Ineligible Roth Rollover
I have a client who rolledover her 401(k) into a Roth IRA in [b]2009[/b]. Unfortunately, I was unaware of this until April of 2011 when the client asked me what the tax liability was on their rollover. I was like, you did what??
The client did give me a 1099-R for 2009 with a code G. I entered that information on the 2009 tax return reporting the amount rolledover and a taxable amount of zero. Of course, the code was incorrect and the client wasn’t eligibile anyhow to make a Roth conversion as their Modified AGI exceeded $100,000. I know at this stage the only possible way to do a recharacterization is through a private letter ruling which cost $4000. So, scratch that. Now, what to do.
From researching this very informative site it seems like the client will be stuck with a 6% excise tax for both 2009 and 2010. Or maybe just 2009? Because of the elimination of the MAGI phaseout in 2010 the clients would have been eligible to do a 2010 Rollover into a Roth IRA. It looks like the must file form 5329 for 2009 and pay the 6% excise tax.
Now for 2010 since they would have been eligible can a 1040X be filed for 2010 reporting the taxable rollover into a Roth IRA, avoid the 6% excise tax for 2010, and pay the ordinary tax on the conversion amount in tax years 2011 & 2012?
Or are they stuck having to pay the 6% excise tax in 2010 too? If this is the case I am correct in the rest of what I stated? What about the earnings in the account?
One last thing…clients were obviously misinformed by the trustee of the account. Do they have any recourse or forgiveness from the excise tax(es)?
Thanks for your help!
Permalink Submitted by Alan Spross on Thu, 2011-06-30 01:12
Subject to the amount of this failed conversion, pursuing that PLR to allow a super extended due date to recharacterize the conversion should be seriously considered, after reviewing the corrective procedure following.
Since the extended due date has passed, the failed conversion must be treated as a taxable distribution from the TIRA in 2009 and an excess regular contribution to the Roth IRA. That Roth contribution would be subject to the 6% excise tax for 2009 for amounts in excess of the amount of regular Roth contributions the client would otherwise have been eligible for (probably -0-).
Assuming no distributions from the Roth have been taken since the conversion, the 6% excise tax would also apply for 2010, and a 5329 would be needed for each year. Currently, a distribution would be needed that would likely be tax free as a return of a regular Roth contribution. Any earnings get to stay in the Roth, which is the consolation for incurring the 6% excise tax. Earnings distributions and the excise tax are mutually exclusive.
I doubt there is any chance whatsoever of a friendly PLR allowing the conversion to be treated as a 2010 conversion, but if the recharacterization is allowed the funds would remain in the TIRA and could be converted anew this year or in the future. The 6% excise taxes would be eliminated as would the income tax on the 2009 distribution. The failure of the QRP to show a taxable amount in Box 2a might improve the chances of a friendly letter ruling. I think the PLR request should be seriously considered in this case since it would solve most all of the consequences of the current situation.
I think the IRS erred in eliminating a reference to “failed conversion” in Pub 590 so soon, just because the last day to have one was 12/31/2009.
Permalink Submitted by Bruce Steiner on Thu, 2011-06-30 02:50
The $4,000 is the IRS user fee for applying for a ruling to allow a late recharacterization. There will also be legal fees unless the original poster is willing to volunteer his/her services. But I agree with Alan that it’s worth considering applying for a ruling unless the amount involved is too small for that to make sense.
In deciding on requests to waive a deadline, one of the factors the IRS considers is whether the taxpayer is trying to benefit from hindsight. A helpful fact In this regard is that the taxpayer’s income was over $100,000, so that he was not eligible to convert.
Now that the $100,000 income cap is no longer in effect, if the ruling request is granted, the taxpayer will have another opportunity to convert, either all at once, or over a number of years, if he doesn’t want to bunch the income from the conversion into a single year.
Permalink Submitted by Christopher Dennehy on Thu, 2011-06-30 04:26
Thanks for such a quick reply.
Hopefully I understood everything…The failed conversion from the QRP to the Roth IRA in 2009 must be treated as a taxable distribution.
Therefore,
1) I should amend the 2009 tax return and have client pay the tax liability in that year. Unfortunately, taxpayer was under 59 1/2 so there will be a 10% penalty plus the 6% excise tax for 2009.
2) For 2010 file form 5329 by on a standalone basis and pay another 6% excise tax.
3) As soon as possible, take a current distribution from the Roth IRA of the excess contributions, but earnings can stay in the Roth.
The amount of the failed conversion was about $18,000 and their marginal tax rate was 25% so it’s going to cost them (18,000 * .25 +.06 +.06 +.10 ) $8460 plus any interest and penalties plus state income tax. Geez.
Lesson learned for me. When I get a 1099-R with a code G from a client I am going to make sure I get the facts to make certain the 1099-R is correct.
Permalink Submitted by Christopher Dennehy on Thu, 2011-06-30 04:38
What about a carryforward?
3. Carry Forward – You can carry forward the excess amount and use it up in subsequent years as contributions for those years. This is generally only a good idea for contributions when you are fairly certain that you will be eligible to make a contribution in the next year. You will still owe the 6% excess contribution penalty for each year that you have excess funds in the account.
Permalink Submitted by Alan Spross on Thu, 2011-06-30 18:11
Re carryforward for a regular contribution – that is correct, the 5329 will apply a reduction to the excess amount for regular Roth contributions client was eligible to make, but did not make. It will also credit distributions taken from the Roth as reductions to the excess amount. Either of these would reduce the 6% excise tax at the end of the year since the excess balance has been reduced.
Re prior post:
1) Yes, the 2009 return needs to be amended to eliminate the 8606 reporting the conversion, and a detailed explanatory statement included. The taxes have already been paid, but not the 10% penalty on the distribution.
2) Agree – IRS will probably bill interest on both 1 and 2
3) Not necessarily as soon as possible. Another 6% penalty is not incurred until year end, and since earnings get to stay in the Roth, might as well wait till December to take out the remainder of the excess contribution as this is another 6 months to generate earnings. The distribution would be reported on an 8606 for 2011, probably tax free since it is coming from what are deemed to be regular contributions.
Even if you plan to pursue the PLR, the above should be done to limit the damage. If the ruling is successful, the returns can be amended again to get a tax refund and the funds can be returned to the TIRA (or whatever else the ruling allows).