Penalty on 401k distribution

[Wilhud]

Is it possible to take penalty off for a distribution from 401k. Client received 1099R, had tax withheld and it is coded a 1. They took the money within 60 days and put into a Roth IRA. I know they have to pay the tax on the distribution, BUT, can I take the penalty off?
This client is 22 years. The penalty would not even be questionable to me except that they did reinvest with the 60 days. My software takes care of the penalty if it is a Tradtional IRA. However, it does not want to take penalty off for Roth IRA.

[veritas]

I don't know how

they could take a 401k distribution and deposit directly it into a Roth? I would have had to open a traditional rollover IRA first for the 401k and receive it. Then I could convert it to a seperate Roth IRA.

[Koss]

New Rules

There are some new rules that went into effect as of 01/01/08.

Did your client receive the distribution in late 2007, and then complete the rollover in 2008?

Even if this is not what happened, there may be a solution for this one...

[Koss]

Rollover

Effective 01/01/08, distributions from an employer retirement plan, such as a 401(k) can be rolled over into a Roth IRA. The result is that the distribution is taxable, but not subject to the 10% penalty. The intent is to streamline the process.

It has always been possible to do this in two steps. As Veritas noted, the process involved first rolling it into a Traditional IRA, and then performing a conversion. This two-step process resulted in the issuance of two different Forms 1099-R, one of which reflected a nontaxable rollover, and the other which reflected a taxable conversion.

The IRS figured out that this was causing headaches and confusion for taxpayers and financial institutions, and decided to allow the rollover and conversion to be collapsed into a single step.

But this new process is only available in 2008.

I don't know whether the new process is applicable to a distribution that was made in 2007 and rolled over in 2008. In fact, I'd be willing to bet that the IRS might not have contemplated that particular set of circumstances.

For your client, there is an abundant variety of possible solutions.

(1) It is possible that your client's financial institution actually performed the rollover, and then performed the conversion.

Was federal tax withheld from the distribution?

If not, the original distribution may have been a trustee-to-trustee rollover that your client never saw. Maybe the Form 1099-R is for the conversion. But if that's the case, they have it coded wrong. A conversion from a Traditional IRA to a Roth IRA is usually coded with a 2. This makes it taxable, but avoids the penalty.

(2) Maybe the bank or broker completed the rollover in 2007, and then performed the conversion in 2008. If that's what happened, then all you have to do is report the rollover from the 401(k) to a Traditional IRA. The conversion will be taxable for him in 2008, and he'll get a new 1099 next year.

(3) Maybe the bank used the "401(k) to Roth Rollover" process improperly. If your client requested the distribution late in December, but didn't get the check until January, and then didn't get to the bank until the beginning of February, maybe the banker thought he had received the distribution in 2008. If he had, then he would have been able to roll it into a Roth using the new rules.

(4) Or maybe... well, let's stop here. There's a very easy resolution.

Assume for the sake of argument that the new process is not available, even if he got the distribution in late 2007, and then completed the "rollover" in 2008. That means he didn't really roll anything over. He took a distribution from a 401(k), and then he did something else. He put money into a Roth IRA. If it wasn't a rollover, then it will be treated as an ordinary contribution for the tax year 2007.

And any contribution to any type of IRA for tax year 2007 can be recharacterized prior to the due date of the 2007 tax return.

So your client should immediately contact the bank or broker, and direct them to recharacterize the contribution. This process basically redefines the type of contribution. He can recharacterize the IRA from a Roth to a Traditional.

Before he does anything, your client really needs to find out exactly what happened here. If the bank screwed this up once already, you want to make sure they don't screw it up again. There is a very high probability that there has already been a serious miscommunication between your client and the rep at the bank or brokerage.

How much money is involved? If he doesn't straighten this out, it could result in an excess contribution to the Roth IRA. The distribution from the 410(k) could have been $25,000. If it fails as a rollover, then he just a made a regular contribution to his Roth IRA for 2007 in the amount of $25,000. That's a reeeeally bad idea. LOL

Recharacterization, if it's done correctly and within the applicable time frame, allows you to change almost any attribute of the contribution. You can change the year, you can change whether it is Roth or Traditional, and you should also be able to change whether it is designated as a rollover contribution. A rollover contribution, by definition has no tax year associated with it. The contribution has to be made in a certain year, but it does not reduce the contribution limits for any year.

So make sure your client accurately communicates with the bank. They'll want something in writing. You should help him write it, and make sure it gets faxed by the due date of the return. But first have him call the bank from your office on a speakerphone.

Have fun with this...

[superman]

I had one earlier

to this year. the client came in and said she did this late in December of 07 and the bank told her it was fine to do but they did not know the new rules. It goes to show that maybe they should counsult us first. Long story short she had to have them correct the 1099 and make this a traditional IRA it took forever luckly she came in early.



Superman

[Koss]

Rollover

In the case described by Superman, he refers to the institution issuing a corrected Form 1099. And maybe that was somehow appropriate under the individual facts and circumstances of that client.

But in the scenario described in the original post, the 1099 appears to have been issued by the institution that made the distribution from the 401(k). That 1099 is probably correct.

You can take a code 1 distribution from a 401(k) when you leave your job. The institution that is closing the account and sending you the money doesn't need to know that you are going to roll it over. Yes, I know, there's the issue of withholding, but that's beside the point. If you complete the rollover properly within 60 days, the whole thing is nontaxable, even though it has code 1. It doesn't even have to be exactly the same funds. You can spend the distribution on a trip to Europe, and then on the 59th day, borrow the money from your aunt, walk into your local bank, and complete the rollover.

The 1099 issued for the distribution doesn't control the treatment if the rollover is properly completed. What's important is how the new bank treats the contribution--and how that contribution is reported to the IRS when Form 5498 is issued in May.

[Koss]

More Thoughts

First: if your client gets the contribution recharacterized as a Traditional IRA, then it's as if the Roth never existed. And that's how you report it. Just tell your software that he rolled it directly from the 401(k) to a Traditional IRA. Your software may have some questions or fields for recharecterization, but it may be easier to just make the correct entry manually. Recharacterization turns back the clock, and literally changes the past.

Also:

In general, it is possible to recharacterize any contribution that was made during the calendar year 2007 for the tax year 2007, or during the calendar year 2008 and prior to 04/15.

The bank is required to honor a recharacterization request if it falls within the IRS rules and it is properly communicated. Yes, they can make you fill out their form. But many institutions will accept a memo or letter signed by the account holder if the instructions are clear. And most banks and brokers will accept these documents by fax.

In general, if the bank or broker actually receives the recharacterization instructions on or before the due date of the return, they can and must honor the recharacterization request.

So your client should nail down the details of this mess, and then use certified mail or fax the document and save the fax confirmation. Reputable institutions use a good old-fashioned time stamp to log when these documents come in.

The complete process may take weeks, but that's okay. If the institution acknowledges receipt of the instructions by April 15, your client will be okay, and you can just report it as a rollover to a Traditional IRA. The broker will recharacterize it as of the date of the contribution.

Lawyers use Latin to refer to a court order that is entered by a judge on one day, but is explicitly designated as taking effect as of an earlier date. Generally, judges can only do this to correct clerical errors, or under other extenuating circumstances. But that's the whole point here. Recharacterization is meant to allow the taxpayer to correct his own clerical errors. What if I contributed to a Traditional IRA, and then after the end of the year, discover that I made too much money? (Covered by a retirement plan at work.) I can recharacterize it to a Roth (as long as I didn't make waaaaay too much money LOL).

A backdated court order is referred to as nunc pro tunc.

"Now for then."

[Wilhud]

Thank you all. I had also decided that the best thing to do is have institution rechar into a Trad IRA and then she can convert to Roth later on. That way I can take penalty off.

I did see the new rules for 2008. However those did not apply.

Again thanks!