March/April Dates to Remember


March 15

Partnerships. File a 2017 calendar year return (Form 1065). Provide each partner with a copy of Schedule K-1 (Form 1065), “Partner’s Share of Income, Deductions, Credits, etc.,” or a substitute Schedule K-1. If you want an automatic six-month extension of time to file the return and provide Schedule K-1 or a substitute Schedule K-1, file Form 7004.

S corporations. File a 2017 calendar year income tax return (Form 1120S) and pay any tax due. Provide each shareholder with a copy of Schedule K-1 (Form 1120S), “Shareholder’s Share of Income, Deductions, Credits, etc.,” or a substitute Schedule K-1. If you want an automatic six-month extension of time to file the return, file Form 7004 and deposit what you estimate you owe in tax.

S corporation election. File Form 2553, “Election by a Small Business Corporation,” to choose to be treated as an S corporation beginning with calendar year 2018. If Form 2553 is filed late, S corporation treatment will begin with calendar year 2019.

Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in February if the monthly rule applies.

APRIL 2018

April 17

Individuals. File a 2017 income tax return. If you want an automatic six-month extension of time to file the return, file Form 4868, “Application for Automatic Extension of Time to File U.S. Individual Income Tax Return.” Then, file Form 1040, 1040A, or 1040EZ by October 15.

If you are not paying your 2018 income tax through withholding (or will not pay in enough tax during the year that way), pay the first installment of your 2018 estimated tax. Use Form 1040-ES.

Employers. For Social Security, Medicare, withheld income tax, and nonpayroll withholding, deposit the tax for payments in March if the monthly rule applies.

Household employers. If you paid cash wages of $2,000 or more in 2017 to a household employee, file Schedule H (Form 1040) with your income tax return and report any household employment taxes. Report any federal unemployment (FUTA) tax on Schedule H if you paid total cash wages of $1,000 or more in any calendar quarter of 2016 or 2017 to household employees. Also, report any income tax you withheld for your household employees.

Corporations. File a 2017 calendar year income tax return (Form 1120) and pay any tax due. If you want an automatic six-month extension of time to file the return, file Form 7004 and deposit what you estimate you owe in taxes.

Corporations. Deposit the first installment of estimated income tax for 2018.

The Bipartisan Budget Act of 2018 (BBA)



The Bipartisan Budget Act of 2018 (BBA), which was enacted after IRS issued final versions of 2017 tax forms, made retroactive tax law changes that affect 2017 returns. This article discusses how IRS is progressing in making it possible for taxpayers to file 2017 returns that reflect those retroactive changes.

Background—the Bipartisan Budget Act’s retroactive provisions. On Feb. 9, 2018, Congress passed, and the President signed into law, the BBA (P.L. 115-123). In addition to providing a continuing resolution to fund the federal government, BBA contained a host of tax law changes. Among those changes were retroactive extensions through 2017 of over 30 so-called “extender” provisions, 2017 tax relief to victims of the California wildfires, and small revisions to previously-provided relief for victims of Hurricanes Harvey, Irma, and Maria.

IRS issued final versions of 2017 tax forms during January of 2018; those January 2018 versions did not reflect the changes made by the BBA.

IRS’s actions to date regarding the retroactive provisions. Not surprisingly, IRS anticipated the possibility of a retroactive extenders law; it therefore had certain lines on forms with “Reserved for future use” as the caption for those lines, and it put notes in the form instructions about the fact that the law provisions for which those lines had applied had expired but might retroactively be extended. For example, Line 34 on the version of final 2017 Form 1040 that was issued in late January of 2018 was captioned “Reserved for future use”, while, in prior years, it was used for the tuition and fees deduction.

On Feb. 22, 2018, IRS announced, in IR 2018-33, that it has reprogrammed its processing systems to handle the three BBA retroactive benefits that it considers likely to be claimed on returns filed early in the tax season, i.e.,

  • The exclusion from gross income of discharge of qualified principal residence indebtedness (often, foreclosure-related debt forgiveness), claimed on Form 982;
  • Mortgage insurance premiums treated as qualified residence interest, generally claimed by low- and middle-income filers on Form 1040, Schedule A; and
  • The deduction for qualified tuition and related expenses claimed on Form 8917.

And, as of February 22, IRS has published updated versions of Form 1040, Schedule A, Form 1017, and Form 1040 (but not yet Form 982) to reflect the above announcement.

Other 2017 forms/instructions needing updating. Here is a list of some other 2017 forms/instructions that still need to be updated:

  • Form 4684, Casualties and Thefts;
  • Form 5695, Residential Energy Property Credit;
  • Form 6478, Biodiesel Producers Credit;
  • Form 8844, Empowerment Zone Credit;
  • Form 8845, Indian Employment Credit;
  • Form 8864, Biodiesel and Renewable Diesel Fuels Credit;
  • Form 8900, Qualified Railroad Track Maintenance Credit;
  • Form 8908, Energy Efficient Homes Credit;
  • Form 8911, Alternative Fuel Vehicle Refueling Credit.

Tax preparation software. IRS has published new Modernized eFile specifications and business rules for the tax preparation software industry. But IRS requires the software companies to run tests before going live with their software, and, as of February 20, IRS was not prepared for those tests.

Advantage of holding off filing a return until IRS issues all forms needed for that return. Taxpayers who have filed 2017 federal tax returns and then wish to claim one of BBA’s retroactive tax benefits can do so by filing an amended return on Form 1040X. However, amended returns cannot be filed electronically and can take up to 16 weeks to process.

RIA recommendation: Thus, in almost all cases, it will be wiser to hold off filing any 2017 return for a taxpayer for which a retroactive BBA provision applies, until all of the needed forms can be prepared.

RIA observation: The BBA provisions that provide California wildfire victims with 2017 tax return relief, are, in most cases, identical to provisions contained in P.L. 115-63, the Disaster Tax Relief and Airport and Airway Extension Act of 2017—legislation that provides relief to victims of 2017 Hurricanes Harvey, Irma and Maria (Hurricanes)—except with respect to the dates that define the disasters. Thus, practitioners who don’t wish to postpone filing returns for wildfire victims while they wait for updated form instructions with respect to wildfire victim relief should consider applying various instructions for Form 1040 and supporting forms that are specific to Hurricane victims—but substituting dates that are contained in the BBA with respect to wildfire victim relief—to the returns of wildfire victims.

For example, the instructions to Form 4684, Casualties and Thefts, reflect special instructions for victims of the Hurricanes but have not been updated to reflect the fact that the wildfire victims are entitled to the same relief.


Tax Cuts and Jobs Act – Mandatory Repatriation in 2017


The Tax Cuts and Jobs Act (“the Act”) signed into law on December 22, 2017 has significant impact on taxation of foreign-earned income. The Act lays the framework to transition the United States to a territorial tax regime and, as part of this transition, there is a one-time mandatory repatriation of accumulated foreign earnings and profits required to be included in income for tax year 2017.

If a taxpayer is a 10% or greater U.S. shareholder of a specified foreign income corporation (“SFC”), the taxpayer must include in 2017 income its share of the SFC’s earnings that have not previously been subject to U.S. tax. A U.S. shareholder for the mandatory repatriation is any U.S. individual, partnership, trust or corporation. A SFC includes a controlled foreign corporation (“CFC”) and a foreign corporation in which a U.S. corporation owns 10% or more of voting power.

The starting point of the calculation is post-1986 accumulated earnings and profits (“E&P”) as determined on November 2 or December 31, 2017. If a taxpayer is a shareholder in multiple SFCs, the negative E&P of one SFC can offset the positive E&P of another SFC. The U.S. shareholder’s Subpart F income increases by the higher accumulated E&P amount between these two measuring dates.

A final important note for U.S. shareholders that have U.S. GAAP financial statements and, in the past, may have included an assertion stating the intent to permanently reinvest earnings outside the U.S. for purposes of the income tax provision. This assertion will no longer be valid. The tax cost of the mandatory repatriation will have to be accounted for in the 2017 U.S GAAP financial statements.

Taxation of the Subpart F income can receive reductions in two forms:

  • 5% for accumulated E&P attributable to cash or cash equivalents, and
  • 8% for accumulated E&P reinvested into non-U.S. property, plants, and equipment.

Taxpayers can elect to pay off the tax liability in installments over eight years as follows:

  • 8% each year for the first 5 years after 2017 (i.e., 2018-2022)
  • 15% in year 6 (2023)
  • 20% in year 7 (2024)
  • 25% in year 8 (2025)

After the mandatory repatriation in 2017, US C-corporations that are 10% or greater shareholder of SFCs will receive 100% dividend received deductions. Under the new participation exemption regime, foreign-earned income will generally be taxed only once.

To understand the implication of these changes for your 2017 tax return, please contact your HLB Gross Collins advisor.




Tax Cuts and Jobs Act – Final Version: BUSINESSES

Corporate Taxes
The Conference Committee version of H.R. 1 calls for a 21-percent corporate tax rate beginning in 2018. The Conference bill makes the new rate permanent. The maximum corporate tax rate currently tops out at 35 percent.

Bonus Depreciation
The Conference bill increases the 50-percent “bonus depreciation” allowance to 100 percent for property placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for longer production period property and certain aircraft). A 20-percent phase-down schedule would then kick in. It also removes the requirement that the original use of qualified property must commence with the taxpayer, thus allowing bonus depreciation on the purchase of used property.

The bonus depreciation rate has fluctuated wildly over the last 15 years, from as low as zero percent to as high as 100 percent. It is often seen as a means to incentivize business growth and job creation.

Vehicle Depreciation
The Conference bill would raise the cap placed on depreciation write-offs of business-use vehicles. The new caps would be $10,000 for the first year a vehicle is placed in service (up from a current level of $3,160); $16,000 for the second year (up from $5,100); $9,600 for the third year (up from $3,050); and $5,760 for each subsequent year (up from $1,875) until costs are fully recovered. The new, higher limits apply to vehicles placed in service after December 31, 2017, and for which additional first-year depreciation under Code Sec. 168(k) is not claimed.

Section 179 Expensing
The Conference bill would also enhance Code Sec. 179 expensing. The Conference bill sets the Code Sec. 179 dollar limitation at $1 million and the investment limitation at $2.5 million.

Deductions and Credits
Numerous business tax preferences would be eliminated under the Conference version of H.R. 1. These include the Code Sec. 199 domestic production activities deduction, non-real property like-kind exchanges, and more. Additionally, the rules for business meals would be revised, as would the rules for the rehabilitation credit.

The Conference bill leaves the research and development credit in place, but requires five-year amortization of research and development expenditures. The Conference bill also creates a temporary credit for employers paying employees who are on family and medical leave.

Interest Deductions
The Conference bill generally caps the deduction for net interest expenses at 30 percent of adjusted taxable income, among other criteria. Exceptions would exist for small businesses, including an exemption for businesses with average gross receipts of $25 million or less.

Pass-Through Businesses
Currently, owners of partnerships, S corporations, and sole proprietorships – as “pass-through” entities – pay tax at the individual rates, with the highest rate at 39.6 percent. The House bill proposed a 25-percent tax rate for certain pass-through income after 2017, with a nine-percent rate for certain small businesses. The Senate bill generally would have allowed a temporary deduction in an amount equal to 23 percent of qualified income of pass-through entities, subject to a number of limitations and qualifications.

The Conference bill generally follows the Senate’s approach to the tax treatment of pass-through income, but with some changes, including a reduction in the percentage of the deduction allowable under the provision to 20 percent (not 23 percent), a reduction in the threshold amount above which both the limitation on specified service businesses and the wage limit are phased in, and a modification in the wage limit applicable to taxpayers with taxable income above certain threshold amounts.

Net Operating Losses
The Conference Committee version of H.R. 1 modifies current rules for net operating losses (NOLs). Generally, NOLs would be limited to 80 percent of taxable income for losses arising in tax years beginning after December 31, 2017. The Conference bill also denies the carryback for NOLs in most cases while providing for an indefinite carryforward, subject to the percentage limitation.

The House bill called for repealing many current energy tax incentives, including the credit for plug-in electric vehicles. Other energy tax preferences, such as the residential energy efficient property credit, would have been modified. The Conference bill retains the credit for plug-in electric vehicles and did not adopt any of the other repeals of or modifications to energy credits from the House bill.

The Conference bill does not modify or repeal the so-called “Johnson amendment.” This provision generally restricts Code Sec. 501(c)(3) organizations from political campaign activity.

The Conference bill would extend from nine months to two years the period for bringing a civil action for wrongful levy. The Conference bill does not prohibit increases in IRS user fees, as proposed by the Senate bill.

The Conference Committee version of H.R. 1 follows the lead of both the House and Senate bills in moving the United States to a territorial system. The Conference bill would create a dividend-exemption system for taxing U.S. corporations on the foreign earnings of their foreign subsidiaries when the earnings are distributed. The foreign tax credit rules would be modified, as would the Subpart F rules. The look-through rule for related controlled foreign corporations would be made permanent, among other changes.

A portion of deferred overseas-held earnings and profits (E&P) of subsidiaries would be taxed at a reduced rate of 15.5 percent for cash assets and 8 percent for illiquid assets. Foreign tax credit carryforwards would be fully available and foreign tax credits triggered by the deemed repatriation would be partially available to offset the U.S. tax.




Tax Cuts and Jobs Act – Final Version: INDIVIDUALS

The House and Senate Tax Cuts and Jobs Act Conference Committee unveiled its tax reform package on December 15. The Committee, after a week of intense negotiations, blended the House and Senate versions of the Tax Cuts and Jobs Act (H.R. 1) into one legislative package. GOP leaders predict that Congress will pass this final version of H.R. 1 before lawmakers leave for their holiday recess. The Conference agreement generally tracks the overall framework for tax reform released by the GOP earlier this year and the House and Senate versions of H.R. 1. This final bill carries a January 1, 2018, effective date for most provisions.

The Conference bill would impact virtually every individual and business on a level not seen in over 30 years. As with any tax bill, however, there will be “winners” and “losers.” The bill calls for lowering the individual and corporate tax rates, repealing countless tax credits and deductions, enhancing the child tax credit, boosting business expensing, and more. The bill also impacts the Affordable Care Act (ACA), effectively repealing the individual shared responsibility requirement.

President Trump has signaled his support for tax legislation before year-end. Few possible roadblocks to ultimately getting a bill to the President’s desk before year-end remain. Prior Senate hold-outs have now signaled their support of the Conference bill, while support in the House appears to be holding steady Nevertheless, some still-hidden parliamentary hurdle or sudden public concern should not be discounted until all the votes are in.

Tax Rates
The Conference Committee version of H.R. 1 proposes temporary tax rates of 10, 12, 22, 24, 32, 35, and 37 percent after 2017. Under current law, individual income tax rates are 10, 15, 25, 28, 33, 35, and 39.6 percent.

Conference Agreement Brackets

RateJoint ReturnIndividual Return
10%$0 - $19,050$0 - $9,525
12%$19,050 - $77,400$9,525 - $38,700
22%$77,400 - $165,000$38,700 - $82,500
24%$165,000 - $315,000$82,500 - $157,500
32%$315,000 - $400,000$157,500 - $200,000
35%$400,000 - $600,000$200,000 - $500,000
37%Over $600,000Over $500,000

Under the Conference bill, income levels would be indexed for inflation for a “chained CPI” instead of CPI. Both the original House bill and the Senate bill called for a chained CPI. In general, this change would result in a smaller annual rise in rate brackets, which the Joint Committee of Taxation estimates, when combined with using the chained CPI for all other inflation-adjusted tax amount, would bring $128 billion more into the U.S. Treasury over the next ten-year period. The chained CPI is permanently applied to almost all amounts subject to annual inflation adjustment, even the permanent amounts that would apply if provisions are allowed to expire after 2025.

Standard Deduction
The Conference bill calls for a near doubling of the standard deduction. It increases the standard deduction to $24,000 for married individuals filing a joint return, $18,000 for head-of-household filers, and $12,000 for all other individuals, indexed for inflation (using chained CPI) for tax years beginning after 2018. All increases are temporary and would end after December 31, 2025. Under current law, the standard deduction for 2018 had been set at $13,000 for joint filers, $9,550 for heads of households, and $6,500 for all other filers. The additional standard deduction for the elderly and the blind ($1,300 for married taxpayers, $1,600 for single taxpayers) is retained.

Deductions and Credits
The Conference bill makes significant changes to some popular individual credits and deductions. Many of the changes, however, are temporary, generally ending after 2025, in order to keep overall revenue costs for the bill within budgetary constraints.

Mortgage interest deduction. The Conference bill limits the mortgage interest deduction to interest on $750,000 of acquisition indebtedness ($375,000 in the case of married taxpayers filing separately), in the case of tax years beginning after December 31, 2017, and beginning before January 1, 2026. For acquisition indebtedness incurred before December 15, 2017, the Conference bill allows current homeowners to keep the current limitation of $1 million ($500,000 in the case of married taxpayers filing separately).

The Conference agreement also allows taxpayers to continue to include mortgage interest on second homes, but within those lower dollar caps. However, no interest deduction will be allowed for interest on home equity indebtedness.

Some homeowners dodged a bullet when the Conference bill rejected the additional limitation in both the House and Senate bills to increase the holding period for the homeowners’ capital gain exclusion to a five-out-of-eight year principal-residence test.

State and Local Taxes.
The Conference bill limits annual itemized deductions for all nonbusiness state and local taxes deductions, including property taxes, to $10,000 ($5,000 for married taxpayer filing a separate return). Sales taxes may be included as an alternative to claiming state and local income taxes.

Miscellaneous Itemized Deductions
The Conference bill repeals all miscellaneous itemized deductions that are subject to the two-percent floor under current law.

Medical Expenses
The Conference bill follows the Senate bill in not only retaining the medical expense deduction, but also temporarily enhancing it. The Conference bill lowers the threshold for the deduction to 7.5 percent of adjusted gross income (AGI) for tax years 2017 and 2018.

Family Incentives
The Conference bill temporarily increases the current child tax credit from $1,000 to $2,000 per qualifying child. Up to $1,400 of that amount would be refundable. The Conference bill also raises the adjusted gross income phaseout thresholds, starting at adjusted gross income of $400,000 for joint filers ($200,000 for all others).
The child tax credit is further modified to provide for a $500 nonrefundable credit for qualifying dependents other than qualifying children.

The Conference agreement retains the student loan interest deduction, as proposed in the Senate bill. It also modifies section 529 plans and ABLE accounts. The Conference bill does not overhaul the American Opportunity Tax Credit, as proposed in the House bill. The Conference bill also does not repeal the exclusion for interest on U.S. savings bonds used for higher education, as proposed in the House bill.

The Conference bill repeals the deduction for alimony payments and their inclusion in the income of the recipient.

The Conference Committee version of H.R. 1 generally retains the current rules for 401(k) and other retirement plans. However, the Conference bill would repeal the rule allowing taxpayers to recharacterize Roth IRA contributions as traditional IRA contributions to unwind a Roth conversion. Rules for hardship distributions would be modified, among other changes.

Federal Estate Tax
The Conference bill follows the Senate bill in not repealing the estate tax, but rather doubling the estate and gift tax exclusion amount for estates of decedents dying and gifts made after December 31, 2017, and before January 1, 2026. The generation-skipping transfer (GST) tax exemption is also doubled.

Alternative Minimum Tax
The Conference Committee version of the bill retains the alternative minimum tax (AMT) for individuals with modifications. The Conference bill would temporarily increase (through 2025) the exemption amount to $109,400 for joint filers ($70,300 for others, except trusts and estates). It would also raise the exemption phase-out levels so that the AMT would apply to an income level of $1 million for joint filers ($500,000 for others). These amounts are all subject to annual inflation adjustment.

Affordable Care Act
The Conference bill repeals the Affordable Care Act (ACA) individual shared responsibility requirement, making the payment amount $0. This change would be effective for penalties assessed after 2018.

Carried Interest
Under the Conference bill, the holding period for longterm capital gains is increased to three years with respect to certain partnership interests transferred in connection with the performance of services.

How Small Companies Can Address Harassment Issues


How Small Companies Can Address Harassment Issues

Politicians, journalists, and other celebrities are not the only ones vulnerable to charges of sexual harassment. As a business owner, you could be in the spotlight if allegations of improper behavior arise, especially if they are brought by one or more employees. Even if your own conduct has been beyond reproach, harassment among staff members might damage your company’s workplace morale, public image, and profitability.
This issue is not going away. Here are some ideas on how to minimize problems and deal with any that might surface.

Get serious

A plan for addressing sexual harassment at your firm is not something you should assign to just anyone. Get involved personally or delegate the task to a reliable person with proven ability to accomplish vital matters. The higher in your company the responsibility lies, the greater the importance of preventing problems will appear to all of your people.

Get a lawyer

You shouldn’t believe that your knowledge of the company and good old common sense will enable you to deal with any incidents. The legalities and public perceptions can be complex. One way to start facing potential perils from sexual harassment is to get in touch with an attorney who is knowledgeable about local law in your state and perhaps your city.
It’s likely that such an attorney will advise you to create and disseminate a formal policy, expressing your company’s abhorrence of sexual harassment. The policy can spell out what actions will not be tolerated by employees at any level of the firm. Make it clear that any problems can be brought to you or to someone in a senior position without fear of retaliation. At the same time, the policy should assert that anyone accused of stepping out of line won’t be prejudged until all the facts are revealed.

Get ready to follow through

Accept the fact that some harassment claims will arise at some point. Therefore, you should have a plan in place to investigate the dispute, perhaps a procedure suggested by your attorney.
You’ll probably begin by hearing both sides. This might be done separately, so the parties won’t fear intimidation. Get statements from third parties if they have witnessed the activities in question.
Keep records that thoroughly document what has been said and what has been done about it. The complaint might be dismissed, the person accused might be told to undergo counseling, or the guilty party could be fired. Again, it’s a good idea to touch base with your lawyer before announcing any resolution of the complaint.

Set an example

Perhaps the best way to indicate that sexual harassment won’t be condoned at your company is to walk the walk as well as talk the talk. Refrain from saying or doing anything that might be misconstrued, no matter how innocent it might seem to you. If you’re married, and if you have children, think about how any questionable actions might be perceived by your spouse or your kids.

Demonstrate to all your employees that your place of business is somewhere that they can do their jobs without feeling uncomfortable.

Five-Year Tests for Roth IRAs


Two Five-Year Tests for Roth IRAs

The pros and cons of Roth IRAs, which were introduced 20 years ago, are well understood. All money flowing into Roth IRAs is after-tax, so there is no upfront tax benefit.

As a tradeoff, all qualified Roth IRA distributions can be tax-free, including the parts of the distributions that are payouts of investment earnings.

To be a qualified distribution, the distribution must meet two basic requirements. First, the distribution must be made on or after the date the account owner reaches age 59½, be made because the account owner is disabled, be made to a beneficiary or to the account owner’s estate after his or her death, or be used to buy or rebuild a first home.

Second, the distribution must be made after the five-year period beginning with the first tax year for which a contribution was made to a Roth IRA set up for the owner’s benefit.

Note that the calculation of a Roth IRA’s five-year period is very generous. It always begins on January 1 of the calendar year.

Example 1: Heidi Walker, age 58, opens her first Roth IRA and makes a contribution to it on March 29, 2018. Heidi designates this as a contribution for 2017, which can be made until April 17, 2018.

Under the five-year rule, Heidi’s five-year period starts on January 1, 2017. As of January 1, 2022, Heidi’s Roth IRA distributions are tax-free, qualified distributions because they will have been made after she turned 59½ and after the five-year period has ended. The five-year period is determined based on the first contribution to the Roth IRA; the starting date of the five-year period is not reset for the subsequent contributions.

Note that if Heidi opens her first Roth IRA late in 2018, even in December, the first contribution will be a 2018 Roth IRA contribution and Heidi will reach the five-year mark on January 1, 2023.


Conversion factors

Other than making regular contributions, Roth IRAs may be funded by converting a traditional IRA to a Roth IRA and paying tax on any pre-tax dollars moved to the Roth side. For such conversions, a separate five-year rule applies. There generally is a five-year waiting period before a Roth IRA owner who is under age 59½ can withdraw the dollars contributed to the Roth IRA in the conversion that were includible in income in the conversion, without owing a 10% early withdrawal penalty.

Similar to the five-year rule for qualified distributions, the five-year period for conversions begins on the first day of the year of the conversion. However, unlike the five-year rule for qualified distributions, the five-year rule for conversions applies separately to each Roth IRA conversion.

Example 2: In 2018, Jim Bradley, age 41, leaves his job and rolls $60,000 from his 401(k) account to a traditional IRA, maintaining the tax deferral. If Jim decides to withdraw $20,000 next year, at age 42, he would owe income tax on that $20,000 plus a 10% ($2,000) penalty for an early withdrawal.

Instead, in 2019, Jim converts $20,000 from his traditional IRA to a Roth IRA and includes the entire amount converted in income. However, if Jim withdraws that $20,000 in 2019, he also will owe the 10% penalty because he does not meet the five-year rule for conversions; the rationale is that the IRS doesn’t want people to avoid the early withdrawal penalty on traditional IRA distributions by making a Roth conversion.

The good news is that, in this example, Jim will have started the five-year clock with his 2019 Roth IRA conversion. Therefore, he can avoid the 10% early withdrawal penalty on the conversion contribution after January 1, 2024, even though he will only be age 47 then. Jim will owe income tax on any withdrawn earnings, though, until he reaches age 59½ or he meets one of the other qualified distribution criteria.

Note that various exceptions may allow Jim to avoid the 10% penalty before the end of the five-year period. Altogether, the taxation of any Roth IRA distributions made before five years have passed and before age 59½ can be complex. If you have a Roth IRA, our office can explain the likely tax consequences of any distribution you are considering. Generally, it is better to wait until the age 59½ and five-year tests are passed before making Roth IRA withdrawals, to avoid taxes.


Trusted Advice

Roth IRA Distributions

  • Roth IRA distributions after age 59½ (and five years after you set up and make a contribution to your first Roth IRA) qualify for complete tax-free treatment.
  • Distributions that do not qualify for this tax-free treatment may be subject to income tax, a 10% early withdrawal penalty, or both.
  • Ordering rules apply to non-qualified distributions. 
      • First come regular contributions, rollover contributions from other Roth IRAs, and rollover contributions from a designated Roth account.
      • Next come conversion contributions, on a first-in, first-out basis. The taxable portion comes before the nontaxable portion.
      • Earnings on contributions are the last dollars to come out.
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