IRA Distribution Mishap

Submitted by CONTEY SMITH on Fri, 2022-12-16 17:36

A client cashed an IRA distribution check intended for their employer 401(k) plan in their personal bank account. This was a direct r/o with checks issued as “FBO” so the bank did so in error. This was done to isolate basis within the IRA to ultimately convert the funds to a ROTH. The conversion has happened. To avoid the early withdrawal penalties and taxation, Schwab stated the client can deposit a check for the full amount within 60 days to be treated as a 60-day rollover. The check was distributed on 11/9. Can the client deposit the check on 1/2 to avoid the pro-rata rule but meet the 60 day requirements to avoid taxation of the ROTH conversion?



Submitted by Alan - IRA critic on Fri, 2022-12-16 19:23

Yes, as long as the 401k plan will accept a 60 day rollover from an IRA. The one rollover limit is not a factor since the funds will be going to a non IRA plan. Now if the 401k does not accept the rollover, the conversion will be pro rated, even if the funds must be returned to the IRA and are returned after year end. 



Submitted by CONTEY SMITH on Fri, 2022-12-16 21:17

Thank you for your response. One point of clarification – the funds will be routed back to Schwab who is the custodian of their IRA which would (in my understanding) make it a 60-day rollover. Given the end of year timeline, we don’t want to risk the funds not being deposited by the 401k plan custodian causing a pro rata error. Therefore, we’d return the funds in Jan. 2023 to bypass the IRA holding funds on 12/31.



Submitted by David Mertz on Fri, 2022-12-16 21:51

  • If the rollover back to the traditional IRA does not occur until January 2023, the amount of this outstanding rollover must be added to the 12/31/2022 traditional IRA account balance to come up with the value to include on line 6 of Form 8606 for calculating the taxable amount of the Roth conversion.  Delaying this rollover ensures the undesirable result by making the Roth conversion largely taxable and retaining a significant amount of traditional IRA basis in the client’s traditional IRAs.  The deposit into the 401(k) account does not have to happen in 2022 but the distribution from the traditional IRA (after the rollover back to the traditional IRA in 2022) must happen in 2022.
  • Note that the rollover back to the traditional IRA would be a violation of the one-rollover-per-12-months rule after 11/9/2021 the client made any other IRA distribution that was rolled over to the same type IRA.


Submitted by CONTEY SMITH on Sat, 2022-12-17 00:08

Understand. The client is considering keeping the funds as an early distribution with penalty (for home purchase). I was looking for other options given the OI tax and penalty. With that said, to be sure, if they keep the funds, there is no negative tax impact to the ROTH conversion, correct? 



Submitted by Alan - IRA critic on Sat, 2022-12-17 00:30

  • If they keep the distribution, both the distribution and the conversion will have the IRA basis pro rated by the same factor. If there is no year end balance left in any TIRA account,  the same amount of basis will be applied to the conversion as before, but the rest of the basis will be applied to the recent distribution. The penalty on the recent distribution will only apply to the taxable portion of that distribution.
  • If the home purchase qualifies for the first house penalty exception of 10,000 lifetime, the penalty will be waived on 10,000 of the taxable distribution. This is claimed on Form 5329, Part I, Code 09 on line 2.  


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