The IRS hasn't provided answers for all the Roth conversion questions out there, leaving some taxpayers in the lurch.
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Question: "Agnes" is 56 years old. She has a $600,000 IRA from which she is receiving a penalty-free "series of substantially equal periodic payments" (SOSEPP). She would like to convert $100,000 of the account to a Roth IRA in 2010. She knows that any "modification" of her SOSEPP prior to reaching age 59½ (or prior to the fifth anniversary of the first series payment, whichever is later) would result in losing her exemption from the 10 percent penalty that is normally applicable to "early distributions." Furthermore, the loss of the exemption would be retroactive so she would owe the penalty on all distributions she has already received under the SOSEPP; since she is already six years into the series, she does not want to risk that happening.
Can she do a partial Roth conversion of the SOSEPP-supporting IRA without causing a modification of the SOSEPP? If the answer is yes, would she continue to take the post-conversion SOSEPP distributions from the money left in the traditional IRA (about $500,000), the new Roth IRA ($100,000), or proportionately from each?
Natalie: I wish I knew.
Under the IRS's Roth IRA conversion regulation, the conversion of a SOSEPP-supporting traditional IRA to a Roth IRA is not treated as a modification of the SOSEPP, provided that the participant continues to take the SOSEPP payments from the Roth IRA following the conversion. That's the good news. The bad news is that the regulation doesn't discuss partial Roth conversions.
If a total Roth conversion is not considered a modification, then there does not appear to be any way the IRS could claim that a partial conversion IS a modification. The IRS guidelines on SOSEPPs state that "nontaxable" transfers from the SOSEPP-supporting IRA to another account are considered modifications; a full or partial Roth conversion is not covered by that prohibition because it is a taxable transfer. But following a partial conversion, we have no guidance on whether the IRS cares about which account the post-conversion SOSEPP payments come out of.
I don't see how the IRS could fault Agnes if, following a partial Roth conversion, she took her post-conversion SOSEPP payments from both accounts, in proportion to the relative sizes of the accounts. I also don't see why the IRS would care if she decided to take all of the post-conversion payments from the remaining traditional IRA money or all from the new Roth IRA. Maybe the IRS would get upset if she fine tuned her SOSEPP payments each year, taking them from both the traditional and Roth IRAs in proportions selected by her to minimize her present and future taxes. But my speculation is worthless; what you need is IRS guidance to be sure of avoiding a modification of the SOSEPP.
It appears to me that Agnes has the following choices with respect to her SOSEPP-supporting IRA, if she wants to avoid risking a modification of her SOSEPP:
1. Do no Roth conversion in 2010. That is the safest course, obviously.
2. Do a total Roth conversion, and elect to push the income forward into 2011 and 2012 (one-time election available for 2010 conversions only), then take post-conversion SOSEPP payments from the Roth IRA until she reaches age 59½. Note that any SOSEPP payments taken in 2010 and 2011 will accelerate the inclusion of the conversion income to the extent of the amount distributed. The point of this option is to allow a Roth conversion within the IRS published guidelines, but possibly make the total conversion more "affordable" by deferring the income.
3. Take the 2010 SOSEPP payment from the traditional IRA now, then do a partial Roth conversion later in 2010. If, by October 15, 2011, the IRS issues guidance explaining how to take SOSEPP payments following a partial Roth conversion, Agnes can comply with that guidance by taking the 2011 SOSEPP payment from whichever account or combination of accounts the IRS approves. If the IRS has NOT issued guidance by October 15, 2011, Agnes can recharacterize (undo) her partial Roth conversion and essentially revert to course of action #1. Like #1 and #2, this approach should be totally "safe" in the sense that it does not require taking any actions not clearly blessed by published guidance.
4. Seek an IRS private letter ruling blessing the partial Roth conversion prior to doing it, including IRS instructions regarding which IRA to take the post-conversion SOSEPP payments out of. While safe, this approach is probably too expensive and time-consuming to be justified in this situation.
5. Finally, Agnes could do a partial Roth conversion, then continue taking SOSEPP payments proportionately from each account following the conversion. This gets Agnes the partial conversion she is seeking, and, as mentioned, I don't see how the IRS could possibly object to that approach. However, there is no IRS guidance specifically blessing this approach, and my column is not legal authority.
Resources: Regarding deferral of the income on a 2010 Roth conversion, see Internal Revenue Code § 408A(d)(3)(A)(iii). Regarding acceleration of deferred income if a distribution occurs, see § 408A(d)(e)(E)(i). See Chapter 9 of the author's book Life and Death Planning for Retirement Benefits with respect to the 10 percent penalty on "early distributions," including the "SOSEPP" exception to the penalty, and Chapter 5 regarding Roth IRA conversions; $89.95 plus shipping at www.ataxplan.com or 800-247-6553. For complete explanation of all aspects of Roth IRAs and other Roth retirement plans, get Natalie's 97-page Special Report Roth-Ready for 2010!, downloadable for $49.95 at www.ataxplan.com.