I have a question about the duty of a IRA custodian. Vanguard in this case, but I think the question is pretty general.

I do understand that the custodian merely operates the machinery of the account as directed regardless of the advisability of directions and bears no responsibility for outcomes. For example, Vanguard’s IRA agreement includes “…the Custodian shall be fully entitled to rely upon the directions of the Investor…”

That said, it seems intuitive to me that the role of custodian (or anyone handling anything like an “account”) exists to bear responsibility for operating the machinery _correctly_. Including recognizing and rejecting directions to do something that isn’t possible. For example, if Alice directs her IRA custodian to sell n shares of XYZ when Alice (her custodian on her behalf) has never held a share of XYZ in her account, then the custodian should recognize that Alice’s order does not describe a possible action and they should reject the order. If they do perform some action and record something in her account and call it a sale of shares of XYZ, then they’ve screwed up and created a nonsensical situation. The custodian is not fully entitled to rely upon Alice’s confused order in that instance.

Is my intuition correct in that example?

My actual question is a bit more subtle but — I think — essentially similar. I hope you can help me either support that or understand how I’m wrong.

== tedium ahead == exit now or check coffee ==

This came up last year for our 2016 return and remains unsettled. In 2016 my wife converted some of her Traditional IRA to Roth. Before filing our joint return for that year I learned that she has some after-tax money in her TIRA from before we married, which should reduce the amount of the conversion subject to tax. However, she had not been filing 8606s to track the after-tax portion. While trying to sort that out, I found what appears to be the result of her custodian doing nonsense with her accounts when they should have — I think — rejected a confused order that they should have recognized as impossible to fulfill.

In 2011, prompted by a couple changes of employment and income expectation, she directed Vanguard through the year as follows:
1. contribute $a to her Roth IRA
2. recharacterize that contribution ($a) from her Roth to her TIRA
3. contribute $b to her Roth ($a + b = 2011 contribution limit)
4. recharacterize contributions $b and $a from her Roth to her TIRA

Of that, 1, 2 & 3 were valid orders which Vanguard fulfilled as routine.

To the best of my understanding, once they completed the first recharacterization of the $a contribution from Roth to TIRA, for which they produced a 5498 reporting the distribution from the Roth as a recharacerization and a 1099-R reporting the contribution to the TIRA as a current year contribution, then all should be as if that contribution had been made to the Traditional IRA in the first place and as if it had never been contributed to the Roth.

Yes/no?

The last order was obviously a product of confusion. On receipt of that order, V recharacterized both the second contribution of $b plus earnings with corresponding 5498 & 1099, which makes sense, and also “recharacterized” “again” the already-recharacterized, as-if-it-had-never-happened, first Roth contribution plus earnings and produced another 5498 & 1099 where the 5498 reports the distribution as a recharacterization, which does not make sense.

It seems to me that when V fulfills an order to recharacterize a contribution, which includes calculating earnings attributed to that contribution, then they unavoidably must match up the direction to recharacterize a contribution with a contribution to recharacterize. If there is no contribution to recharacterize, then they should recognize that they cannot fulfill the order and reject it. If they move money and produce a 5498 reporting that distribution out of the Roth as a recharacterization then they’ve committed an error and created a nonsensical situation.

Yes/no?

As I read the instructions to filers for forms 5498 and 1099-R, the IRS holds that a filer on discovering an error “must” file corrected forms. The same instructions also describe how to file corrections for prior years. It is not true that the error can not be corrected. Rather, it can and “must” be corrected.

I contend that Vanguard should a) acknowledge their error in committing nonsense with accounts under their custodianship, regardless of what directions they received, b) reverse the bogus Roth->TIRA transfer ($a + 2011 earnings), with earnings, back to the Roth, and c) correct (i.e. nullify) the bogus 5498 & 1099-R.

Yes/no/depends/thoughts/suggestions?

Or, if V really can’t deal with correcting information returns, they should at least cover my wife’s accumulated penalty for excess 2011 contribution if not also give some consideration for loss of Roth status for some her her money.

And give their Flagship customer a _very_ convincing apology for a) screwing up the first place and b) not owning the error and remediating the consequences promptly and cheerfully on discovery. Or explain what I misunderstand.

Anyhow – last year I filed for extension to deal with this. From the point of (words to the effect of) “oh yeah that’s a problem I’ll submit it for resolution”, Vanguard has stonewalled hard. The best private advice I could find was an eye roll, shrug and suggestion that the amount & circumstance in question isn’t likely to draw attention. Since the extension carried into the IRS off-season, the IRS didn’t have anyone available to field non-trivial questions from John Q Public. I did have a long telephone conversation with an IRS rep and a ~90min sit-down with my wife at a local IRS office, but with people who were not in a position to go off script and the script doesn’t account for the impossible. The in-person session concluded with “good luck!”. Now that we’re in tax season again, I spoke with an IRS rep who said a) to them it’s a Roth distribution and an excess TIRA contribution with unavoidable accumulating penalty, b) they don’t have anything to say to or about custodians, and c) custodians don’t answer to the IRS but to the FDIC. Now, I question the last points about who Vanguard answers to. I still find this unclear but as far as I can tell: a) banks answer to the FDIC but the IRS regulates non-bank custodians, b) Vanguard isn’t a bank, and c) Vanguard doesn’t appear in the IRS list of approved non-bank trustees – nor does VFTC.

What type of IRA custodian is Vanguard? Who authoritatively defines the function & obligations of that type of custodian?

Many thanks to anyone who read all that.