Overcontribution problem when isolating 401K basis?
This is a repost of my Dec. query – in case I missed your expertise during the busy holidays!
===============================================================================
Earlier this year I recommended to a client and followed to the letter the strategy of isolating 401k basis by
taking a single indirect distribution from the QRP and rolling the pre-tax and after-tax (non-Roth) portions into, respectively,
a rollover IRA and a new Roth IRA. We made up for the required tax withholding with available after-tax cash.
After taking a tax update this month, the instructor and I discussed this strategy in light of the 2011
Paschall v Commissioner ruling (137 T.C., No.2). Not that facts and circumstances are similar, but I have
become concerned that, if the isolation of basis strategy is challenged, then it may follow this course:
1. Rolling QRP after-tax dollars into a Roth IRA is different that rolling them into
a TIRA. A Roth IRA is a different animal than a TIRA.
2. That being the case, if disqualified, the amounts in the Roth represent an excess contribution
and, as such, are subject to the 6% penalty. It’s that 6% on $65,000 that concerns me.
I want to present to the client the plusses and minuses so they can decide whether to stay put or simply
remove the new Roth dollars into a taxable account (or a non-deductible IRA, for that matter).
Are there opinions or experiences with the isolation strategy that have developed during 2011 that can be shared?
Many thanks and Happy Holidays!
Chip Simon, CFP(r)
Permalink Submitted by Alan Spross on Wed, 2012-01-11 22:41
Chip,
I thought I recalled posting to your original post, but there is nothing there now.
Having just reviewed Paschall, my first thought was that there surely must be associated IRS action against all the self directed IRA custodians involved in this sham, as well as Stover and his employers, Grant Thornton and the succeeding firm. However, the IRS response in Paschall is limited to his own involvement. My next thought is that a prohibited transaction had taken place with respect to Paschall’s ownership in the sham corporations set up to carry out the “Roth restructure”. That would have resulted in a taxable distribution of the entire TIRA, but instead the IRS went after the 6% excise taxes, and if there was anything in there about the income taxes due on the sham conversion, I missed it.
That said, I do not see anything in the Paschall case that remotely relates to the isolation of basis strategy. The Roth conversion is not an excess contribution. The only argument the IRS could have would be how the basis was split up between the two different IRA types and therefore what taxes were due on the conversion. If by chance the IRS interpreted Sec 402(c)2 not to apply here and therefore the basis had to be pro rated, then part of the Roth conversion would be taxable and part of the basis would have gone to the TIRA. That would produce a tax bill for part of the conversion OR the client might be allowed to recharacterize the conversion to erase the taxes and then everything would be in the TIRA. Form 8606 would need to be filed to get credit for the after tax basis in the TIRA. So the downside there is not so bad, and both IRAs would be intact.