Roth Conversion Penalty
Client made (two) $5000 non-deductible contributions in March 2010. (for prior year 2009, and 2010). Money was then converted to a Roth. The same excercise was done in 2011, and again in 2012. No taxes were paid.
Turns out he has a small $5000 traditional IRA. Since there was no distributions from this traditional IRA, I am not sure if the accountant picked up on this. Taxes shouls have been paid on the conversions (pro-rata basis).
The client, just now (in 2012) converted the $5000 traditional IRA to a Roth, and will pay taxes on the conversion in April of 2013.
Are there penalties owed on the prior year conversions? (I assume yes). And/or how do you rectify a situation like this with the IRS? (forms, re-file, etc…)
Thanks
Permalink Submitted by Alan Spross on Tue, 2012-05-22 21:52
He would have to amend his 2010 and 2011 returns to reflect the pro rate rules as applied on Form 8606. Since he thought his 2010 conversion was tax free, he probably checked the box on Form 8606 to opt out of the two year deferral. If so, that election cannot be changed now.
His 2010 amended 8606 with 1040X would show the total IRA balance of 15,000. This will make 1/3 of his 10,000 conversion taxable, ie 3,333 would be additional 2010 taxable income.
His 2011 amended 8606 and return will show a total balance of 10,000 (50% converted) with a taxable amount of 835.
For 2012 it sounds like he did two conversions of 5,000 each. The remaining taxable amount of 832 will be the taxable amount for 2012.
Note that the taxable amounts add up to the 5,000, which was the pre tax amount in the other TIRA. Since the actual numbers will vary somewhat due to IRA earnings or losses, the actual 8606 instructions need to be followed carefully. The IRS will probably levy some late interest charges for the 2010 and 2011 amounts due.
Permalink Submitted by Mark Fletcher on Tue, 2012-05-22 23:35
Thank you. That makes sense.
And Yes, in 2012 he did two conversions (I did not think of it that way).
Last question…if the client does ‘nothing’ in terms of amending prior tax returns, does this have the ability just ‘go away’ ? Or is this a clear flag that will catch the IRS attention and lead to some type of notofication in the mail? It seems to me the taxes are being paid on the $5000, and the late interest/charges would be minimal.
Permalink Submitted by Alan Spross on Tue, 2012-05-22 23:46
I think your question relates to how the IRS would react if the client filed his 2012 return reporting 5,000 taxable income on his conversion in lieu of amending the two prior years, ie overstating the taxable share in 2012 to offset understating it previously.
Unfortuneately, it is not possible to predict whether the IRS would catch the prior act with or without the 100% conversion of 2012 since their IRA compliance is very spotty. When the IRS does catch something it is usually not within the first few months of the error, so client would have to wait quite awhile to know whether this avoided amended returns or not.
Permalink Submitted by Mark Fletcher on Wed, 2012-05-23 02:58
THX Again. I appreciate your time.