the total RMD for the year from any of the accounts in any combination you choose.

Step 1: Find the account balance of your IRA as of the previous December 31. The account balance to be used for figuring a required minimum distribution (RMD) is the account balance as of the end of the year before the year for which you are figuring the RMD. Thus, if you reach age 70½ during 2018, the account balance to be used for figuring your first required minimum distribution (RMD), the RMD for 2018, is the account balance as of December 31, 2017. Use the year-end 2017 balance even if you delay taking the RMD for 2018 until the first quarter of 2019 (January 1–April 1).

The year-end account balance must be adjusted if toward the end of the year there is an outstanding rollover. For example, if in December of 2017 you withdrew funds from your IRA and you rolled the funds back to the same IRA or a different one within 60 days (8.10) but not until early in 2018, the rollover amount must be included as part of the December 31, 2017 account balance of the receiving IRA, even though it was not actually in either account on that date.

Step 2: Divide the account balance (Step 1) by the applicable life expectancy. Your life expectancy under the IRS rules is taken from the Uniform Lifetime Table unless your sole beneficiary is your spouse who is more than 10 years younger than you are. The Uniform Lifetime Table (Table 8-3) provides a joint life expectancy for you and a “deemed” beneficiary who is exactly 10 years younger than you are. Your beneficiary’s actual age does not matter. The life expectancy period from the uniform table applies even if you have not named a beneficiary as of your required beginning date (April 1 of the year after the year you reach age 70½). Furthermore, you continue to use the Uniform Lifetime Table even if you change your beneficiary or beneficiaries after starting to receive RMDs, unless the change results in the naming of your spouse as sole beneficiary for the entire year and you qualify to use the Joint Life and Last Survivor Expectancy Table (Table 8-4) because your spouse is more than 10 years younger than you are.

Your “deemed” life expectancy from the Uniform Lifetime Table is the number of years listed next to your age on your birthday in the year for which you are making the computation. For example, if you are figuring your RMD for 2018, and you are age 71 on your birthday in 2018, your life expectancy from the table, based on age 71, is 26.5 years. When you figure your RMD for 2019, you will use a life expectancy of 25.6 years, the life expectancy from the Uniform Lifetime Table for someone age 72.

Exception for younger spouses. If the sole beneficiary of your IRA is your spouse and he or she is more than 10 years younger than you are, do not use the Uniform Lifetime Table (Table 8-3 below) to get your life expectancy for Step 2. Use the actual joint life expectancy of you and your spouse, which will allow you to spread out RMDs over an even longer period. See Table 8-4, which has a sample section of the Joint Life and Last Survivor Expectancy Table from IRS Publication 590-B.

This rule applies only if your spouse meets the age test and is the sole beneficiary of your entire interest in the IRA at all times during the calendar year for which the RMD is being figured. If your spouse is named beneficiary during the year or he or she is one of several beneficiaries on the account, the Uniform Lifetime Table must be used for that year. Your spouse would not meet the sole beneficiary test. However, if you are married on January 1 of a year and during the year you divorce or your spouse dies, you are considered married for the entire year and may use the spousal exception to figure that year’s RMD using the joint life table(Table 8-4).

If this exception for younger spouse beneficiaries applies, find your joint life expectancy from the IRS table corresponding to both of your ages on your birthdays for the year of the computation. For example, if you are age 71 on your birthday in 2018 and your spouse on his or her birthday in 2018 is age 58, use a joint life expectancy of 28.6 years (see Table 8-4) to figure your RMD for 2018. This is longer than the 26.5-year distribution period provided by the Uniform Lifetime Table (Table 8-3) for a 71-year-old, which means that your RMD will be somewhat lower.

Step 3: If you have more than one traditional IRA, total the required minimum distributions (RMDs) for all the accounts. After separately figuring the required minimum distribution (RMD) for each of your IRAs under Step 2, total the amounts. This is the minimum you must receive for the year; you are, of course, free to withdraw more than that. Although you must calculate the RMD separately for each account, you do not have to make withdrawals from each of them. The total RMD from all accounts may be taken from any one account, or more than one account if you prefer. For example, if you have five bank IRAs, you may take the entire RMD from the bank where you have the largest balance, or from any other combination of banks; see Example 3 below. The entire distribution is taxable unless part is allocable to nondeductible IRA contributions (8.9).

8.14 Inherited Traditional IRAs

Although inheritances are generally tax free (11.4), distributions that you receive as a beneficiary of a traditional IRA are taxable. However, if the account owner made nondeductible contributions to the account, distributions allocable to those contributions on Form 8606 are tax free under the rules at 8.9. Taxable distributions that you receive as a beneficiary before you reach age 59½ are not subject to the 10% penalty for early distributions (8.12).

Surviving spouses. A surviving spouse who is the sole beneficiary of a deceased spouse’s IRA may elect to treat the account as his or her own IRA by designating himself or herself as the account owner. By becoming the IRA owner, the surviving spouse determines his or her required minimum distributions (RMDs) under the regular owner rules (8.13), rather than under the beneficiary rules discussed in this section. A surviving spouse (whether or not the sole beneficiary) who does not become owner of the deceased spouse’s IRA and who receives a distribution from the IRA may roll it over within 60 days to his or her own IRA (8.10). These rules for surviving spouse beneficiaries are discussed further at the end of this section (8.14).

Nonspouse beneficiaries. A nonspouse beneficiary may not elect to be treated as the owner or make a rollover. However, the IRS allows a nonspouse beneficiary to make a trustee-to-trustee transfer of the IRA to another financial institution as long as the IRA into which the funds are moved is set up and maintained in the name of the deceased IRA owner for the benefit of the nonspouse beneficiary. Whether or not the account is transferred, a nonspouse beneficiary must receive required minimum distributions (RMDs) under the beneficiary rules below. The financial institution holding the account will change the Social Security number on the account from the deceased owner’s number to the number of the beneficiary for purposes of tracking RMDs. However, a nonspouse beneficiary must make sure that the deceased owner’s name remains on the account. Putting the account in the nonspouse beneficiary’s name would be treated by the IRS as a prohibited rollover, resulting in a taxable distribution, as if the beneficiary had received a total distribution of his or her share of the IRA. For example, if Jane Smith dies on March 4, 2018, and her brother John is her IRA beneficiary, the account should be retitled to indicate that Jane has died and that the IRA is now being held for the benefit of (FBO) John as beneficiary, with wording such as this: “Jane Smith, deceased March 4, 2018 , IRA FBO John Smith, Beneficiary.”

Beneficiaries must receive required minimum distributions (RMDs) annually. Beneficiaries of a traditional IRA must receive a required minimum distribution (RMD) from the inherited account for each year after the year of the IRA owner’s death. This includes a surviving spouse who elects to receive distributions from an inherited traditional IRA as a beneficiary rather than treating the IRA as her or his own.

If you are the “designated beneficiary” as determined under the final IRS regulations discussed below, RMDs may be spread over your life expectancy (see Table 8-5). You must receive the first RMD by the end of the year following the year of the IRA owner’s death. The RMD for each subsequent year must be received by December 31 of that year. If the RMD for a year is not received, you are subject to a penalty tax of 50% on the difference between the required minimum amount and the amount actually received, unless the IRS waives the penalty. Of course, you are not limited to the RMD. You may withdraw more than the annual RMD amount or even withdraw your entire interest in the account should you want the funds. Keep in mind that whatever you receive will be taxable except to the extent that it is allocable to nondeductible contributions made by the deceased account owner.

Who Is the Designated Beneficiary?

The maximum life expectancy period over which required minimum distributions (RMDs) may be extended generally depends on the identity of the “designated beneficiary” as of September 30 of the year following the year of the owner’s death. Any individual who is a beneficiary as of the date of the owner’s death can be a “designated” beneficiary, whether he or she is selected as beneficiary by the IRA owner or is selected under the terms of the plan, but for purposes of determining the maximum period over which RMDs can be paid, there can be only one “designated beneficiary” for each inherited traditional IRA. Where multiple individuals are co-beneficiaries, the oldest beneficiary is treated as the designated beneficiary unless the IRA is split into separate accounts; see the rules for multiple beneficiaries below.

Under the final IRS regulations, the determination of the designated beneficiary is not made until September 30 of the year following the year of the IRA owner’s death. However, despite the September 30 rule, an exception allows multiple individual beneficiaries to separate their accounts and use their individual life expectancies to figure their RMDs, provided the separate accounts are established by December 31 of the year following the year of the owner’s death; see the discussion of the separate account rule below.

A beneficiary named through an estate, either under the owner’s will or by state law, cannot be a designated beneficiary for RMD purposes. An estate or a charity cannot be a designated beneficiary. Trust beneficiaries may qualify if certain tests are met, as discussed below.

The delay in determining the designated beneficiary does not mean that new beneficiaries can be added after the owner’s death. However, after the account owner’s death and prior to the September 30 determination date, a beneficiary named as of the date of death can be eliminated by means of the beneficiary’s qualified disclaimer or distribution of the beneficiary’s benefit. A beneficiary’s interest can be cashed out by the September 30 determination date, leaving the balance to other co-beneficiaries named by the owner. For example, if a charity and an individual are named as co-beneficiaries, and the charity’s interest is cashed out by the September 30 determination date, the remaining beneficiary can use his or her life expectancy to figure RMDs.

Qualified disclaimer. A qualified written disclaimer made no later than nine months after the IRA owner’s death can be used by an older primary beneficiary to pass all or part of an IRA to a younger contingent beneficiary. The disclaimer, made by the September 30 determination date, leaves the younger beneficiary as the designated beneficiary, thereby allowing required minimum distributions to be spread out over his or her longer life expectancy. Of course, a younger primary beneficiary may also disclaim in favor of an older contingent beneficiary. An estate may not disclaim its interest in order to create a designated beneficiary.

One of the requirements for a qualified disclaimer is that the person making the disclaimer must not have accepted the property prior to the disclaimer. The IRS in Revenue Ruling 2005-36 held that this rule does not prevent a beneficiary from making a disclaimer after taking the RMD for the year of the death (where the owner dies before receiving it). The act of taking the RMD is treated as an acceptance of that portion of the property, plus the income attributable to the distribution. However, after receiving the RMD, the beneficiary may make a qualified disclaimer (by the nine-month deadline) of all or part of the balance of the account, except for the income allocable to the RMD. The disclaimed amount and the income allocable to the disclaimed amount must either be paid outright to the successor beneficiary entitled to receive it following the disclaimer or be segregated in a separate IRA for the benefit of that beneficiary. See Revenue Ruling 2005-36 for further details.

Multiple individual beneficiaries can split IRA into separate accounts. If a traditional IRA has several beneficiaries as of the September 30 determination date, all of whom are individuals, the general rule under the regulations is that the oldest beneficiary is considered to be the designated beneficiary, and that person’s life expectancy, which will be shorter than that of the other benficiaries, is the period over which all the beneficiaries must receive required minimum distributions (RMDs). This result can be avoided by splitting the IRA into separate IRAs, one for each beneficiary, with each beneficiary getting his or her separate share of the account, as listed in the IRA document. Each beneficiary can then spread distributions over his or her individual life expectancy. Keep in mind that non-spouse beneficiaries may not do a rollover (as discussed at the beginning of 8.14), so nonspouse beneficiaries must use trustee-to-trustee transfers to set up the separate accounts, rather than withdrawing funds and redepositing them into separate accounts, which would be a prohibited rollover, resulting in a taxable distribution of the beneficiary’s entire share of the IRA .

If the IRA account owner did not split the account into separate IRAs, the regulations allow the beneficiaries to do so by December 31 of the year after the year of the owner’s death. If the account is split in the year following the year of the owner’s death by the December 31 date, each beneficiary may compute RMDs (for the year following the year of the owner’s death and also for later years) using his or her own life expectancy, which, depending on a particular beneficiary’s age, could be much more advantageous than having to use the life expectancy of the oldest beneficiary. For example, if the IRA owner dies in 2018 and the beneficiaries split the account into separate accounts by December 31, 2019 (the year after the year of the owner’s death), then each beneficiary would compute his or her RMD for 2019 by following the regular rules for beneficiaries, as shown above in the Todd and Fred Johnson example. That is, each beneficiary would figure his or her RMD for 2019 (their first RMD) by finding their life expectancy, based on his/her age in 2019, in Table 8-5 (Single Life Expectancy Table), and dividing that life expectancy into his or her share of the account balance as of the end of 2018 (the year of the owner’s death). For each subsequent year that initial life expectancy is reduced by one year, and the reduced life expectancy is divided into the account balance as of the end of the preceding year to figure that year’s RMD. Although the regulations allow the beneficiaries to use their individual life expectancies if the IRA is split by December 31 of the year after the year of the owner’s death, it is advisable not to wait until the last minute, in order to avoid the possibility that a problem may arise that could prevent the splitting of the account by the December 31 deadline.

Estate or charity is named beneficiary or there is individual and non-individual beneficiary for same account. If as of the September 30 determination date there is a non-individual beneficiary other than a qualifying trust, or there is a non-individual beneficiary as well as one or more individual beneficiaries, the owner is treated as not having a designated beneficiary. If the owner’s death was on or after his or her required beginning date (April 1 of the year after the year age 70½ is reached), the regulations require RMDs to be made over the owner’s remaining life expectancy. Use the owner’s life expectancy as of his or her birthday in the year of death and reduce it by one year for each subsequent year. For example, assume an 80-year-old IRA owner received his RMD for 2017 in mid-2017 and then died later in the year, leaving the IRA to his estate. The owner’s life expectancy in 2017 was 10.2 years (Table 8-5 life expectancy for 80-year old), and that would be reduced by one, to 9.2 years, to figure the RMD for 2018 that the estate must receive. If the account balance at the end of 2017 was $200,000, the RMD for 2018 would be $21,739 ($200,000 ÷ 9.2).

The 5-year rule applies if the owner died before the required beginning date (April 1 of the year after the year age 70½ is reached) without a designated beneficiary. Under the 5-year rule, the entire account must be distributed by the end of the fifth year following the year of death. No distribution has to be received before that fifth year. For example, if a 68-year old IRA owner dies in 2017, leaving his IRA to his estate, the entire account must be distributed by the end of 2022.

If a charity or the IRA owner’s estate is a co-beneficiary of the IRA along with one or more individuals, there is an advantage to the individual beneficiaries of having the interest of the charity or estate paid out in full before September 30 of the year after the year of the IRA owner’s death. This would leave only the individual beneficiary or beneficiaries as of the September 30 determination date. A single individual beneficiary could then use his or her own life expectancy to figure RMDs. Multiple individual co-beneficiaries have until the end of that year (December 31 of the year after the year of the owner’s death) to split the inherited IRA into separate accounts, thereby allowing them to base RMDs on their own life expectancies.

Trust as beneficiary. If a trust is named the beneficiary of the account, the trust beneficiaries may be treated as designated beneficiaries if certain tests are met. The trust must be valid under state law and be irrevocable or become irrevocable upon the account owner’s death. The beneficiaries who are entitled to receive the trust’s interest in the inherited IRA must be identifiable from the trust instrument. Documentation of the trust beneficiaries must be provided to the IRA trustee or plan administrator. The deadline under the regulations for providing the documentation is October 31 of the year following the year of the owner’s death. However, even if the required conditions are met, the regulations do not allow separate accounts to be created for the trust beneficiaries. All of the trust beneficiaries must receive RMDs over the life expectancy of the oldest beneficiary.

If the required conditions are not met, then the owner is treated as not having a designated beneficiary and the rules discussed above for an estate or charity apply. That is, the IRA must be paid out either: (1) under the five-year rule if the IRA owner died before the required beginning date, or (2) over the remaining life expectancy of the deceased owner if death was on or after the required beginning date.

If a trust is a co-beneficiary of an IRA along with one or more individuals, and the interest of the trust is distributed before the September 30 determination date, the individual beneficiaries may be able to use their own life expectancies in figuring RMDs, as discussed above where a charity or the owner’s estate is a co-beneficiary.

Beneficiary’s death before September 30 determination date. If an individual named as a beneficiary by the account owner dies after the owner but before the September 30 date for determining the designated beneficiary, that individual continues to be treated as a designated beneficiary under the final regulations. This means that the remaining life expectancy of the deceased beneficiary must be used by his or her successor beneficiary, whether that successor was named by the original beneficiary or under the terms of the original beneficiary’s estate.

Did IRA Owner Die Before His/Her Required Beginning Date or On or After the Required Beginning Date?

The distribution period for beneficiaries may depend on whether the IRA owner died before his or her required beginning date, or on or after the required beginning date, which is April 1 of the year that the owner reached or would have reached age 70½ (8.13).

Owner’s death on or after required beginning date. If an owner dies on or after the required beginning date (April 1 of the year after the year the owner reaches age 70½), and there is a designated beneficiary, required minimum distributions (RMDs) are generally payable over the beneficiary’s life expectancy. However, if on the date of the owner’s death the designated beneficiary is older than the owner, the final regulations allow the beneficiary to receive RMDs over the owner’s remaining life expectancy rather than over the beneficiary’s shorter life expectancy. If there is no “designated” beneficiary, as when the owner’s estate is named as the beneficiary, RMDs are based upon the deceased owner’s remaining life expectancy.

If the owner did not receive his or her RMD for the year of death, the beneficiary must receive that amount in the year of death or as soon as possible in the next year. The beneficiary must receive the RMD that the owner was required to receive for the year of death (under the owner RMD rules, 8.13); the owner’s age as of his or her birthday in the year of death is used to figure the RMD even if the owner died earlier in the year.

The first RMD to a designated beneficiary must be received by the beneficiary in the year following the year of the owner’s death. The RMD is figured by dividing the year-end account balance for the year of death by the designated beneficiary’s life expectancy in the year following the year of death, taken from the Beneficiary’s Single Life Expectancy Table (Table 8-5). To figure the RMDs for later years, the designated beneficiary reduces his or her initial life expectancy by one for each succeeding year, and that reduced life expectancy is divided into the account balance as of the end of the prior year . The Example at the beginning of 8.14 (Todd and Fred Johnson) illustrates how the beneficiary’s RMD computations are made.

Successor beneficiaries. If the designated beneficiary dies before receiving the balance of the inherited IRA, the successor beneficiary may not start a new RMD schedule based upon his or own life expectancy. The successor must use the remaining life expectancy of the designated beneficiary. For example, assume a 47-year-old designated beneficiary figures his first RMD (for the year after the year of the IRA owner’s death) using his initial life expectancy of 37 years (Table 8-5 for 47-year- old), and he dies after receiving two more RMDs. The successor beneficiary “steps into the shoes” of the designated beneficiary and continues to reduce the designated beneficiary’s life expectancy each year just as the designated beneficiary would have. Thus, the successor beneficiary would use a remaining life expectancy of 34 years to figure his or her first RMD and would continue to reduce it by one each year until the IRA is completely distributed or the declining life expectancy is used up.

Owner’s death before required beginning date. If an owner dies before the required beginning date and there is an individual designated beneficiary, the period for receiving required minimum distributions (RMDs) is generally the life expectancy of the designated beneficiary. The computation of required minimum distributions under the life expectancy method is explained above under “Owner’s death on or after required beginning date.” The life expectancy method is the “default” rule under the final regulations, so the designated beneficiary automatically gets the benefit of the life expectancy method unless he or she elects the five-year rule.

For an individual designated beneficiary, there is no advantage to electing the five-year rule. Under the five-year rule, the entire account must be distributed by the end of the fifth year after the year of the owner’s death. The beneficiary is allowed but not required to take any distribution for any year prior to that fifth year. For example, if the IRA owner dies in 2017 at age 58 (before required beginning date), and the designated beneficiary elects the five-year rule, he or she must receive the entire account by December 31, 2022; no distribution must be received before 2022. Even if the beneficiary plans to withdraw the entire account within the five-year period, that result can be achieved with the life expectancy method, which provides the flexibility to spread distributions over the longer life expectancy period, while allowing the beneficiary to accelerate distributions however he or she wishes, including taking the entire account at any time within a few years after the owner’s death.

As noted above, the five-year rule is mandatory if the owner dies before the required beginning date and there is no designated beneficiary, as is the case where the owner’s estate is the beneficiary.

Special Rules for Surviving Spouses

A surviving spouse may take advantage of rules not available to nonspouse beneficiaries.

Surviving spouse’s rollover or election to treat IRA as his or her own. A surviving spouse who is the sole beneficiary of an IRA with unlimited withdrawal rights may elect to treat the IRA as his or her own by retitling the IRA in his or her name. If the surviving spouse contributes to the IRA or does not receive a timely RMD under the beneficiary rules (December 31 of the year after the year of the deceased owner’s death), the surviving spouse is deemed to have made the election. The final regulations confirm that to make the election, the surviving spouse must take the RMD for the year of the owner’s death (if any) to the extent that it was not received by the owner.

A surviving-spouse beneficiary may make a spousal rollover from the deceased spouse’s IRA, either by authorizing a direct transfer (trustee-to-trustee) to an IRA in the surviving spouse’s name, which is the preferable method, or by rolling over a distribution within 60 days of receiving it to his or her own IRA (8.10). However, if the deceased IRA owner did not receive the RMD for the year of death, the surviving spouse must receive and pay tax on that RMD; that amount cannot be rolled over (or directly transferred).

If the surviving spouse elects to treat the inherited IRA as his or her own or makes a spousal rollover, the surviving spouse is then subject to the same rules as any IRA owner. The surviving spouse should immediately name a new beneficiary for the IRA. The regular distribution rules apply, including the 10% penalty for taxable distributions received before age 59½ (8.8). If the surviving spouse is under age 70½, RMDs may be delayed until April 1 of the year following the year in which he or she reaches age 70½, at which time his or her RMDs will be based on the Uniform Lifetime Table for owners (8.13).

Surviving spouse as sole beneficiary. If the surviving spouse does not elect to treat an inherited IRA as his or her own, and does not make a spousal rollover, the surviving spouse must receive required minimum distributions (RMDs) as a beneficiary . A surviving spouse who is under age 59½ and needs the funds from the IRA may prefer this option because withdrawals, although taxable (unless allocable to nondeductible contributions made by the deceased spouse), are not subject to the 10% penalty for pre-59½ distributions (8.12).

If the surviving spouse is the sole designated beneficiary, RMDs are based on his or her life expectancy from the Beneficiary’s Single Life Expectancy Table (Table 8-5). Each year, life expectancy is recalculated using the spouse’s attained age during the year. A spousal beneficiary is the only beneficiary who may recalculate life expectancy. Others must reduce their life expectancy from Table 8-5 for the year after the year of the owner’s death by one year in each succeeding year.

If a surviving spouse is the sole designated beneficiary and the deceased spouse died before the year in which he or she would have reached age 70½, the surviving spouse does not have to begin receiving RMDs until the year that the deceased spouse would have reached age 70½.

Even if a surviving spouse begins receiving RMDs under the beneficiary rules, the surviving spouse may make a spousal rollover to his or her own IRA (8.10), excluding the RMD for the year, which must be received and reported as income as it is not eligible for rollover. As noted earlier, it is advisable to make a spousal rollover by authorizing a direct trustee-to-trustee transfer, rather than taking a distribution and doing a 60-day rollover (8.10), as the direct tansfer avoids concerns over missing the 60-day deadline and it is not treated as a rollover subject to the once-a-year rollover limitation.

8.15 SEP Basics

A simplified employee pension plan (SEP) set up by an employer allows the employer to contribute to an employee’s IRA account more money than is allowed under regular IRA rules. For 2017, your employer generally could contribute and deduct up to 25% of your compensation or $54,000, whichever is less. Your employer’s SEP contributions are excluded from your pay and are not included on Form W-2 unless they exceed the limit. If contributions exceed the limit, the excess is included in your gross income and a 6% penalty tax may be imposed unless the excess (plus allocable income) is withdrawn by the due date of the return, plus extensions (8.7). If you are under age 59½, the 10% early distribution penalty may apply to the withdrawal of income earned on the excess contributions (8.12).

Self-employed plans. Self-employed individuals may set up a SEP as an alternative to a self-employed retirement plan; see Chapter 41.

Eligibility. A SEP must cover all employees who are at least age 21, earn over $600 (this amount may get an inflation adjustment for 2018), and who have worked for the employer at any time during at least three of the past five years. Union employees covered by union agreements may generally be excluded.

SEP salary-reduction arrangements. If a qualifying small employer set up a salary-reduction SEP before 1997, employees may contribute a portion of their pay to the plan instead of receiving it in cash (8.16).

SEP distributions. Distributions from a SEP, including salary-reduction SEPs established before 1997, are subject to the regular distribution rules for traditional IRAs (8.8).

8.16 Salary-Reduction SEP Set Up Before 1997

Qualifying small employers may offer employees the option of deferring a portion of their salary to an IRA. There are two types of salary-reduction IRAs, with different eligibility and contribution rules: (1) salary-reduction SEPs established before 1997 and (2) “SIMPLE” IRA accounts established after 1996.

After 1996, an employer may establish a SIMPLE plan but not a salary-reduction SEP. Rules for SIMPLE IRAs established after 1996 are at 8.17–8.18. A salary-reduction SEP that was established before 1997 may continue to receive contributions under the prior law rules discussed below, and employees hired after 1996 may participate in the plan, subject to those rules.

Salary-reduction SEPs established before 1997. Salary reductions are allowed for a year only if the employer had no more than 25 employees eligible to participate in the SEP at any time during the prior taxable year. Furthermore, at least 50% of the eligible employees must elect the salary-reduction option, and the deferral percentage for highly compensated employees may not exceed 125% of the average contribution of regular employees.

If salary reductions are allowed, the maximum salary-reduction contribution under the law for 2017 was $18,000 ($24,000 for participants age 50 or older if the plan permitted the extra deferral), although a lower limit may be imposed by the plan terms. These are the same limits as for 401(k) plans (7.18). Deferrals over $18,000 ($24,000 if extra deferral for participants age 50 or older was allowed) are taxable, and if not timely distributed to the employee, can be taxed again when distributed from the plan. The deferral limits for 2018 will be in the e-Supplement at jklasser.com.

If an employee contributes to both a SEP and a 401(k) plan, the annual limit applies to the total salary reductions from both plans. If an employee makes salary-reduction contributions to a SEP and also to a tax-sheltered annuity plan (7.21), the annual limit generally applies to the total salary reductions to both plans. In some cases, employees with at least 15 years of service may be able to defer an additional $3,000 to the tax-sheltered annuity plan (7.21).

8.17 Who Is Eligible for a SIMPLE IRA?

A SIMPLE IRA is a salary-reduction retirement plan that qualifying small employers may offer their employees. For 2017, the maximum salary-reduction contribution was $12,500, or $15,500 for participants age 50 or older (by the end of 2017) if the plan allowed the additional contributions. See the e-Supplement at jklasser.com for the 2018 limits. Employers are required to make matching contributions or a flat contribution (8.18).

Qualifying employers. A SIMPLE IRA may be maintained only by an employer that (1) in the previous calendar year had no more than 100 employees who earned compensation of $5,000 or more and (2) does not maintain any other retirement plan (unless the other plan is for collective bargaining employees). A self-employed individual who meets these tests may set up a SIMPLE IRA, as discussed in Chapter 41. A simple IRA must be maintained on a calendar-year basis.

In determining whether the 100-employee test is met for the prior year, all employees under the common control of the employer must be counted. For example, Joe Smith owned two businesses in 2016, a computer rental company with 80 employees and a computer repair company with 60 employees. If they all earned at least $5,000, they all count towards the 100 limit, so if Joe decides in 2017 to set up a retirement plan for his businesses, a different type of plan must be used. He may not establish a SIMPLE IRA for either business under the 100-employee limit.

If a SIMPLE IRA is established but the employer in a later year grows beyond the 100-employee limit, the employer generally has a two-year “grace period” during which contributions may continue to be made.

Eligible employees. In general, an employee must be allowed to contribute to a SIMPLE IRA for a year in which he or she is reasonably expected to earn $5,000 or more, provided at least $5,000 of compensation was received in any two prior years, whether or not consecutive. If the employer owns more than one business (under common control rules) and sets up a SIMPLE IRA for one of them, employees of the other business must also be allowed to participate if they meet the $5,000 compensation tests. Employees who are covered by a collective bargaining agreement may be excluded if retirement benefits were the subject of good-faith negotiations.

The employer may lower or eliminate the $5,000 compensation requirement in order to broaden participation in the plan. No other conditions on eligibility, such as age or hours of work, are permitted.

Deadline for setting up a SIMPLE IRA. An employer generally may establish a SIMPLE IRA effective on any date between January 1 and October 1 of a year. If the employer (or a predecessor employer) previously maintained a SIMPLE IRA, a new SIMPLE IRA may be effective only on January 1 of a year. A new employer that comes into existence after October 1 of a year may establish a SIMPLE IRA for that year if the plan is established as soon as administratively feasible after the start of the business.

The employer may use a model SIMPLE IRA approved by the IRS to set up a SIMPLE IRA. Form 5304-SIMPLE allows employees to select a financial institution to which the contributions will be made. With Form 5305-SIMPLE, the employer selects the financial institution to which contributions are initially deposited, but employees have the right to subsequently transfer their account balances without cost or penalty to another SIMPLE-IRA at a financial institution of their own choosing. Use of the IRS model forms is optional; other documents satisfying the statutory requirements for a SIMPLE IRA may be used.

SIMPLE IRA contributions and distributions. Contributions and distributions to SIMPLE IRAs are subject to limitations (8.18).

8.18 SIMPLE IRA Contributions and Distributions

The only contributions that may be made to a SIMPLE IRA are elective salary-reduction contributions by employees and matching or non-elective contributions by employers. All contributions are fully vested and nonforfeitable when made.

Regardless of compensation, eligible employees (8.17) may elect each year to make salary-reduction contributions to the plan up to the annual SIMPLE IRA limit (8.17). Salary-reduction contributions are excluded from the employee’s taxable pay on Form W-2 and not subject to federal tax withholding. They are subject to FICA withholding for Social Security and Medicare tax.

Eligible employees must be given notice by the employer of their right to elect salary-reduction contributions and at least 60 days to make the election. After the first year of eligibility, the election to defer for the upcoming year is made during the last 60 days (at minimum) of the prior calendar year. If the employer uses model IRS Form 5304-SIMPLE or 5305-SIMPLE, a notification document is included.

If an employee contributes to a SIMPLE IRA and also to a 401(k) plan, 403(b) or salary-reduction SEP of another employer for the same year, the salary-reduction contributions to the SIMPLE IRA count toward the overall annual limit on tax-free salary-reduction deferrals (7.17). Deferrals over the annual limit are taxable and must be removed to avoid being taxed again when distributed from the plan (7.18).

Employer contributions. Each year, the employer must make either a matching contribution or a fixed “non-elective” contribution. If the employer chooses matching contributions, the employee’s elective salary-reduction contribution generally must be matched, up to a limit of 3% of the employee’s compensation. For up to two years in any five-year period, the 3% matching limit may be reduced to as low as 1% for each eligible employee.

Instead of making either the 3% or reduced (between 1% and 3%) limit matching contribution, the employer may make a “non-elective” contribution equal to 2% of each eligible employee’s compensation. If this option is chosen, the 2% contribution must be made for eligible employees whether or not they elect to make salary-reduction contributions for the year. The 2% contribution is subject to an annual compensation limit, which for 2017 was $270,000. Thus, for 2017, the maximum 2% non-elective contribution was $5,400 (2% of $270,000) even if an employee earned more than $270,000. The 3% matching contribution is not subject to the annual compensation limit, but only to the annual salary-reduction limit (8.17). The employer must notify eligible employees of the type of contribution it will be making for the upcoming year prior to the employees’ 60-day election period for making elective salary-reduction contributions. The employer must make the matching or non-elective contributions by the due date for filing the employer’s tax return (plus extensions) for the year.

Distributions from a SIMPLE IRA. A distribution from a SIMPLE IRA is fully taxable unless a tax-free rollover or trustee-to-trustee transfer is made. The penalty for distributions before age 59½ (8.12) is increased to 25% from 10%, assuming no penalty exception applies, if the distribution is received during the two-year period starting with the employee’s initial participation in the plan. After the first two years, the regular 10% penalty applies.

In the initial two-year period, a tax-free rollover or direct trustee-to-trustee transfer (8.10) of a SIMPLE IRA may be made to another SIMPLE IRA. After two years of participation, a tax-free rollover or direct transfer may be made to a traditional IRA, qualified plan, 403(b) plan, or state or local government 457 plan, as well as to a SIMPLE IRA. The mandatory distribution rules that apply to regular IRAs after age 70½ also apply to SIMPLE IRAs (8.13).

8.19 Roth IRA Advantages

As with traditional IRAs, earnings accumulate within a Roth IRA tax free until distributions are made. The key benefit of the Roth IRA is that tax-free withdrawals of contributions may be made at any time and earnings may be withdrawn tax free after a five-year holding period by an individual who is age 59½ or older, is disabled, or who pays qualifying first-time home-buyer expenses.

A Roth IRA can provide attractive retirement planning and estate planning opportunities. Although annual contributions to a traditional IRA are barred once you reach age 70½ (8.2), contributions to a Roth IRA are allowed after age 70½, provided you have taxable compensation for the year and your modified adjusted gross income does not exceed the annual limitation under the phaseout rule (8.20). Also, the minimum required distribution rules that apply to traditional IRAs after age 70½ (8.13) do not apply to Roth IRAs. Thus, a Roth IRA can remain intact after age 70½ and continue to grow tax free. The balance of the account not withdrawn during the owner’s lifetime generally may be paid out to the beneficiaries tax free over their life expectancies, thereby providing a substantial tax-deferred buildup within the plan over an extended period (8.24).

A Roth IRA is funded by making annual nondeductible contributions (subject to the income phaseout rule at 8.20), by converting a traditional IRA, SEP or SIMPLE IRA, or rolling over a distribution from an employer plan, but the conversion or rollover to the Roth IRA is treated as a taxable transfer, as discussed at 8.21.

Your employer can set up a “deemed Roth IRA” as a separate account under a qualified retirement plan. As long as the separate account otherwise meets the Roth IRA rules, you can make voluntary employee contributions that will be subject only to the Roth IRA rules. A deemed IRA can also be set up as a traditional IRA (8.1).

8.20 Annual Contributions to a Roth IRA

You may make a nondeductible Roth IRA contribution, regardless of your age, for a year in which you have taxable compensation for personal services and your modified adjusted gross income (MAGI) does not exceed the upper end of the phaseout range for your filing status. The maximum contribution to a Roth IRA, prior to any phaseout, is the same as the traditional IRA limit. For 2017, the limit is $5,500 if you are under age 50, or $6,500 if you are age 50 or older at the end of the year, assuming taxable compensation is at least much; the 2017 phaseout rule for Roth IRA contributions is explained below. A Roth IRA contribution is not reported on your tax return.

If you decide to contribute to a traditional IRA to get a tax deduction, you can in a later year transfer the funds to a Roth IRA by making a taxable conversion (8.22). If you initially contribute to a traditional IRA, you have until the filing deadline to “recharacterize” the contribution as a Roth IRA contribution, and similarly, if you initially contribute to a Roth IRA, you can recharacterize it as a traditional IRA contribution; see 8.21 for the recharacterization rules. You can contribute to both a Roth IRA and a traditional IRA for the same year, but the annual contribution limit ($5,500/$6,500 for 2017) applies to the combined contributions, as discussed further below.

The Roth IRA rules do not replace the traditional IRA nondeductible contribution rules (8.6). For an individual who is unable to contribute to a Roth IRA because the contribution limit is phased out, and who is unable to make deductible traditional IRA contributions because of the phaseout rules for active plan participants (8.4), nondeductible contributions may still be made to a traditional IRA (8.6).

Contributing to Roth IRA and traditional IRA for the same year. If you contribute to both a traditional IRA and Roth IRA for the same year, total contributions for the year to both types of IRAs may not exceed the lesser of (1) the annual limit ($5,500/$6,500 for 2017), or (2) your taxable compensation. This overall limit is applied first to the traditional IRA contributions and then to the Roth IRA contributions. Thus, the maximum contribution limit for 2017 to a Roth IRA is: (1) $5,500, or $6,500 if you are age 50 or older, or, if less, your taxable compensation, minus (2) deductible (8.4) or nondeductible (8.6) contributions to traditional IRAs. However, this maximum contribution limit may be reduced, as discussed below, by the phaseout rule.

Contribution deadline. Contributions to a Roth IRA for a year may be made by the filing due date, without extensions. For 2017 contributions, the deadline is April 17, 2018.

Spousal contribution on joint return for nonworking or low-earning spouse. If you are married filing jointly, you generally may contribute to a Roth IRA for each spouse up to the annual limit ($5,500 for spouse under age 50 or $6,500 for spouse age 50 or older at end of 2017) so long as your combined taxable compensation is at least $11,000 if both of you are under age 50 at the end of 2017, $12,000 if one of you is age 50 or older at the end of 2017, or $13,000 if both of you are age 50 or older at the end of 2017. This is the same spousal contribution rule as for traditional IRAs (8.3); the lower-earning spouse is allowed to “borrow” compensation of the higher-earning spouse for contribution purposes. However, the Roth IRA contribution limit may be reduced because of the MAGI phaseout rules, discussed below.

Roth IRA contribution limit may be phased out because of your MAGI. The 2017 Roth IRA contribution limit of $5,500 or $6,500 (or if less, your taxable compensation) is phased out if your 2017 modified adjusted gross income (MAGI) is:

• Over $186,000 and under $196,000, if you are married filing jointly, or a qualifying widow/widower.
• Over $118,000 and under $133,000, if you are single, head of household, or married filing separately and you lived apart for the entire year.
• Over $0 and under $10,000, if you are married filing separately and you lived with your spouse at any time during the year.

If your MAGI (see computation below) exceeds your Roth IRA phaseout threshold of $118,000, $186,000, or $0, and is within the phaseout range of $10,000 (if married filing jointly, a qualifying widow/widower, or married filing separately and you lived with your spouse at any time in the year), or $15,000 (if single or head of household), your contribution limit is reduced by a phaseout percentage; see Worksheet 8-2 below. If MAGI equals or exceeds the applicable $196,000, $133,000, or $10,000 phaseout endpoint, no Roth IRA contribution for 2017 is allowed. The MAGI phaseout rule applies to Roth IRA contributions regardless of whether you are covered by an employer retirement plan, unlike the deductible traditional IRA phaseout rules (8.4), which apply only to active plan participants.

For 2018, the $118,000 and $186,000 phaseout thresholds may be increased by an inflation adjustment; see the e-Supplement at jklasser.com for an update.

Note that the Roth IRA phaseout ranges are considerably higher than the phaseout ranges for deductible contributions to a traditional IRA (8.4), unless you are married filing separately and lived with your spouse at any time during the year. If you could claim a deduction for a traditional IRA contribution, consider whether the present tax benefit from the deduction is outweighed by the value of being able to obtain tax-free distributions from a Roth IRA in the future (see 8.24 for the Roth IRA distribution rules).

Worksheet 8-2 below can be used to figure the reduced contribution limit for 2017 under the phaseout rules, and the example below that worksheet illustrates the computation.

Figuring MAGI. For purposes of determining if your Roth IRA contribution limit is reduced by the phaseout rule, MAGI may be higher than the actual AGI reported on your return because certain deductions and exclusions must be added back to AGI. On the other hand, income from a conversion to a Roth IRA (or rollover from employer plan to a Roth IRA) is subtracted from AGI. Specifically, compute MAGI as follows:

1. Start with the AGI reported on your return but subtract any income from a conversion to a Roth IRA or a rollover to a Roth IRA from an employer plan.
2. Increase the Step 1 AGI by the following deductions or exclusions from income that you claimed:
   • Any deductions claimed for: traditional IRA contributions (8.4), student loan interest (33.14), qualified college tuition and fees (33.13), foreign housing expenses (36.4), or domestic production activities (40.23), and
   • Any exclusions claimed for: employer-provided adoption assistance (3.6), interest on U.S. Savings Bonds used for tuition (33.4), or foreign earned income (36.1).

Excess contributions. If Roth IRA contributions exceed the allowable limit, the excess contribution is subject to a 6% penalty tax unless you withdraw the excess, plus any earnings on the excess contribution, by the filing due date including extensions. The earnings must be reported as income for the year the contribution was made. If you timely file your 2017 return (by April 17, 2018) without withdrawing an excess contribution made in 2017, the IRS will give you until October 15, 2018 to make the withdrawal, and an amended return must be filed for 2016 to report the earnings on the withdrawn contributions; see the instructions to Form 5329.

8.21 Recharacterizing a Traditional IRA Contribution to a Roth IRA and Vice Versa

You may be able to change an annual contribution from a traditional IRA contribution to a Roth IRA contribution, or a Roth IRA contribution to a traditional IRA contribution, by making a trustee-to-trustee transfer. This is called a recharacterization.

For example, you make a contribution to a traditional IRA early in the year with the expectation of being able to claim a deduction for your contribution (8.4), but it turns out that your MAGI is much higher than expected, such as when you receive large year-end capital gain distributions, and you realize that no deduction would be allowed under the phaseout rule, or that only part of your contribution would be deductible. In this situation, you could recharacterize all or part of the contribution (the part that would not be deductible) by transferring it (plus allocable income) to a Roth IRA, provided the contribution is not barred by the Roth IRA phaseout rule (8.20). For example, if you are single, a 2017 deduction for a traditional IRA contribution (up to $5,500 if under age 50 or $6,500 if age 50 or more at end of year) begins to phase out when your MAGI exceeds $62,000 and is completely phased out if MAGI is $72,000 or more (8.4), but the limit for a 2017 Roth IRA contribution does not begin to phase out until MAGI reaches $118,000, with a complete phaseout at $133,000 or more (8.20).

On the other hand, if you initially contribute to a Roth IRA, you could decide to recharacterize and switch the contribution to a traditional IRA. This could be the case if you initially contribute to a Roth IRA and it turns out that your MAGI for the year would allow you to claim a full traditional IRA deduction.

Effect of a recharacterization. When you recharacterize a contribution, the IRA which receives the recharacterized amount is treated as if it had received the original contribution (and the earnings transferred over in the recharacterization) on the date of the original contribution. A recharacterization is not counted as a rollover for purposes of the one-rollover-per-year limit (8.10).

How to recharacterize and deadline for completing transfer. You make an election to recharacterize a contribution by notifying the trustees of both IRAs of your intention. If you are changing trustees, you authorize a trustee-to-trustee transfer from the first IRA (to which the contribution was originally made) to the second IRA (the transferee IRA). If the account is remaining with the same trustee, instruct the trustee that you are electing to treat the contribution as having been made to the second IRA rather than the first. The transfer must include any net income allocable to the original contribution; an allocable loss would reduce the amount that must be transferred.

The election and the transfer itself must be completed on or before the due date, including extensions, for filing your tax return for the year of the original contribution. If you miss this deadline, but you timely filed the return, the IRS allows you six months from the original due date (without extensions) to complete a recharacterization, which in the case of a 2017 return, would allow until October 15, 2018. If you take advantage of this extension and recharacterize after a timely filing, you must file an amended return (47.1) to report the recharacterization.

When you recharacterize an IRA contribution (traditional to Roth or Roth to traditional), you must attach a statement to your return to explain the recharacterization. See the instructions to Form 8606 for the details to be included in the statement. Form 8606 does not have to be filed unless you recharacterized only part of a traditional IRA contribution and some of the contribution left in the traditional IRA is nondeductible, or you partially recharacterized a Roth IRA contribution and a portion of the contribution transferred to the traditional IRA is nondeductible.

8.22 Converting a Traditional IRA to a Roth IRA

A conversion of a traditional IRA to a Roth IRA is a taxable transfer, unlike a tax-free direct transfer or rollover (8.10) to a traditional IRA. If you converted a traditional IRA to a Roth IRA in 2017, the entire transfer must be reported as 2017 income unless after-tax contributions were made to any of your traditional IRAs (see “How to report a 2017 conversion to a Roth IRA,” below).

You can convert a traditional IRA to a Roth IRA regardless of your income or filing status. A conversion may be made by directing the trustee of your traditional IRA to make a trustee-to-trustee transfer of your IRA to a new Roth IRA trustee, or by keeping the account with the same trustee but instructing the trustee to change the registration of the account from a traditional IRA to a Roth IRA. You may also make a conversion by receiving a distribution from your traditional IRA and rolling it over to a Roth IRA; the rollover must be completed within 60 days from the time you receive the distribution.

A conversion to a Roth IRA is not treated as a rollover for purposes of the one-rollover-per-year rule (8.10).

Conversion from SEP or SIMPLE IRA. You may also convert a SEP (8.15) to a Roth IRA. A SIMPLE IRA (8.18) may be converted to a Roth IRA if more than two years have passed since you began participation in the SIMPLE IRA.

Rollover from employer plan to Roth IRA. The tax treatment of a rollover to a Roth IRA from a 401(k) plan or other qualified employer plan, 403(b) plan, or governmental 457 plan is similar to that of a conversion from a traditional IRA. That is, the rollover is a taxable distribution except to the extent that it is a return of your after-tax contributions, if any.

Required minimum distributions (RMDs) may not be converted to a Roth IRA. If you are age 70½ or older, you may not convert to a Roth IRA amounts that represent the required minimum distribution (RMD) from a traditional IRA (8.13). Similarly, the RMD from an employer plan (7.13) may not be rolled over to a Roth IRA. Only the amount exceeding the RMD is eligible for conversion or rollover.

How to report a 2017 conversion to a Roth IRA. If you converted a traditional IRA to a Roth IRA in 2017, you have to report the conversion on Form 8606 and the entire amount must be reported as a taxable distribution on your 2017 return, except to the extent that it is allocable to after-tax contributions in all of your traditional IRAs. If you made after-tax contributions to any of your traditional IRAs and you are converting only part of your traditional IRAs, a prorated portion of the converted amount is treated as allocable to the after-tax contributions and that is the nontaxable portion of the conversion. You figure the tax-free percentage on Part 1 of Form 8606 by dividing the after-tax contributions by the sum of the year-end value of all the IRAs plus the conversion amount. Multiplying the resulting percentage by the conversion amount gives you the tax-free part of the conversion. The balance is the taxable part of the conversion. The 10% penalty for pre-age-59½ distributions (8.12) does not apply to the taxable part of the conversion.

If you withdrew funds from a traditional IRA towards the end of 2017 and complete a rollover to a Roth IRA in early 2018 within 60 days of withdrawal, this is treated as a 2017 conversion and not a 2018 conversion.

8.23 Recharacterizing a Conversion and Reconversions

When you convert a traditional IRA to a Roth IRA (8.22), you have an opportunity to reconsider the move. You can in effect “undo” the conversion by recharacterizing all or part of it. If you timely file your return for the year of the conversion, you have until October 15 of the following year to complete a recharacterization; see below for deadline details.

You may want to recharacterize because the value of the Roth IRA has dropped substantially since the conversion, and you do not want to pay the tax that would be due on the higher value at conversion, or you may simply be unable to pay the tax due on the conversion (8.22). In a declining stock market, a recharacterization may be the first step in a plan to reconvert back to a Roth IRA when the taxable conversion value is lower, subject to the waiting period for reconversions (see below).

How to recharacterize. You make an election to recharacterize the conversion by authorizing a trustee-to-trustee transfer of the Roth IRA contribution (part or all) to a traditional IRA; it does not have to be the same traditional IRA from which the conversion was made. You can also recharacterize by keeping the account with the same trustee and notifying the trustee to transfer the account to a traditional IRA. The transfer must include any net income allocable to the contribution being recharacterized. If there has been a loss in value since the conversion, the allocable negative net income reduces the amount that must be transferred to a traditional IRA. If only part of the Roth IRA is being transferred in the recharacterization, a computation must be made to figure the allocable earnings that must be transferred along with the contribution to the traditional IRA. The Roth IRA trustee generally figures the net income or loss allocable to the recharacterized contribution; IRS Publication 590-A has a worksheet for calculating the amount.

You must notify both trustees (if different) of your intent to recharacterize by specifically identifying the original contribution that is being recharacterized and the amount being recharacterized and you must direct the transferor trustee to make the transfer, including any allocable income.

The effect of the recharacterization is to disregard the conversion to the Roth IRA and to treat the contribution as if it had been contributed to the transferee traditional IRA (to which recharacterization was made) on the date of the conversion. The recharacterized contribution is not treated as a rollover for purposes of the one-rollover-per-year rule (8.10).

If you recharacterize only part of the amount converted, you have to report the amount not recharacterized on Form 8606, Part II. If you recharacterize the entire amount converted, the conversion should not be reported on Form 8606. A statement explaining the recharacterization must be attached to your return; see the Form 8606 instructions.

Deadline for recharacterization. IRS regulations generally require that a recharacterization election and the actual transfer be made on or before the due date, including extensions, for filing the tax return for the year of the conversion. However, the IRS allows timely filers an automatic extension of six months from the original filing due date, excluding extensions. To recharacterize a conversion made in 2017, you have until October 15, 2018, provided that you timely file your 2017 return, including any extension. If you file a timely 2017 return and pay tax on the converted amount, and then recharacterize by the October 15, 2018 deadline, you must file an amended return for 2017. For example, by April 17, 2018 (the regular due date for a 2017 return), you file your 2017 return, which includes a taxable conversion made in 2017, and then by October 15, 2018, you recharacterize the converted amount back to a traditional IRA. You must file an amended return for 2017 to report the recharacterization and claim a refund for the tax paid on the conversion. The amended return must be filed within the regular amendment period, generally three years (47.1). On the amended return, write “Filed pursuant to Section 301.9100-2.”

What if you miss the IRS recharacterization deadlines? A regulation gives the IRS authority to grant an extension if an “innocent” mistake was made and you act in good faith by promptly asking the IRS for the additional time after discovering the error (Reg. Sec. 301.9100-3). However, an extension beyond the six-month extension for timely filers is unlikely. Prior to 2010, when conversions were barred if MAGI exceeded $100,000, the IRS in several private rulings allowed the extra extension to taxpayers who missed the deadline and who requested recharacterization relief before the IRS discovered that they did not qualify for the conversion under the pre-2010 $100,000 MAGI limit and before the expiration of the statute of limitations (8.21). Given the repeal of the income restriction for years after 2009, it is less likely that the IRS will grant extensions beyond the extension for timely filers (to October 15, 2018 for 2017 returns).

Reconverting to a Roth IRA after a recharacterization. If a traditional IRA contribution is converted to a Roth IRA and then transferred back to a traditional IRA in a recharacterization, that amount may subsequently be reconverted back to a Roth IRA. This recharacterization/reconversion rule may allow an IRA owner to lower the tax due on a conversion to a Roth IRA. For example, if you convert a traditional IRA to a Roth IRA and the value of the account drops as a result of a stock market decline, you may be able to reduce the taxable conversion amount value by recharacterizing the account as a traditional IRA and then reconverting to a Roth IRA at a time when the value of the account is lower. The amount that you must include in income from the conversion is based on the value of the account as of the date of the reconversion.

However, the IRS has imposed a waiting period before a reconversion of the recharacterized funds may be made. You may not convert to a Roth IRA, recharacterize back to a traditional IRA, and reconvert the same funds to a Roth IRA in the same calendar year. For example, if you convert a traditional IRA to a Roth IRA and also recharacterize that amount back to a traditional IRA during 2017, you may not reconvert those same funds to a Roth IRA until January 1, 2018. If the recharacterization is made in the last 30 days of 2017, you must wait until the 30th day following the date of the recharacterization before a valid reconversion may be made in early 2018.

The 30-day waiting period also applies if a conversion made in one year is recharacterized in the following year, as where a conversion made in 2017 is recharacterized in 2018. A reconversion after the 2018 recharacterization is treated as a new conversion in 2018; see the Joe Smith Example below.

The effect of the waiting period is to make it impossible to take immediate advantage of a stock market decline that lowers the value of a Roth IRA. If you want to recharacterize back to a traditional IRA and then reconvert to a Roth IRA in order to lower the taxable conversion amount, you will have to wait a minimum of 30 days following the recharacterization before you can reconvert and if you converted and recharacterized an amount in the same year, you cannot reconvert until the following year. By that time, the value of the reconverted account may be as high, or higher, than it was at the time of the recharacterization.

If a reconversion is attempted before the end of the waiting period, the attempt will be treated as a “failed” conversion. A failed conversion is treated as a taxable distribution from the traditional IRA followed by a regular contribution to a Roth IRA. The pre–age 59½ early distribution penalty could apply to the taxable distribution (8.12) and the excess of the deemed regular contribution to the Roth IRA over the annual limit would be subject to the 6% excess contribution penalty (8.7). A failed conversion may be remedied by making a timely recharacterization to a traditional IRA.

8.24 Distributions From a Roth IRA

A distribution from a Roth IRA is tax free if it is a qualified distribution, as discussed below. Even if a distribution is not a qualified distribution, it is tax free to the extent it does not exceed your regular Roth IRA contributions (8.20) and conversion contributions (8.22). The part of a non-qualified distribution allocable to earnings is taxable, but distributions are considered to be from contributions first and then from earnings; see the “Ordering rules for nonqualified distributions” below for the allocation between contributions and earnings. You must report Roth IRA distributions on Form 8606.

You may make a tax-free direct transfer from one Roth IRA to another. A tax-free rollover of a Roth IRA distribution may be made to another Roth IRA if you complete the rollover within 60 days, but the rollover is subject to the one-rollover-per-year limit (8.10).

You do not have to receive minimum required distributions from a Roth IRA after you reach age 70½ as you would from a traditional IRA (8.13). No Roth IRA distributions at all are required during your lifetime. After your death, your beneficiaries will be subject to a minimum distribution requirement (8.25).

Qualified Roth IRA distributions are tax free. Two tests must be met for a Roth IRA distribution to be “qualified,” and thus completely tax free: (1) the distribution must be made after the end of the five-year period beginning with the first day of the first taxable year for which any Roth IRA contribution was made and (2) one of the following conditions must be met:

• you are age 59½ or older when the distribution is made,
• you are disabled,
• you use the distribution to pay up to $10,000 of qualifying first-time home-buyer expenses as discussed below, or
• you are a beneficiary receiving distributions following the death of the account owner (8.24).

Five-year holding period for qualified distributions. In order to receive tax-free withdrawals of earnings from a Roth IRA, you must satisfy the five-year holding period and also be at least age 59½, be disabled, be a beneficiary, or pay qualifying first-time home-buyer expenses. The five-year holding period begins with January 1 (assuming you are a calendar-year taxpayer) of the first year for which any Roth IRA contribution is made.

For purposes of determining qualified distributions, you have only one five-year period regardless of the number of Roth IRAs you have. Once you satisfy the five-year test for one Roth IRA, you also meet it for all subsequently established Roth IRAs. For example, if you converted a traditional IRA to a Roth IRA during 1998 (the first year Roth IRA contributions were allowed), or made a regular Roth IRA contribution for 1998 at any time between January 1, 1998, and April 15, 1999, your five-year holding period began January 1, 1998. If in a later year you converted (8.22) a traditional IRA to a Roth IRA, or made a regular Roth IRA contribution to a different account (8.20), that new Roth IRA does not get its own five-year holding period. In this case, the five-year period for all your Roth IRAs began January 1, 1998, and ended December 31, 2002. If your first Roth IRA contribution was a regular contribution for 2013 (made by April 15, 2014) or a conversion made during 2013, the five-year period for all your Roth IRAs ends December 31, 2017 .

If you receive a Roth IRA distribution after the end of your five-year holding period, and you also meet one of the other qualified distribution requirements such as being age 59½ or older, the distribution is completely tax free. If you receive a distribution before satisfying both the five-year holding period requirement and one of the other qualified distribution requirements, and the withdrawal exceeds your contributions, the excess (i.e., earnings) is taxable and possibly subject to the 10% penalty for pre–age 59½ distributions (8.12). Under the ordering rules discussed below, Roth IRA distributions are treated as being made first from contributions and then from earnings.

Ordering rules for nonqualified distributions. Even if a distribution does not meet the tests for a qualified distribution and thus is not fully tax free, it is not taxable to the extent of your Roth IRA contributions. All of your Roth IRAs are treated as one account for purposes of determining if contributions or earnings have been withdrawn. If a distribution does not exceed total contributions to all of your Roth IRAs, it is not taxable. The taxable part of a distribution is figured on Form 8606.

Where you have made regular annual contributions and also conversion contributions from a traditional IRA or rollover contributions from an employer plan to a Roth IRA, the regular contributions are considered to be withdrawn first. Allocate a distribution to your contributions and then to earnings in this order:

1. Regular Roth IRA contributions. This is the total of all of your annual contributions for all years.
2. Conversion contributions and rollover contributions. Conversion contributions and rollover contributions are considered to be withdrawn in the order in which they were made. For example, if you made a conversion in 2009 and another conversion in 2010, you allocate the distribution first to the 2009 conversion and then to the 2010 conversion. If part of a conversion or rollover contribution was not taxable (because it was allocable to nondeductible or after-tax contributions in the converted or rolled-over account), the taxable part of the conversion or rollover is deemed withdrawn before the nontaxable part. Assume that the 2009 conversion was partly taxable and partly nontaxable, and the same was true for the 2010 conversion. You would first allocate the distribution to the taxable part of the 2009 conversion, then to the nontaxable part of the 2009 conversion, then to the taxable part of the 2010 conversion, and finally, to the nontaxable part of the 2010 conversion.

   Taking into account the taxable part of a conversion or rollover contribution before the nontaxable part (if any) of the contribution may be important for purposes of determining whether the 10% early distribution penalty applies to the withdrawal before age 59½ of a conversion or rollover contribution within five years of the conversion/rollover (see below).

3. Earnings. Earnings on Roth IRA contributions are considered to be withdrawn last, after all contributions are taken into account. If a distribution is not a qualified distribution, and it exceeds the contributions under (1) and (2) above, the withdrawn earnings are subject to tax and, if you are under age 59½, to the 10% early distribution penalty, unless a penalty exception applies (8.12).

Potential 10% early distribution penalty on withdrawal within five years of conversion or rollover. If you receive a Roth IRA distribution before age 59½ and within the prior five years you made a conversion from a traditional IRA or rollover from an employer plan, you may be subject to the regular 10% early distribution penalty (8.12). Do not confuse this potential 10% penalty on conversions or rollovers with the 10% penalty that applies before age 59½ to a nonqualified distribution that is allocable to taxable earnings (category 3 under the “Ordering rules” above).

The 10% penalty applies only if all of the following are true: (1) you are under age 59½ when you receive the Roth IRA distribution, (2) you converted or rolled over an amount to a Roth IRA within the five-year period preceding the current Roth IRA distribution, (3) the Roth IRA distribution is allocable to the taxable portion of any conversion or rollover made within the five-year period, and (4) you do not qualify for a penalty exception, such as for first-time homebuyer expenses or higher education costs, or being disabled (8.12).

For purposes of determining the five-year period under test 2, every conversion or rollover is considered made on January 1 of the year in which it occurred, regardless of its actual date. Thus, there is a separate five-year period for each conversion or rollover you have made. For any conversion (or rollover) made in 2012, the five-year period began January 1, 2012, and ended December 31, 2016, so a 2017 Roth IRA distribution cannot be penalized on account of a 2012 conversion (or rollover) even if the 2017 distribution is before age 59½. The 10% penalty could apply to a 2017 distribution if it is allocable to a conversion or rollover made in 2013 through 2017.

Even if there were conversions or rollovers within the five-year period, the penalty applies only to the extent that the current distribution from the Roth IRA is allocable to the taxable portion of any of those conversions or rollovers, as determined by the ordering rules above; see category 2 of the ordering rules. Note that under the ordering rules, the entire Roth IRA distribution may be tax free because it is allocable to your contributions- either regular annual contributions (category 1) or your conversion or rollover contributions (category 2). But even if the distribution is entirely tax free, the 10% penalty applies to an early distribution that is allocable to the category 2 conversions or rollovers that were taxable when made, assuming a penalty exception (8.12) is not available.

Follow the instructions to Form 5329 to figure whether you owe the penalty on any of your Roth conversions or rollovers.

Distribution used for up to $10,000 of first-time home-buyer expenses. A Roth IRA distribution is “qualified”, and therefore tax free, if you meet the five-year holding period and the distribution is used for up to $10,000 of qualifying “first-time” home-buyer expenses. The $10,000 limit is a lifetime cap per IRA owner, not an annual limitation. Expenses qualify if they are used within 120 days of the distribution to pay the acquisition costs of a principal residence for you, your spouse, your child, or your grandchild, or an ancestor of you or your spouse. The residence does not have to be your “first” home. A qualifying first-time home-buyer is considered to be someone who did not have a present ownership interest in a principal residence in the two-year period ending on the acquisition date of the new home. If the home-buyer is married, both spouses must satisfy the two-year test. Eligible acquisition costs include buying, constructing, or reconstructing the principal residence, including reasonable settlement, financing, and closing costs.

8.25 Distributions to Roth IRA Beneficiaries

If you are the surviving spouse of the Roth IRA owner and you are the owner’s sole Roth IRA beneficiary, you may elect to treat the inherited account as your own Roth IRA. If you treat the account as your own, you do not have to take distributions from the account at any time, since a Roth IRA owner is not subject to minimum distribution requirements. If you take some distributions, you are not locked into a specific distribution schedule unless you agree to that schedule.

Surviving spouses who do not elect to treat an inherited Roth IRA as their own, and beneficiaries other than surviving spouses, must receive required minimum distributions (RMDs). If there is an individual designated beneficiary under the final IRS regulations as of September 30 of the year following the year of the Roth IRA owner’s death (8.14), RMDs are generally payable over the life expectancy of the designated beneficiary; see the Single Life Expectancy table (Table 8-5) (8.14). If there is more than one individual beneficiary, they may split the inherited account into separate accounts by December 31 of the year following the year of the Roth IRA owner’s death, allowing each beneficiary to use his or her own life expectancy in figuring RMDs (8.14). For each year that a RMD is required, the beneficiary must divide the account balance as of the end of the prior year by the applicable life expectancy to figure the amount of the RMD (8.14). Although it is unlikely, the plan document may require distributions under the five-year rule, which requires that the entire account be distributed by December 31 of the fifth year following the year of the owner’s death but does not require any distributions prior to that date. The plan may allow a choice between the life expectancy rule and the five-year rule. Of course, a beneficiary who is receiving RMDs under the life-expectancy method may choose to receive more than the minimum amount required under the life expectancy rule.

Failure to take an RMD will result in a penalty unless the IRS waives it. A penalty tax of 50% applies to the difference between the RMD and the amount you received.

When distributions to beneficiary must start under life expectancy rule. For a nonspouse beneficiary to use the life expectancy rule, RMDs must begin by the end of the year following the year of the Roth IRA owner’s death. This is also the starting date for a surviving spouse who is a co-beneficiary of the account along with other individuals.

If you are the surviving spouse and are sole beneficiary of the Roth IRA, you may elect to treat the Roth IRA as your own and if you do, you do not have to receive any RMDs. If you do not treat it as your own and your spouse had not reached age 70½ when he or she died, you may delay the start of RMDs until December 31 of the year your spouse would have reached age 70½.

If there is no designated beneficiary under the IRS rules, such as where the Roth IRA owner’s estate is the beneficiary (8.14), the entire account must be paid out by the end of the fifth year following the year of the owner’s death.

Five-year holding period for tax-free treatment. The same five-year holding period for receiving fully tax-free distributions that applied to the account owner (8.24) also applies to you as the beneficiary. The five-year holding period began on January 1 of the year for which the owner’s first Roth IRA contribution was made. If you receive distributions before the end of the five-year holding period, the distributions will be tax free to the extent that they are a recovery of the owner’s Roth IRA contributions and taxable to the extent they are earnings under the “ordering rules” at 8.24. Distributions you receive after the end of the owner’s five-year holding period are completely tax free.

8.26 my RA Program Discontinued

The myRA was supposed to be a retirement plan solution for those without access to employer programs. However, in July 2017 the Treasury announced an end to myRAs due to lack of interest.

If you opened an myRA account but never funded it, the account was automatically closed on September 15, 2017. You do not have to take any action.

If you have been funding an account through payroll withholding, notify your employer to end withholding. The Treasury has not yet provided specific dates on when to take this action.

If you have been funding an account with direct deposits from your bank, you do not have to take any action. The Treasury will notify the bank to stop any debits of funds.

You can transfer funds in your myRA to a financial institution that will act as custodian or trustee of a Roth IRA. Alternatively, you can take a distribution of your myRA funds and deposit them into a Roth IRA. If you make the deposit within 60 days, the earnings on your myRA funds will not be taxed.

Further details are available at myra.gov. Also see the e-Supplement at jklasser.com.