[Federal Register Volume 67, Number 141 (Tuesday, July 23, 2002)]
[Proposed Rules]
[Pages 48067-48070]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-18452]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-124256-02]
RIN 1545-BA82


Earnings Calculation for Returned or Recharacterized IRA 
Contributions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: These proposed regulations provide a new method to be used for 
calculating the net income attributable to IRA contributions that are 
distributed as a returned contribution pursuant to section 408(d)(4) of 
the Internal Revenue Code or recharacterized pursuant to section 
408A(d)(6). The regulations will affect IRA owners and IRA trustees, 
custodians and issuers.

DATES: Written or electronic comments must be received by October 21, 
2002.

ADDRESSES: Send submissions to: CC:ITA:RU (REG-124256-02), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:ITA:RU (REG-124256-02), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit comments 
electronically directly to the IRS Internet site at www.irs.gov/regs.

FOR FURTHER INFORMATION CONTACT: Cathy Vohs at 622-6090.

SUPPLEMENTARY INFORMATION:

Background

    Section 408(d)(4) provides that an IRA contribution will not be 
included in the IRA owner's gross income when distributed as a returned 
contribution if: (1) It is received by the IRA owner on or before the 
day prescribed by law (including extensions) for filing the owner's 
Federal income tax return for the year of the contribution; (2) no 
deduction is allowed with respect to the contribution; and (3) the 
distribution is accompanied by the amount of net income attributable to 
the contribution.
    Section 408A governs Roth IRAs and was added by section 302 of the 
Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat. 788). Section 
408A(d)(6) provides that a contribution made to one type of IRA may be 
recharacterized as having been made to another type of IRA if: (1) The 
recharacterization transfer occurs on or before the date prescribed by 
law (including extensions) for filing the IRA owner's Federal income 
tax return for the year for which the contribution was made; (2) no 
deduction is allowed with respect to the contribution to the transferor 
IRA; and (3) the transfer is accompanied by any net income allocable to 
the contribution.
    Section 1.408-4(c)(2)(ii) of the Income Tax Regulations prescribes 
the method (the old method) for calculating the amount of net income 
attributable to a contribution distributed pursuant to section 
408(d)(4). The old method bases the calculation of the amount of net 
income attributable to a contribution on the income earned by the IRA 
during the period beginning on the first day of the taxable year in 
which the contribution is made and ending on the date of the 
distribution from the account. Under the old method, net income cannot 
be negative.
    Section 1.408A-5, A-2(c), provides that if a contribution being 
recharacterized is in an IRA that at any time contained other 
contributions, the net income attributable to the contribution being 
recharacterized is calculated in the manner prescribed by Sec. 1.408-
4(c)(2)(ii) (the old method), except that net income can be negative. 
Section 1.408A-5, A-2(b), provides that if an IRA is established with a 
contribution and no other contributions or distributions are made, then 
the subsequent recharacterization transfer of the entire account 
balance of the IRA will satisfy the requirement that the transfer be 
accompanied by any net income allocable to the contribution.
    In connection with issuing the regulations under section 408A 
governing Roth IRAs, it became apparent that the old method produced 
anomalous results for contributions made late in the year. This is 
because, under the old method, account activity in the part of the year 
that precedes the date the contribution is made is taken into account 
in the calculation of the net income attributable to the contribution.
    In response to this concern, the IRS issued Notice 2000-39 (2000-30 
I.R.B. 132), which provided a new method for calculating net income 
that generally bases the calculation of the amount of net income 
attributable to a contribution on the actual earnings and losses of the 
IRA during the time it held the contribution. Under this new method, 
net income can be negative. Notice 2000-39 provided that until further 
guidance is issued, either the old method or the new method may be used 
to calculate net income. Notice 2000-39 also requested comments 
regarding the new method.
    The Service received comments on the new method which were 
generally favorable. However, commentators provided a number of 
suggestions for improving the method, including: (1) Allowing a single 
computation period to be used in the case of multiple IRA 
contributions; (2) clarifying how transfers in or out of IRAs are 
treated under the new method; and (3) allowing net income to be 
determined on the basis of tracing specific assets, rather than dollar 
amounts. This last suggestion was focused primarily on the calculation 
of net income in the case of a recharacterization back to a traditional 
IRA following a conversion of an amount in a traditional IRA to a Roth 
IRA.

Explanation of Provisions

New Method for Net Income Calculation Under Section 408(d)(4)

    These proposed regulations would incorporate, with certain 
modifications, the new method provided in Notice 2000-39. Under the 
proposed regulations, for purposes of returned contributions under 
section 408(d)(4), the net income attributable to a contribution is 
determined by allocating to the contribution a pro-rata portion of the 
net income on the assets in the IRA (whether positive or negative) 
during the period the IRA held the contribution. This new method is 
represented by the following formula:

[[Page 48068]]

[GRAPHIC] [TIFF OMITTED] TP23JY02.020

    Under this formula, the opening balance is the fair market value of 
the IRA immediately before the contribution being returned is made to 
the account and the closing balance is the fair market value of the 
account immediately before the contribution is removed. The opening 
balance then is adjusted to include the amount of any contributions or 
transfers made to the IRA during the computation period. In addition, 
the closing balance is adjusted to include the amount of any 
distributions or transfers made from the IRA during the computation 
period. In the case of an IRA that has received more than one regular 
contribution for a particular taxable year, the last regular 
contribution made to the IRA for the year is deemed to be the 
contribution that is distributed as a returned contribution under 
section 408(d)(4), up to the amount of the contribution identified by 
the IRA owner as the amount distributed as a returned contribution.
    In response to comments received, the proposed regulations would 
clarify that a transfer made in or out of an IRA during the computation 
period is treated in the same manner as a contribution or distribution 
made to or from the IRA. The proposed regulations also provide that a 
single computation period is used if more than one contribution was 
made to the IRA as a regular contribution.

New Method for Net Income Calculation Under Section 408A(d)(6)

    The proposed regulations would provide rules for calculating net 
income allocable to a contribution being recharacterized under section 
408A(d)(6) that are substantially similar to the rules applicable to 
contributions being returned under section 408(d)(4). However, if more 
than one contribution is being recharacterized, different rules apply. 
In the case of multiple contributions for a particular year that are 
eligible for recharacterization, the IRA owner chooses (by date and 
dollar amount, not by specific assets acquired with those dollars) 
which contribution is to be recharacterized. In addition, if a series 
of regular contributions was made, and consecutive contributions in 
that series are being recharacterized, the computation period is 
determined using a single computation period, based on the first 
contribution in the series.
    The proposed regulations would retain the rule that net income 
calculations must be based on the overall value of an IRA and the 
dollar amounts contributed, distributed or recharacterized to or from 
the IRA. Even in a recharacterization of an amount converted to a Roth 
IRA, the proposed regulations would not permit net income to be 
calculated on the basis of the return on specific assets. The dollars 
contributed to an IRA are invested in assets that generate gains and 
losses. Once contributions are commingled in an account, those dollars 
are no longer associated with particular assets. In the absence of 
maintaining separate accounts, tying particular assets to a particular 
contribution would create administrative problems for taxpayers, IRA 
providers and the IRS.

Proposed Effective Date

    The regulations are proposed to be applicable for calculating 
income allocable to IRA contributions made on or after January 1, 2004. 
For purposes of determining net income applicable to IRA contributions 
made during 2002 and 2003, taxpayers may continue to apply the rules 
set forth in Notice 2000-39 or may rely on these proposed regulations. 
If, and to the extent, future guidance is more restrictive than these 
proposed regulations, the future guidance will be issued without 
retroactive effect.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations. Because 
proposed Sec. 1.408-11 and revised A-2(c) of Sec. 1.408A-5 impose no 
new collection of information on small entities, a Regulatory 
Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) is not required. Pursuant to section 7805(f) of the Internal 
Revenue Code, this notice of proposed rulemaking will be submitted to 
the Chief Counsel for Advocacy of the Small Business Administration for 
comment on its impact on small business.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing may be scheduled if requested in writing by a 
person that timely submits written comments. If a public hearing is 
scheduled, notice of the date, time and place for the hearing will be 
published in the Federal Register.

Drafting Information

    The principal author of these regulations is Cathy A. Vohs of the 
Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and 
Government Entities). However, other personnel from the IRS and 
Treasury participated in their development.

List of Subjects 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    1. The authority citation for part 1 is amended by adding entries 
in numerical order to read in part as follows:


    Authority: 26 U.S.C. 7805 * * *


Sec. 1.408-4  also issued under 26 U.S.C. 408.


Sec. 1.408-11  also issued under 26 U.S.C. 408. * * *

    2. Section 1.408-4 is amended by adding the following text before 
the first sentence of (c)(1):


Sec. 1.408-4  Treatment of distributions from individual retirement 
arrangements.

* * * * *
    (c) * * * (1) * * *
    The rules in this paragraph (c) apply for purposes of determining 
net income attributable to IRA contributions made before January 1, 
2004, and returned pursuant to section 408(d)(4). The rules in 
Sec. 1.408-11 apply for purposes of determining net income attributable 
to IRA contributions made on or after January 1, 2004, and returned 
pursuant to section 408(d)(4).
* * * * *
    3. Section 1.408-11 is added to read as follows:

[[Page 48069]]

Sec. 1.408-11  Net income calculation for returned or recharacterized 
IRA contributions.

    (a) Net income calculation for returned IRA contributions--(1) 
General rule. For purposes of returned contributions under section 
408(d)(4), the net income attributable to a contribution made to an IRA 
is determined by allocating to the contribution a pro-rata portion of 
the earnings on the assets in the IRA during the period the IRA held 
the contribution. This attributable net income is calculated by using 
the following formula:
[GRAPHIC] [TIFF OMITTED] TP23JY02.021

    (2) Special rule. If an IRA is established with a contribution and 
no other contributions, distributions or transfers are made to or from 
that IRA, then the subsequent distribution of the entire account 
balance of the IRA pursuant to section 408(d)(4) will satisfy the 
requirement of that Code section that the return of a contribution be 
accompanied by the amount of net income attributable to the 
contribution.
    (b) Definitions. For purposes of this section the following 
definitions apply--
    (1) Adjusted opening balance. The term adjusted opening balance 
means the fair market value of the IRA at the beginning of the 
computation period plus the amount of any contributions or transfers 
(including the contribution that is distributed as a returned 
contribution pursuant to section 408(d)(4) and recharacterizations of 
contributions pursuant to section 408A(d)(6)) made to the IRA during 
the computation period.
    (2) Adjusted closing balance. The term adjusted closing balance 
means the fair market value of the IRA at the end of the computation 
period plus the amount of any distributions or transfers (including 
recharacterizations of contributions pursuant to section 408A(d)(6)) 
made from the IRA during the computation period.
    (3) Computation period. The term computation period means the 
period beginning immediately prior to the time that the contribution 
being returned was made to the IRA and ending immediately prior to the 
removal of the contribution. If more than one contribution was made as 
a regular contribution and is being returned from the IRA, the 
computation period begins immediately prior to the time the first 
contribution being returned was contributed.
    (4) Regular contribution. The term regular contribution means an 
IRA contribution made by the IRA owner that is neither a trustee-to-
trustee transfer from another IRA nor a rollover from another IRA or 
retirement plan.
    (c) Additional rules--(1) When an IRA asset is not normally valued 
on a daily basis, the fair market value of the asset at the beginning 
of the computation period is deemed to be the most recent, regularly 
determined, fair market value of the asset, determined as of a date 
that coincides with or precedes the first day of the computation 
period. In addition, solely for purposes of this section, 
notwithstanding A-3 of Sec. 1.408A-5, recharacterized contributions are 
taken into account for the period they are actually held in a 
particular IRA.
    (2) In the case of an IRA that has received more than one regular 
contribution for a particular taxable year, the last regular 
contribution made to the IRA for the year is deemed to be the 
contribution that is distributed as a returned contribution under 
section 408(d)(4), up to the amount of the contribution identified by 
the IRA owner as the amount distributed as a returned contribution.
    (3) In the case of an individual who owns multiple IRAs, the net 
income calculation is performed only on the IRA containing the 
contribution being returned, and that IRA is the IRA that must 
distribute the contribution.
    (d) Examples. The following examples illustrate the net income 
calculation under section 408(d)(4) and this section:

    Example 1. (i) On May 1, 2004, when her IRA is worth $4,800, 
Taxpayer A makes a $1,600 regular contribution to her IRA. Taxpayer 
A requests that $400 of the May 1, 2004, contribution be returned to 
her pursuant to section 408(d)(4). Pursuant to this request, on 
February 1, 2005, when the IRA is worth $7,600, the IRA trustee 
distributes to Taxpayer A the $400 plus attributable net income. 
During this time, no other contributions have been made to the IRA 
and no distributions have been made.
    (ii) The adjusted opening balance is $6,400 [$4,800 + $1,600] 
and the adjusted closing balance is $7,600. Thus, the net income 
attributable to the $400 May 1, 2004, contribution is $75 [$400 x 
($7,600--$6,400) / $6,400]. Therefore, the total to be distributed 
on February 1, 2005, pursuant to Sec. 408(d)(4) is $475.
    Example 2. (i) Beginning in January 2004, Taxpayer B contributes 
$300 on the 15th of each month to an IRA for 2004, resulting in an 
excess regular contribution of $600 for that year. Taxpayer B 
requests that the $600 excess regular contribution be returned to 
her pursuant to section 408(d)(4). Pursuant to this request, on 
March 1, 2005, when the IRA is worth $16,000, the IRA trustee 
distributes to Taxpayer B the $600 plus attributable net income. The 
excess regular contributions to be returned are deemed to be the 
last two made in 2004: the $300 December 15 contribution and the 
$300 November 15 contribution. On November 15 the IRA was worth 
$11,000 immediately prior to the contribution. No distributions or 
transfers have been made from the IRA and no contributions or 
transfers, other than the monthly contributions (including $300 in 
January and February 2005), have been made.
    (ii) As of the beginning of the computation period (November 
15), the adjusted opening balance is $12,200 [$11,000 + $300 + $300 
+ $300 + $300] and the adjusted closing balance is $16,000. Thus, 
the net income attributable to the excess regular contributions is 
$187 [$600 x ($16,000--$12,200) / $12,200]. Therefore, the total to 
be distributed as returned contributions on March 1, 2005, to 
correct the excess regular contribution is $787 [$600 + $187].

    Par. 4. In Sec. 1.408A-5, A-2(c) is revised to read as follows:


Sec. 1.408  A-5 Recharacterized contributions.

* * * * *
    A-2 * * *
    (c) (1) If paragraph (b) of this A-2 does not apply, then, for 
purposes of determining net income attributable to IRA contributions, 
the net income attributable to the amount of a contribution is 
determined by allocating to the contribution a pro-rata portion of the 
earnings on the assets in the IRA during the period the IRA held the 
contribution. This attributable net income is calculated by using the 
following formula:
[GRAPHIC] [TIFF OMITTED] TP23JY02.022


[[Page 48070]]


    (2) For purposes of this paragraph (c), the following definitions 
apply--
    (i) The term adjusted opening balance means the fair market value 
of the IRA at the beginning of the computation period plus the amount 
of any contributions or transfers (including the contribution that is 
being recharacterized pursuant to section 408A(d)(6) and any other 
recharacterizations) made to the IRA during the computation period.
    (ii) The term adjusted closing balance means the fair market value 
of the IRA at the end of the computation period plus the amount of any 
distributions or transfers (including contributions returned pursuant 
to section 408(d)(4) and recharacterizations of contributions pursuant 
to section 408A(d)(6)) made from the IRA during the computation period.
    (iii) The term computation period means the period beginning 
immediately prior to the time the particular contribution being 
recharacterized is made to the IRA and ending immediately prior to the 
recharacterizing transfer of the contribution. If a series of regular 
contributions was made to the IRA, and consecutive contributions in 
that series are being recharacterized, the computation period begins 
immediately prior to the time the first of the regular contributions 
being recharacterized was made.
    (3) When an IRA asset is not normally valued on a daily basis, the 
fair market value of the asset at the beginning of the computation 
period is deemed to be the most recent, regularly determined, fair 
market value of the asset, determined as of a date that coincides with 
or precedes the first day of the computation period. In addition, 
solely for purposes of this paragraph (c), notwithstanding A-3 of this 
section, recharacterized contributions are taken into account for the 
period they are actually held in a particular IRA.
    (4) In the case of an individual with multiple IRAs, the net income 
calculation is performed only on the IRA containing the particular 
contribution to be recharacterized, and that IRA is the IRA from which 
the recharacterizing transfer must be made.
    (5) In the case of multiple contributions made to an IRA for a 
particular year that are eligible for recharacterization, the IRA owner 
can choose (by date and by dollar amount, not by specific assets 
acquired with those dollars) which contribution, or portion thereof, is 
to be recharacterized.
    (6) The following examples illustrate the net income calculation 
under section 408A(d)(6) and this paragraph:

    Example 1. (i) On March 1, 2004, when her Roth IRA is worth 
$80,000, Taxpayer A makes a $160,000 conversion contribution to the 
Roth IRA. Subsequently, Taxpayer A discovers that she was ineligible 
to make a Roth conversion contribution in 2004 and so she requests 
that the $160,000 be recharacterized to a traditional IRA pursuant 
to section 408A(d)(6). Pursuant to this request, on March 1, 2005, 
when the IRA is worth $225,000, the Roth IRA trustee transfers to a 
traditional IRA the $160,000 plus allocable net income. No other 
contributions have been made to the Roth IRA and no distributions 
have been made.
    (ii) The adjusted opening balance is $240,000 [$80,000 + 
$160,000] and the adjusted closing balance is $225,000. Thus the net 
income allocable to the $160,000 is -$10,000 [$160,000 x ($225,000 / 
$240,000) / $240,000]. Therefore, in order to recharacterize the 
March 1, 2004, $160,000 conversion contribution on March 1, 2005, 
the Roth IRA trustee must transfer from Taxpayer A's Roth IRA to her 
traditional IRA $150,000 [$160,000--$10,000].
    Example 2. (i) On April 1, 2004, when her traditional IRA is 
worth $100,000, Taxpayer B converts the entire amount, consisting of 
100 shares of stock in ABC Corp., and 100 shares of stock in XYZ 
Corp., by transferring the shares to a Roth IRA. At the time of the 
conversion, the 100 shares of stock in ABC Corp., are worth $50,000 
and the 100 shares of stock in XYZ Corp., are also worth $50,000. 
Taxpayer B decides that she would like to recharacterize the ABC 
Corp., shares back to a traditional IRA. However, B may choose only 
by dollar amount the contribution or portion thereof that is to be 
recharacterized. On the date of transfer, November 1, 2004, the 100 
shares of stock in ABC Corp., are worth $40,000 and the 100 shares 
of stock in XYZ Corp., are worth $70,000. No other contributions 
have been made to the Roth IRA and no distributions have been made.
    (ii) If B requests that $50,000 (which was the value of the ABC 
Corp., shares at the time of conversion) be recharacterized, the net 
income allocable to the $50,000 is $5,000 [$50,000 x ($110,000 -
$100,000) / $100,000]. Therefore, in order to recharacterize $50,000 
of the April 1, 2004, conversion contribution on November 1, 2004, 
the Roth IRA trustee must transfer from Taxpayer B's Roth IRA to a 
traditional IRA assets with a value of $55,000 [$50,000 + $5,000].
    (iii) If, on the other hand, B requests that $40,000 (which was 
the value of the ABC Corp., shares on November 1) be 
recharacterized, the net income allocable to the $40,000 is $4,000 
[$40,000 x ($110,000 -$100,000) / $100,000]. Therefore, in order to 
recharacterize $40,000 of the April 1, 2004, conversion contribution 
on November 1, 2004, the Roth IRA trustee must transfer from 
Taxpayer B's Roth IRA to a traditional IRA assets with a value of 
$44,000 [$40,000 + $4,000].
    (iv) Regardless of the amount of the contribution 
recharacterized, the determination of that amount (or of the net 
income allocable thereto) is not affected by whether the 
recharacterization is accomplished by the transfer of shares of ABC 
Corp., or of shares of XYZ Corp.

    (7) This paragraph (c) applies for purposes of determining net 
income attributable to IRA contributions, made on or after January 1, 
2004. For purposes of determining net income attributable to IRA 
contributions made before January 1, 2004, see paragraph (c) of this A-
2 of Sec. 1.408A-5 (as it appeared in the April 1, 2003, edition of 26 
CFR part 1).
* * * * *

David A. Mader,
Acting Deputy Commissioner of Internal Revenue.
[FR Doc. 02-18452 Filed 7-22-02; 8:45 am]
BILLING CODE 4830-01-P