Mistake made rolling over traditional IRA to solo 401k – need help on how to correct it

Submitted by Kris Sundene on Wed, 2023-02-08 00:51

In 2022 I switched from a w2 job to having a pllc and working as a sole proprieter with 1099 income. I opened a solo 401k to be able to do employee/employer contributions with my 1099 income. I had an old traditional IRA that had money rolled over from an old work 401k and some non -deductible contributions as well (I didn’t realize this at the time). The IRA had a total of approx $73,000 and of that $21,000 was non-deductible. I wanted to be able to start doing a backdoor Roth so I planned to empty the IRA in order to avoid the pro rata rule. I rolled over the entire $73,000 to my solo 401k not realizing that rolling over the $21,000 that was non-deductible was a prohibited transaction. The solo 401k is at Vanguard and I rolled over the traditional IRA from an different company. This was completed in Nov of 2022. In hindsight, I signed a form saying it was all pretax money I was rolling over but I didn’t realize at the time the $21,000 I had contributed several years ago was considered non-deductible.
I realized in Jan of 2023 after reading another forum that I should have only rolled over the $52,000 that was pretax money and earnings and not the entire $73,000. I have now been trying to figure out how to correct the mistake. I’ve been told I must removed the non-deductible traditional IRA basis that was rolled over in error as well as any earnings on that money. I was also told I won’t be able to put that back into an IRA due to doing the prohibited transaction as it was now “tainted money” now . I was told I should be able to explain the mistake to Vanguard and then remove the money and would get a 1099-R from Vanguard. Now comes the hard part, I can’t figure out how to do this at Vanguard. I have spent many hours on the phone so far with Vanguard. Vanguard has only given me 2 options for removing money from my solo 401k via 2 different forms —

1. Either through excess employer contributions where I have to check on of the following:

1) non deductible contribution – that you use the form 5330, (and if I do this the money has to stay in the account and it says vanguard doesn’t need to be notified of this type of excess)
2) excess deferral
3) excess annual additions or
4) mistake of fact (I’ve been told this mistake does not fit under this category)

OR

2. Distribution form where I have to choose either

1) severance from employment
2) plan termination
3) QDRO
4) disability
5) RMD
6) hardship
7) death
8) in service withdrawal

I am in my mid 40’s so not close to RMD. I don’t meeet any of these other choices. I thought maybe I could choose in the in-service withdrawal but it states the money has to be in there >2 years in order to do this type of distribution at age less than 59 1/2 and I just opened this account July 2022.

Vanguard says they have no other ways for the money to be taken out of the account to correct this. That I have to use one of these forms and thus pick one of the options above. As far as I can tell I don’t meet any of those criteria. I have talked to my accountant and he isn’t sure what to do to correct this.

Does anyone have any advice on how I correct this mistake and what forms to tell Vanguard I need in order to remove the money correctly?



Submitted by Alan - IRA critic on Wed, 2023-02-08 04:12

  • Everyone that rolls IRA basis into a qualified plan runs into this frustrating situation. EPCRS (the IRS correction program) does not clearly address how to report a corrective distribution of these “excess amounts”, as that program focuses on contributions from salary and  employers rather than rollovers. You are correct that the plan should distribute the excess amount to you with any earnings, but the 1099R should also reflect the fact that the excess is after tax and only any gains should be taxable. In Vanguard’s case, they do not even have a form that addresses removal of these excess amounts. Everyone who reports these excess amounts to plan administrators regrets it because of the same reaction you are running into. You may just have to accept the fact that it cannot be corrected and you will eventually owe tax on this amount a second time. The following is all the IRS offers on this matter in Rev Procedure 2021-30:
  • “.06 Special rules relating to Excess Amounts. (1) Treatment of Excess Amounts. A distribution of an Excess Amount is not eligible for the favorable tax treatment accorded to distributions from Qualified Plans or § 403(b) Plans (such as eligibility for tax-free rollover). Thus, for example, if such a distribution was contributed to an IRA, the contribution is not a valid rollover contribution for purposes of determining the amount of excess contributions (within the meaning of § 4973) to the individual’s IRA. A distribution of an Excess Amount is generally treated in the manner described in section 3 of Rev. Proc. 92-93, 1992-2 C.B. 505 (relating to the corrective disbursement of elective deferrals). The distribution must be reported on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the year of distribution with respect to each participant or beneficiary receiving such a distribution. Except as otherwise provided in section 6.02(5)(c) with respect to recovery of small Overpayments, where an Excess Amount has been or is being distributed, the Plan Sponsor must notify the recipient that (a) an Excess Amount has been or will be distributed and (b) an Excess Amount is not eligible for favorable tax treatment accorded to distributions from an eligible retirement plan, as defined in § 402(c)(8)(B) (and, specifically, is not eligible for rollover.”
  • Note that there is no definition of exactly what an excess amount is. However, that is what your IRA basis becomes in the plan.
  • You might try returning the form and adding your own box for “Excess Amounts” and explain the amount that was basis in your IRA and is not eligible for rollover. There should be full agreement that this was not eligible, but Vanguard obviously has no clue on the proper way to fix it. A real mess!


Submitted by Kris Sundene on Wed, 2023-02-08 20:39

Thank you so much for your response. It is very helpful. A couple more questions if you don’t mind:  

  • In the event I can’t get Vanguard to do the distribution of the $21,000 this year (which seems more likely with every conversation I have with them)    I have been told if I just leave the money in the solo 401k and don’t correct it , the IRS could find me guilty of not following proper procedures and could disallow and dissolve my solo 401k and I would have to pay taxes and penalties on all of it. Does that seem like something that is likely to occur?  Or does it seem like if I just keep it in there that when I take it out at retirement it will be treated like all the other money and I will be taxed on it (and in the end pay taxes on it twice). If the penalty here is just paying taxes twice  when it comes out it seems like this might be the easiest road forward.  
  • Would another option be to wait for 2 years until I can take money out by the in service withdrawal as after a 2  year waiting period  I can withdraw the money. This would leave me non-compliance for 2 years until I could report it once the plan will allow me a way to remove the money?

 

  •   I have already done a backdoor roth for both 2022 and 2023 (I didn’t realize I had this mistake in rolling over non-deductible money until after I had already done it for both 2022 and  2023). The last time I did a contribution to my traditional IRA (it was a non deductible contribution without any conversions)  was $6000 for the tax year 2020.  I have found a copy of my  form 8606 from 2020 and on that I have $21,000 on line 3. So when I do the 8606 for tax year 2022 will I put a 0 on line 2 since I didn’t have any money in the traditional IRA on 12/31/22.  Will the IRS compare the 8606 from 2020 and 2022 and wonder where the $21,000 went that was there in 2020. I wasn’t sure if this would be a red flag to the IRS.  I did get a 1099R from Morgan Stanley for the entire $73,000+ rollover and no where on that form does it designate that any of it is non-deductible. 

  Thanks again for your time and wisdom with these questions. 



Submitted by Alan - IRA critic on Wed, 2023-02-08 22:35

  • Yes, while it is possible that the IRS could disqualify your plan, that is highly unlikely, particularly if you can document that you reported this violation to the plan administrator, and the administrator was unable to make the corrective distribution. VG likely understands that rollover of IRA basis is not allowed, but they simply do not have forms or procedures in place to properly issue the corrective distribution. If they did make a distribution it would likely show it as entirely taxable resulting in double taxation currently rather than gradually down the road. For the IRS to determine that you rolled over basis, they would have to either do a complete audit or compare your 8606, the IRA 1099R and the year end value of your IRA to deduct that you rolled over basis. The IRS does not do these detailed comparisons unless you got audited for a different reason. Further, my impression from others in your shoes is that they are not securing the corrective distribution. I have asked for feedback from anyone regarding the 1099R coding for a corrective distribution, and have not received an answer, so it looks like they might not be pursuing the correction given all the conflicting issues about it.
  • Of course, no plan has a time limit for corrective distributions such as excess deferrals or excess contributions, and this infraction should be getting the same treatment with no waiting period. It’s not obvious whether they really understand the problem, or just have no interest in determining how to process the corrective distribution. Part of the problem is that none of your custodians know your IRA basis. Only you and the IRS know, and the IRS assigns a very low priority to tracking IRA basis, mostly ignoring it. This is obvious because despite many 8606 completion errors and omissions by taxpayers, the IRS almost never questions the basis amounts reported on these 8606 forms, at least in these forums no taxpayer has ever reported the IRS doing so, and I have been active at this for nearly 20 years.
  • Waiting the 2 years and taking a distribution might show some good faith on your part, but the 1099R would not be coded as a corrective distribution, and the IRS would just think that you needed the money. An improperly coded 1099R would be treated by the IRS as just another early distribution, not a corrective distribution.
  • The other side of this problem is proper reporting of the IRA direct rollover. You probably have a 1099R coded G for 73k, but since 21k was not rollover eligible, this should actually be reported on your 1040 as a direct rollover of 52k and a (non) taxable distribution of your IRA basis of 21k, which you then separately contributed to the solo K. But your solo K agreement likely does not include non Roth after tax contributions, which still leads to a plan violation. The IRA distribution of 21k would resolve any questions about your 8606 leaving 0 basis on line 14 of your 2022 8606. 
  • Is VG also your IRA custodian, and if so I assume it’s a completely separate division and staff from the 401k administration?  With cooperation of your IRA custodian you might be able to restore the 21k of basis to your IRA by using RP 2020-46 linked below. You would use reason (c) – that you rolled an amount into a plan that you thought was an eligible retirement plan, but was not for IRA basis rollovers. That would allow the IRA custodian to accept a late rollover of the 21k back your TIRA, after which you could convert it tax free.
  • Microsoft Word – rp-20-46.docx (benefitslink.com)


Submitted by Kris Sundene on Thu, 2023-02-09 01:29

You are correct, my 1099 R from Morgan Stanley for the direct rollover from the trad IRA to the solo 401k is for the $73,000 and is coded as a G. 

  • The custodian of my original traditional IRA was Morgan Stanley and was rolled over to the Vanguard solo 401k. I now have a new Vanguard traditional IRA and Vanguard  roth IRA that I opened late 2022  in order to do a backdoor roth.  If I pursued using the RP 2020-46 that you mention above would that have to be restored to the original Morgan Stanley IRA?


Submitted by Gregory Mueller on Tue, 2023-03-21 01:38

I did something similar last year… In my case, I did a disallowed Roth 401k rollover into a tIRA, and then I rolled over that entire tIRA balance, including both the disallowed Roth 401k to tIRA rollover AND tIRA basis (created from a Roth conversion w/ an existing tIRA balance that same year).   After getting some advice on Bogleheads, I was advised to:

  1. Remove the disallowed tIRA rollover amount that originated from the roth 401k AND the tIRA basis from the solo 401k as excess contributions, and issue a 1099-R code E.  
  2. Do a late rollover, using rev proc. 2020-16 of the original Roth 401k to the proper place, my Roth IRA.
  3. This is where I run into the same issue… getting IRA basis back into my IRA.  However, I have one big advantage, which is that I have a self-directed solo 401k meaning I create my own 1099-Rs and it pretty much allows every kind of transation legally allowed within 401ks (in-service withdrawals, after-tax contributions, in-plan conversions, etc).   

But does any of that help me get the basis back into my tIRA so I can convert it to Roth?   



Submitted by David Mertz on Tue, 2023-03-21 02:03

It would seem that getting the tIRA basis back into the tIRA would involve the same sort of late rollover using Rev. Proc. 2020-46 that was used to get the Roth funds into a Roth IRA.



Submitted by Gregory Mueller on Tue, 2023-03-21 23:01

My rollover wouldnt be late, as I did it within 60 days.  But the fact still remains that it is an excess contribution, and excess contributions arent eligible to be rolled over…. 



Submitted by David Mertz on Wed, 2023-03-22 03:50

My reasoning is that the disallowed rollover of tIRA basis to the 401(k) and the subsequent removal with code E would mean that there was only a partial rollover of the original distribution from the tIRA and that depositing the basis back into the tIRA would constitute a completion of the rollover of the remainder of original distribution from the tIRA, a late rollover.  The completion of the tIRA-to-tIRA rollover of the basis would be subject to the one-rollover-per-12-months limitation, so you would have to have not done another tIRA-to-tIRA or Roth IRA-to-Roth IRA rollover within the one year period ending on the date of the original distribution from the tIRA.



Submitted by Gregory Mueller on Thu, 2023-03-23 01:56

But why would it be late if the original disallowed rollover was within 60 days?  Im sure I have not had another like kind rollover within 12 months, I cannot think of why I would even do one, besides this example.  I’ve transfered IRAs from other custodians, but that’s not a rollover, right? Called Vanguard today, they sent me the paper form that they use for VRIP (a self-administered brokerage account they allow you to host with them for self-directed solo 401ks and similar retirement plans).  They advised me to indicate a rollover from that account to my Roth.  But, I didnt think that was allowed.  The CPA who has been helping me to says I need to make a “conversion contribution”.   Meaning tIRA to Roth IRA.  



Submitted by David Mertz on Thu, 2023-03-23 03:50

I’m considering the rollover of the basis to the 401(k) and its distribution via EPCRS to be a failed rollover and therefore a portion of the original distribution from the tIRA that has not yet been successfully rolled over.



Submitted by Gregory Mueller on Thu, 2023-03-23 13:02

Yes, you are right, but it’s still within 60 days, so it is not late.  Interestingly, I think I can fix this right on Vanguard’s site.  I go to “contribute” and then there is a question “Is this a rollover from an employer-sponsored plan OR IRA?I click yes, and then there are 2 options. This rollover is:1. From another Roth IRA2. A conversion from a non-Roth IRA (e.g, traditional IRA) or a non-Roth account in an employer-sponsored plan.I choose #2 and select the remaining basis from my 2023 8606 calculations, $5,657.14.I select where the money is coming from – my linked bank account.I indicated it’s an IRA conversion and it’s not associated w/ my solo k at all. So the 5498 should be marked as a conversion, not a contribution or rollover… Good to go, right?



Submitted by David Mertz on Thu, 2023-03-23 20:06

“This was completed in Nov of 2022.” That appears to be what you said about the timing of the rollover from the traditional IRA to the 401(k) and was much more than 60 days ago.



Submitted by Gregory Mueller on Sat, 2023-03-25 12:39

That was the OP, mine was done in Feb 2023.   I was able to correct this and it’s remarkably simple.  You do it right on the Vanguard website per the steps above.  The excess removal is also very simple for me, since my 401k is self-directed, but I imagine it wouldnt be much more difficult for a Vanguard one. 



Submitted by David Mertz on Sat, 2023-03-25 23:07

I failed to notice that the OP was different.  Since your original distribution was less than 60 days ago, you are correct, no self-certification needed.



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