Traditional IRAs allow deferral of income tax on contributions, but that deferral ends when assets are withdrawn from the account. However, in recent years Congress has given individuals the option of converting a traditional IRA accounts to a Roth IRA, paying income tax on the amount rolled over into the Roth. In contrast to a traditional IRA, withdrawals of both principal and income can be made tax-free.
The attraction of Roth conversion is muted by the fact that the taxpayer has to pay tax on the lump sum that’s rolled over into the Roth. But what if you could convert a traditional IRA to a Roth IRA without paying income tax on the conversion?
Various schemes to do just that have been sold to taxpayers in recent years but they have almost invariably failed, as discovered by the Swansons, who took their dispute over a Roth conversion to the Tax Court.
Mr. Swanson was approached by an accountant with a proposal to convert a traditional IRA with over a million dollars into a Roth IRA, which would permit tax-free withdrawals from the account, saving Mr. Swanson hundreds of thousands of dollars in income tax liability.
Although Mr. Swanson was aware that the Roth IRA contribution limit was only $2,000 at the time the Roth Restructure transaction was entered into, he nevertheless agreed to participate in the scheme, paying $120,000 to the accounting firm for a Roth Restructure.
The accounting firm agreed to defend Mr. Swanson if the transaction was challenged by the IRS and also agreed to indemnify him for any civil negligence or fraud penalties assessed against him by the IRS or state taxation authorities. Mr. Swanson ended up holding the firm to that promise.
The Roth Restructure
Mr. Swanson was the beneficiary of a thrift savings plan (TSP) through his employer and various other investment accounts. Withdrawals from any of those accounts would be taxed to Mr. Swanson. The Roth Restructure was supposed to convert those taxable amounts to nontaxable amounts held in a Roth account.
A series of corporations were formed as part of the restructure; Mr. Swanson was made president, secretary and treasurer of the corporations. Mr. Swanson then opened both Roth and traditional IRAs. He funded the traditional IRA with a rollover from his other retirement accounts. He then directed the IRA to purchase $1.2 million of stock in one of the corporations.
Then, through a complex series of maneuvers involving the IRA, Roth IRA and corporations formed as part of the restructure, Mr. Swanson transferred about $1.6 million from tax deferred accounts to Roth accounts.