2008 Failed Roth Conversion – How to Reduce 6% Excise Tax?
A client of mine did a Roth conversion in 2008. Subsequently, he and his wife ended up filing taxes as Married Filing Separately for Tax Year 2008. As the account had gone up in value, he chose to pay the tax as well as the 6% excise tax for both 2008 and 2009 tax years, with hopes of applying the excess contributions toward future years. Now we come to 2010, where the rules have changed and he would be eligible to do a Roth conversion, even with his Married Filing Separate status. Does this mean he can now apply the unlimited conversion amount for 2010 to the excess contribution that was carried forward? Or can he only reduce the excess he has carried forward by the 2010 contribution limit? I have read and reread the IRS rules in Pub. 590 and still cannot figure it out. Also, what form would you utilize to reduce or eliminate the excess for 2010, assuming that can be done at all. I would really appreciate any knowledge that any of you could pass on for this uncommon situation.
Permalink Submitted by Alan Spross on Fri, 2011-10-14 02:09
First, I guess it is safe to assume that the idea of amending their 2008 returns to joint status will not fly for some combination of reasons, as that would wipe out the failed status of the conversion.
Eliminating that option, he is stuck with a failed conversion. I guess the IRS did not see a need to continue to address failed conversions starting with the 2010 Pub 590, but I think they should have maintained coverage of the situation for 5 years or so until the prior failed conversions were corrected. You are correct that the failed conversion not recharacterized by the deadline is treated as an excess regular Roth contribution.
Such an excess contribution can be corrected by distributions (no consideration as to earnings or loss), or by applying the excess to a regular Roth contribution that was not used. Of course, the latter solution is limited to 5k or 6k per year and therefore would occur too slowly to correct large conversions. Either way, the corrective distributions are reported on Form 8606 and 5329, with the 5329 used to calculate the 6% excise tax and to apply any corrective activity that has occurred.
Note: Since the excess amount can only be treated as an excess regular contribution, it cannot be corrected after 2009 by not making a conversion that the taxpayer is eligible to make.
If the client removes the excess contribution before year end 2011, the 6% excise taxes will end with the 2010 tax. Since the failed conversion is considered to be a regular contribution, the removal will be tax free, and any additional balance from earnings can stay in the Roth. If 2010 is on extension, there is nothing that can be done there unless he qualified for a regular Roth contribution that he did not make, and then the excess amount will be reduced by 5k or 6k (if catchup applies). Same for 2011, but no sense in doing the removal until December since there is no additional excise tax until after year end and the excess contribution has a couple more months to generate earnings that can stay in the Roth.
Finally, if this was client’s first Roth contribution, the 5 year clock did not start since it cannot start with an excess contribution or by earnings on an excess contribution. It would start in the first year that another conversion was made or the excess was applied to a regular contribution.