Distribution error from 401(k) to Roth IRA
A 401(k) distribution check sent to a custodian was coded with the wrong account number. The custodian deposited the funds (all pre-tax) into the client’s Roth IRA instead of a TIRA in November 2010. The error was detected when a smaller check was distributed by the plan in early April 2011.
We have discussed the situation with the custodian. They suggested recharacterizing the funds from the Roth IRA to the Traditional IRA. This was confirmed by another tax professional. Are there any other options?
If recharacterization is the answer, is the growth in the account related to the November deposit taxable in 2011. What tax documents should we expect from the custodian to document the client’s file?
Permalink Submitted by Alan Spross on Tue, 2011-04-19 21:06
Fortuneately, this is one of those errors that can be corrected easily by the client through recharacterization. Earnings in the Roth IRA from the conversion funds would migrate to the TIRA and there would be no taxable event in 2010 or 2011, other than making an explanatory statement on the tax returns outlining what occurred.
But if there are positive earnings, perhaps the client should give consideration to doing only a partial recharacterization, retaining part of the conversion and deferring the remaining conversion income to 2011 and 2012. The markets have done well in the last 5 months, so client might be able to turn an accident to his advantage. If a partial recharacterization is chosen, then the earnings attributed to only that portion go back to the TIRA, and the rest remain in the Roth potentially tax free once the Roth is qualified.
The final decision will affect the 2010 return if all or part of the conversion is retained, since any conversion amount must be reported even though the conversion income is deferred. Client could also opt to report the retained conversion fully in 2010 if it was to his advantage.
If the entire conversion is recharacterized, there will be a 1099R issued next January on the Roth IRA showing this and a 5498 reporting a recharacterized contribution received by the TIRA account. These forms would confirm what the client indicated on the statement with the 2010 return and there would be no further reporting on the 2011 return.
Permalink Submitted by Robert Florian on Wed, 2011-04-20 15:28
Thank you for your reply.
The account increased from November 2010 through today by approx. $20,000. The account owner does not want added income in 2010, 2011 or 2012, therefore it is likely he will recharacterize the full amount. If I understood your post, a full recharacterization in 2011 would create no additional taxable income. No mention of the error was made on the 2010 return since the error was detected after the return was filed. Should the 2010 return be amended with an explanation of the error or should the explanation be attached to the 2011 return?
Permalink Submitted by Alan Spross on Wed, 2011-04-20 17:30
The return is probably incorrect assuming a non taxable rollover was reported, and would be incorrect even if a conversion was reported due to the recharacterization pending to reverse the conversion to a TIRA account. This will require a 1040X, but no additional taxes will be due. The explanatory statement can go on the 1040X.
Once the above is done, there will be no need to report anything on the 2011 return.