New Tax Law Could Have Major Impact

Part two of two parts on the New Tax Law. Read part one.

NEW YORK – It takes 808 pages for CCH, Inc., a tax information service, to explain the new tax law. Most of the provisions are narrow. But when they affect you, they can make a big difference. For example:

– Did you overpay the IRS? You may have, if you forgot a deduction, filed an amended return; or if – during an audit – the IRS finds that you actually owe less.

Starting in January, the IRS will pay interest on overpayments at the same rate it charges for underpayments – currently 8 percent. Under the old law, overpayments earned 1 percentage point less.

– Are you fighting the IRS? In civil court cases, the IRS now bears the burden of proving that your tax returns are wrong.

Previously, the law required you to prove that they were right. You get this privilege, however, only if you keep good records, make credible claims and cooperate with the IRS's investigation.

You won't like this "reform." The IRS may now have to investigate you more thoroughly and intrusively, to build its case.

This change does not apply to regular audits. There, you still bear the burden of proving the income and deductions you claimed.

– Is your accountant representing you in a tax case? You can now talk to him or her in confidence, just as you can talk to a lawyer.

But this privilege is limited, says Mark Luscombe, principal tax analyst for CCH. It doesn't cover tax preparation, tax shelters or criminal matters. But it does shield conversations about an audit or civil court case.

– Are you thinking about converting a regular Individual Retirement Account (IRA) to a Roth IRA? There's no tax on the money you earn in a Roth, assuming you follow all the rules. It can be left to heirs income-tax free. The tax law includes a bunch of new rules and clarifications:

1. Married or single, you can convert an IRA to a Roth if your adjusted gross income doesn't exceed $100,000. The amount you convert does not count toward your $100,000 ceiling, although it's included in your adjusted gross income and is subject to income taxes.

If you're at least 70½ and taking mandatory withdrawals from a regular IRA, those withdrawals currently count toward your $100,000 income ceiling. Beginning in 2005, however, they won't count anymore (unless Congress changes the law again).

2. The money switched from a deductible IRA to a Roth has to be reported as taxable income. In this year alone, you can choose when to pay the taxes due. The income can be spread, and taxed, over four years (1998-2002). Or you can report it all on your '98 return.

Normally, you'd choose to spread the income and defer the tax. But that assumes that you won't be unusually disadvantaged by raising your reported income for the next four years. A higher income makes some taxpayers ineligible for education tax credits, costs them medical deductions or pushes them into a sharply higher tax bracket. In these cases, you might rather pay the tax all at once.

You might also pay the tax all at once if you can offset the IRA income with business losses, says tax expert Sidney Kess of New York City.

3. You have to convert to the Roth by Dec. 31. But you can reverse the transaction without penalty, as long you do so by the due date of your tax return (including extensions). To reverse it, call your Roth trustee and say you want to make the change. You'll be taxed on any money you withdraw in cash.

Why would you switch back to a regular IRA? Two possible reasons: First, you might discover that your income exceeded $100,000, which makes you ineligible for a Roth. Second, the stocks in your IRA might plunge after you switched them to a Roth. If you keep your Roth, you'll be taxed on its former value; if you undo the transaction, you won't, says accountant Ed Slott of Rockville Centre, N.Y., editor of the newsletter, "Ed Slott's Advisor."

4. It's imprudent to take money out of a Roth for the first five years after you convert. There's a 10 percent penalty if you're under 59½. You also owe taxes on the earnings.

If you were spreading the income (and tax) over four years, an early withdrawal foils your plans. You'll owe extra taxes in the current year.

If you die during the first five years, however, your heirs could receive the money income-tax free.

Jane Bryant Quinn welcomes letters on money issues and problems but cannot offer individual financial advice.