Roth Help
A client converted from a standard IRA to a Roth in 2010 taking advantage of the law allowing him to spread the taxes out over two years. Last year he needed funds and took the funds out in February but returned them with in a 60 day window. Then in August he took the funds out and returned them within 60 days once more. The client’s tax accountant tells me that because he did this twice in a 12 month window the client must pay all the taxes in ONE year and must take a distribution of his Roth. Is this the case? I’m really hoping that the CPA is wrong on this one.
Permalink Submitted by Alan Spross on Fri, 2012-10-12 18:11
The CPA is correct. There is a “one rollover per 12 month period per IRA account”. Since IRA custodians do not report dates of distributions to the IRS, the IRS will rarely know about this, so enforcement is typically done at the IRA custodian level, if at all. And even at the custodian level, a custodian would generally not know the source account of the rollover unless the funds were rolled back to the same account.
Since the second Roth distribution occurred here within 12 months, it was not eligible to be rolled back to the Roth IRA. It would be a taxable distribution. For a Roth the distribution would typically be tax free, however the unique 2010 conversion opportunity included income acceleration if the conversion was withdrawn prior to 2012. Client took this distribution in 2011, so for the amount of the distribution, the tax on that amount would be moved from 2012 to 2011. This is all handled on Form 8606. Note that this is not an additional tax, just acceleration of taxable income that would have been reportable in 2012 to the 2011 return. There is also a 10% penalty for removal of conversion funds in the first 5 years, unless client is 59.5. Finally, the second rollback is an excess contribution to the Roth IRA and must be corrected as any other excess regular Roth IRA contribution.
The above scenario is complex. For example, if the client has other Roth funds prior to the conversion, the Form 8606 allows the distribution to be treated as a return of regular contributions and NOT the conversion. That would avoid the accelerated tax and the 10% penalty.
The CPA will therefore have to determine if there was other Roth IRA accounts or prior contributions to the current account to correctly complete Form 8606. Income acceleration and penalty may not apply, but the client still must remove the amount of the second rollover from the Roth IRA, and that means permanent loss of IRA money.
NOTE: If the second rollover was larger than the first one, client can opt to retain the second one and consider the first one as disallowed. If the first one is disallowed, then a smaller amount would need to come out of the Roth IRA as an excess contribution and more Roth funds will stay in the account.
NOTE 2: The 2010 conversion rules were designed to prevent a taxpayer from using the two year deferral just to delay taxes when IRA funds were needed. That’s why the income acceleration feature exists. It’s not clear whether the client planned to take distributions or not, but the one rollover rule exposed the client to the income acceleration rule (if it applies).
Permalink Submitted by alfred keyser on Fri, 2012-10-12 18:44
Thank You, the funds were rolled back into the same Roth account twice. In that case do I need to assume that the IRS and custodian know about this? Would it be risky to leave the funds in the Roth in this case?
Permalink Submitted by Alan Spross on Fri, 2012-10-12 19:32
The custodian should not have even accepted the second rollover if they recognized this rollover limitation. Same situation as not accepting a roll back if more than 60 days have passed. That does not mean that they may not catch it later upon audit. Same with the IRS unless they do an audit of the custodian or the taxpayer. The IRS does have a current initiative to tighten up IRA rule administration.
Another factor to consider is that there is no statute of limitations for excess IRA contributions. In theory the IRS could catch this 10 years from now and charge the 6% excess contribution excise tax plus interest on that money for 10 years. It’s highly unlikely they would at this time, but things may change down the road.