Failed Roth Conversion
One of our clients converted a portion of his IRA in 2009 even though his AGI will be well in excess of the $100,000 maximum. Due to extraordinary medical expenses that year, the amount he converted to the Roth was done at a relative bargain tax rate. Since he was ineligible to make a Roth conversion, the most advantageous course of action would have been to simply take a distribution for that amount. If he were to recharacterize today, the bargain rate distribution in 2009 would be lost.
1) Rather than recharacterize, can the client take a distribution for the full amount of his Roth-IRA, and avoid the 6% excise tax if this is done before the tax filing deadline?
2) Our assumption would be that the conversion amount would be taxable as a 2009 distribution, and that any earnings since the time of conversion would be taxed in 2010 (when it is distributed to the client). Is this correct?
3) If the 6% excise tax cannot be avoided, would it be prorated based on the portion of the year that the assets were in the Roth-IRA, or would it be a full 6% on the entire conversion amount, regardless of what portion of the year the assets were in the Roth-IRA?
This is a very important issue for this client. Thank you in advance for your perspective.
Permalink Submitted by Alan Spross on Thu, 2010-03-18 05:10
Good question, and a convoluted answer.
Obviously, recharacterization by the extended due date is the recommended solution for this, but failing to do that the client pays a considerable price including loss of the funds to any IRA account. Therefore, the ultimate price to be paid here would be that he would effectively end up with a TIRA distribution at a very low ordinary tax rate, but with a 10% early withdrawal penalty and a 6% excise tax for each year the situation remains uncorrected. Beyond these generalities, the IRS is not forthcoming with exact reporting instructions, particularly for where and when to report the early distribution. Technically, the early distribution goes back to the failed conversion date and should probably be reported on an amended return, but there are no IRS instructions for that. Interest charges would also accrue for the year the penalty was reported and each year of the 6% excise tax. Another technical reality is that the 5 year clock for earnings cannot start with an excess contribution or failed conversion. On your specific questions:
1) No. The failed conversion, if not corrected by the usual recharacterization, must be treated as an excess regular Roth contribution. Part IV of Form 5329 levies the 6% excise tax on the smaller of the actual excess contribution OR the value of ALL Roth IRAs as of 12/31/09. So if this were the ONLY Roth he had and it lost value, the 6% would be charged on the lower 12/31/09 value. Probably no relief in this case. The 6% charge shows on line 25 of Form 5329. Because of the distribution you propose, the 12/31/2010 balance might be eliminated, so that would stop the 6% charges at one year vrs repeating for a number of years.
2) Yes, the conversion would still be taxable in 2009 since it was not recharacterized. But since it is failed conversion, the 10% early withdrawal penalty would apply, and a Form 5329 would be needed to report the early distribution on line 1, despite the 1099R not containing Code 1 for an early distribution.
3) There are no pro rations allowed. A new 6% levy accrues every 12/31. Client would be hit with the 2009 levy since the balance is still in the account as of 12/31, but it would be out prior to 12/31/2010. Other than interest charges, client could wait until December to take the withdrawal since any earnings will get to stay in the Roth IRA. That’s another 9 months to generate earnings. If this is the only Roth, those earnings would be the only balance left after the failed conversion was distributed.
In summary, client would pay 6% plus 10% and the funds would be lost to any IRA. But if he recharacterizes, he can reconvert after 30 days using the 2010 rules where there are no MAGI requirements and report over 2 years. He could re establish his Roth IRA after 31 days. He will obviously be taxed more doing this than if he reported the distribution in 2009, so what needs to be compared are these alternatives:
a) Your distribution option will cost 16% plus a small amount of interest plus whatever ordinary tax is due BUT funds are lost to any IRA
b) Roth IRA is maintained at the marginal rate for 2011 and 2012 (or 2010 if opted).
Probably a tough analysis to do – perhaps the 2009 return should be extended while he considers the options.
Permalink Submitted by Steve Gilbertson on Thu, 2010-03-18 13:51
Alan,
Thank your for your excellent, thorough response. As this client is 78 years old, can I assume that just the 6% excise tax, but not the 10% penalty would apply here?
Permalink Submitted by Alan Spross on Thu, 2010-03-18 17:05
Yes, no penalty after 59.5, just the excise tax.