2009 Roth Conversion – no longer eligible due to tax audit
My client did a Roth Conversion in 2009. Now, their tax return has been audited and income for that year was revised upward. Therefore, they no longer qualify for the Roth Conversion. Unfortunately, they are passed the recharacterization deadline.
Is there any way to recharacterize now? What are the other possible issues or repercussions; for example, would it be considered a premature distrubution from the Traditional IRA, if we cannot recharacterize? Or, are they subject to excess contribution penalties to Roth IRA? Other possible issues?
Permalink Submitted by Alan Spross on Fri, 2011-06-03 17:41
Actually, it’s both of the consequences you listed. However, there may be a work around for this referred to as a “super extended deadline for recharacterization”.
First, if client does not wish to pursue that, he has a failed conversion. If a failed conversion is not recharacterized by the extended due date, it must be treated as an excess REGULAR contribution to the Roth IRA, at least for the excess of the amount he would have qualified to make as a regular contribution for 2009. And that is probably -0- due to his income. To correct the excess regular contribution after the due date, he just requests a normal (early) Roth distribution in the amount of the conversion. No adjustments are made for earnings. It is reported on Form 8606, and under the ordering rules would most likely be tax free. However, he also owes a 6% excise tax for both 2009 and 2010 and must file a 5329 for each year. Another large cost is that he must report the TIRA distribution on an amended 2009 return showing tax and penalty. The penalty effectively replaces that same 10% penalty for withdrawing a conversion held under 5 years. He already paid taxes on the conversion, so the net added cost here is the 10%. The total tax cost is therefore 10% + 6% + 6% = 22% plus IRS interest on the late payment of these taxes. Moreover, he has lost future tax deferral because his funds are no longer in either type of IRA account.
Depending on the amount of the conversion, he may want to pursue the PLR for the super extended due deadline. That would allow him to recharacterize the conversion retoractively and wipe out those penalties, and his funds would end up in the TIRA instead of a taxable account. Since the 2009 MAGI was apparently an honest mistake there is good precedent for the IRS to grant the PLR request. Since the income limit for conversions was ended in 2010, the chances of a positive ruling should be increased. But the cost of the PLR is expensive and the process is time consuming. The filing fee is around 10k plus legal costs, so the reduced fees for 60 day rollover extensions do not apply to this type of request. Therefore, the amount of the conversion (excess contribution) would probably drive the decision process.
Permalink Submitted by Bruce Steiner on Fri, 2011-06-03 21:18
There is a reduced IRS user fee of $4,000 for ruling requests on Roth recharacterizations. Rev. Proc. 2011-8, section 6.01(9): http://www.irs.gov/irb/2011-01_IRB/ar13.html#d0e15856 .
Permalink Submitted by Alan Spross on Fri, 2011-06-03 22:39
That would help. Thanks, Bruce.