IRS Adopts Stricter Interpretation of One-Year Waiting Period for IRA Rollovers

An individual can make only one tax-free rollover from one traditional IRA to another in any one-year period.  For at least as far back as 1981, the IRS has interpreted that rule as applying to IRAs on an-IRA-by-IRA basis. However, in the wake of a recent Tax Court case, the IRS announced that it would apply the one-year waiting period on an aggregate basis to all of an individual's IRAs. In Announcement 2014-15, the IRS also stated that it will not apply this more restrictive interpretation to IRA distributions occurring before 2015.

One-Year Waiting Period for IRA Rollovers

Under Code Sec. 408(d)(3)(A), a taxpayer can roll over, tax free, a distribution from a traditional IRA into the same or another traditional IRA. Generally, the individual must make the rollover contribution by the 60th day after the day the individual receives the distribution from the IRA. Code Sec. 408(d)(3)(B) provides that an individual can make only one such rollover in any one-year period. The one-year waiting period begins on the date the individual receives the IRA distribution.

Prop. Reg. Sec. 1.408-4(b)(4)(ii) and IRS Publication 590, Individual Retirement Arrangements (IRAs), provide that the one-year waiting period is applied on an IRA-by-IRA basis. Under this interpretation, an individual who makes a tax-free rollover of any part of a distribution from a traditional IRA cannot, within a one-year period, make a tax-free rollover of any later distribution from that same IRA. The individual also cannot make a tax-free rollover of any amount distributed within the same one-year period from the IRA into which he or she made the tax-free rollover.

For example, applying the one-year waiting period on an IRA-by-IRA basis also means that if an individual maintains more than one IRA say, IRA-1, IRA-2, and IRA-3 - and rolls over the assets of IRA-1 into IRA-3, he or she would not be precluded from making a tax-free rollover from IRA-2 to IRA-3 or any other IRA within one year after the rollover from IRA-1 to IRA-3. However, a recent Tax Court opinion, Bobrow v. Comm'r, T.C. Memo. 2014-21, held that the one-year waiting period applies on an aggregate basis, rather than on an IRA-by-IRA basis. That means an individual cannot make an IRA-to-IRA rollover if he or she has made such a rollover involving any of the individual's IRAs in the preceding one-year period.

IRS Will Follow Bobrow

In Announcement 2014-15, the IRS stated that it anticipates that it will follow the interpretation of Code Sec. 408(d)(3)(B) in Bobrow and, accordingly, intends to withdraw the proposed regulation and revise Publication 590 to the extent needed to follow that interpretation.

The IRS noted that these actions will not affect an IRA owner's ability to transfer funds from one IRA trustee directly to another, because, under Rev. Rul. 78-406, such a "trustee-to-trustee transfer" is not a rollover and, therefore, is not subject to the one-waiting period under Code Sec. 408(d)(3)(B).

Practice Tip: A trustee-to-trustee transfer may be accomplished by any reasonable means of direct payment to the receiving IRA. If the payment is made by wire transfer, the wire transfer must be directed only to the trustee or custodian of the receiving IRA. If payment is made by check, the check must be negotiable only by the trustee or custodian of the receiving IRA.

Proposed Regs Clarify New 3.8% Investment Income Tax

The IRS has issued proposed regulations that provide guidance on the new 3.8% healthcare surtax on investment income and gains (IRC Sec. 1411). This article explains the general operating rules of the tax, and specific rules applicable to estates and trusts.  

The proposed regulations can be found at this link:  Proposed Net Investment Income Tax Rules.  This article does not contain a complete analysis of the regulations.  Please review the regulations before applying them to your own situation.

Although there are still many unresolved issues surrounding 2013's tax rates and the so-called “fiscal cliff,” with this surtax, higher taxes on investment-type income and gains are a relative certainty for higher-income taxpayers who meet the thresholds explained below.

Background. Beginning in 2013, certain “unearned income” of individuals, trusts, and estates is subject to a surtax (i.e., it's payable on top of any other tax payable on that income). The surtax, also called the “unearned income Medicare contribution tax” or the “net investment income tax” (NIIT), is 3.8% of the lesser of:

(1) net investment income (NII); or

(2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). MAGI is adjusted gross income (AGI) plus any amount excluded as foreign earned income under Code Sec. 911(a)(1).

Example:  In 2013, a single taxpayer has net investment income of $100,000 and MAGI of $220,000. He pays the surtax only on $20,000, which is the amount by which his MAGI exceeds the threshold amount of $200,000, and because that is less than his NII of $100,000. Therefore, the surtax is $760 ($20,000 × 3.8%).

For an estate or trust, the surtax is 3.8% of the lesser of undistributed NII, or the excess of AGI (as defined in Code Sec. 67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.

Net Investment Income (NII) is defined as investment income less deductions properly allocable to such income.  Investment income is (a) gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the 3.8% surtax doesn't apply; and (b) other gross income derived from a trade or business to which the Medicare contribution tax does apply; and (c) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the Medicare contribution tax doesn't apply.

The 3.8% surtax applies to a trade or business only if it is a passive activity of the taxpayer or a trade or business of trading in financial instruments or commodities.

Investment income does not include amounts subject to self-employment tax, distributions from tax-favored retirement plans (e.g., qualified employer plans and IRAs), or tax-exempt income (e.g. earned on state or local obligations).

The surtax doesn't apply to trades or businesses conducted by a sole proprietor, partnership, or S corporation (but income, gain, or loss on working capital isn't treated as derived from a trade or business and thus is subject to the tax).

Gain or loss from a disposition of an interest in a partnership or S corporation is taken into account by the partner or shareholder as net investment income only to the extent of the net gain or loss that the transferor would take into account if the entity had sold all its property for fair market value immediately before the disposition.

The tax does not apply to: nonresident aliens; trusts all the unexpired interests in which are devoted to charitable purposes; trusts exempt from tax under Code Sec. 501; or charitable remainder trusts exempt from tax under Code Sec. 664.

General operating rules. The IRS has provided definitional rules in the proposed regs designed to both promote the fair administration of Code Sec. 1411 and prevent taxpayers from circumventing its purposes (significantly, to impose a tax on the unearned income or investments of certain individuals, estates, and trusts).  The IRS will closely review transactions that manipulate a taxpayer's NII to reduce or eliminate the amount of the surtax and, when appropriate, challenge such transactions based on applicable statutes and judicial doctrines (e.g., substance over form).

Application to Estates and Trusts. The proposed regs provide rules with regard to these specific trust types:

(a)   Grantor trusts. The income of a grantor trust (i.e., a trust any portion of which is treated as owned by the grantor, with items of income, deduction, and credit attributed accordingly) is taxed to the owner. So, these amounts are taken into account in calculating the owner's NII.

(b)   Electing Small Business Trusts (ESBTs). ESBTs, which are treated as two separate trusts when a portion of the ESBT's holdings is S corporation stock, are subject to special computational rules. The proposed regs treat the ESBT as two separate trusts for computational purposes, but consolidate the ESBT into a single trust for determining the AGI threshold.

(c)   Charitable remainder trusts (CRTs). CRTs are also subject to special computational rules. The trust itself isn't subject to Code Sec. 1411, but the annuity and unitrust distributions may constitute NII to the noncharitable recipient.

(d)   Foreign estates and foreign nongrantor trusts. In general, foreign estates and foreign trusts aren't subject to Code Sec. 1411.  However, IRS and Treasury believe that the NII of a foreign trust or estate should be subject to Code Sec. 1411 to the extent that such income is earned or accumulated for the benefit of, or distributed to, U.S. persons.

(e)   Bankruptcy estates. A bankruptcy estate of a debtor who is an individual is treated as an individual for Code Sec. 1411 purposes.  Therefore, the bankruptcy estate computes its tax in the same manner as an individual, and the rate is the same as that imposed on a married taxpayer filing separately.  

Effective date. The proposed regs are to be effective for tax years beginning after December 31, 2013.  However, taxpayers may rely on the proposed regs for purposes of compliance with Code Sec. 1411 until the effective date of the final regs.

Designating IRA Beneficiaries to "Stretch" Investment Growth

Desgnating beneficiaries of an IRA can be tricky - especially when using a trust.   I posted an article on my web site to describe the various options for designating the beneficiary of an IRA to "stretch" the payments for maximum investment growth.  Special provisions are required when designating the trustee of a trust as a beneficiary.  Click here for the full article.