[Federal Register Volume 68, Number 86 (Monday, May 5, 2003)]
[Rules and Regulations]
[Pages 23586-23590]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-11046]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9056]
RIN 1545-BA82


Earnings Calculation for Returned or Recharacterized IRA 
Contributions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations that 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 (Code) or 
recharacterized pursuant to section 408A(d)(6). These regulations will 
affect IRA owners and IRA trustees, custodians and issuers.

DATES: Effective Date: These final regulations are effective on May 5, 
2003.
    Applicability Date: These final regulations are applicable for 
calculating income allocable to IRA contributions made on or after 
January 1, 2004.

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

SUPPLEMENTARY INFORMATION:

[[Page 23587]]

Background

    This document contains amendments to the Income Tax Regulations (26 
CFR part 1) under Code sections 408 and 408A. These regulations provide 
a new method for calculating the net income attributable to IRA 
contributions that are distributed as a returned contribution pursuant 
to section 408(d)(4) or recharacterized pursuant to section 408A(d)(6).
    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(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.
    Notice 2000-39 (2000-2 C.B. 132), provided a new method for 
calculating net income that generally based 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, and provided that under the new method, net income could 
be negative. Notice 2000-39 provided that until further guidance is 
issued, either the old method (i.e., the method specified in Sec.  
1.408-4(c)(2)(ii)) or the new method may be used to calculate net 
income.
    Proposed regulations under sections 408 and 408A were published in 
the Federal Register on July 23, 2002 (REG-124256-02, 67 FR 48067). 
These proposed regulations incorporated, with certain modifications, 
the new method provided in Notice 2000-39. The public reaction to 
Notice 2000-39 was generally favorable and few comments were received 
on the proposed regulations. Consequently, these final regulations 
adopt the rules in the proposed regulations without modification.

Explanation of Provisions

    These final regulations retain, without change, the methods 
provided in the proposed regulations. Thus, under these final 
regulations, for purposes of returned contributions under section 
408(d)(4) and recharacterized contributions under section 408A(d)(6), 
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:
[GRAPHIC] [TIFF OMITTED] TR05MY03.001

    Under the final regulations, generally, the 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 
made to the IRA during the computation period. A special rule is 
provided for an IRA asset that is not normally valued on a daily basis. 
In this case, 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. One commentator suggested that the application of this special 
rule be extended to all IRA assets as an alternate fair market value 
determination so that the value of an IRA at the beginning of the 
computation period could be the most recent statement value just prior 
to the contribution, rather than the actual value on the exact date of 
the contribution.
    The final regulations do not extend the special valuation rule to 
all IRA assets because the IRS and Treasury believe that if an IRA 
asset is normally valued on a daily basis, these values must be used so 
that the calculation of the amount of net income attributable to a 
contribution is based on the actual earnings and losses of the IRA 
during the time it held the contribution. The alternate rule suggested 
by the commentator would increase the chances of producing anomalous 
results because account activity in the part of the year that precedes 
the date the contribution was made would be taken into account in the 
calculation of the net income attributable to the contribution.
    One commentator suggested that where both regular Roth IRA 
contributions and conversion contributions have been made to the same 
Roth IRA, the net income calculation attributable to a 
recharacterization of a conversion contribution may require that some 
of the regular Roth IRA contributions be recharacterized to the 
traditional IRA. The commentator recommended that if a conversion 
contribution is being recharacterized, and the Roth IRA contains both 
regular contributions and conversion contributions, the final rules 
should permit the principal amount of any regular Roth IRA 
contributions in that same Roth IRA to remain in the Roth IRA.
    The final regulations retain the rule, without modification, that 
net income calculations and allocations 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 where the Roth IRA contains both regular 
contributions and conversion contributions, the final regulations do 
not permit net income, including any losses, to be allocated other than 
pro rata. Thus, the principal amount of regular Roth IRA contributions 
cannot be protected against adjustment for their pro rata share of net 
income, including any net losses, during the computation period. Once 
contributions are commingled in an account, those dollars are no longer 
associated with particular assets or contributions. 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.

Effective Date

    These final regulations are 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 the proposed regulations.

[[Page 23588]]

Special Analyses

    It has been determined that these final regulations are 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 Sec.  
1.408-11 and 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, the notice of 
proposed rulemaking that preceded these final regulations was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small business.

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 in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 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. * * *

0
Par. 2. In Sec.  1.408-4, paragraph (c)(1) is amended by adding two 
sentences before the current first sentence to read as follows:


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). * * 
*
* * * * *

0
Par. 3. Section 1.408-11 is added to read as follows:


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] TR05MY03.002

    (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 Internal Revenue 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

[[Page 23589]]

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].


0
Par. 4. In Sec.  1.408A-5, A-2(c) is revised to read as follows:


Sec.  1.408A-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] TR05MY03.003

    (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].

[[Page 23590]]

    (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,
Assistant Deputy Commissioner of Internal Revenue.
    Approved: April 25, 2003.
Pamela F. Olson,
Assistant Secretary of the Treasury.
[FR Doc. 03-11046 Filed 5-2-03; 8:45 am]
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