IRS Audit - Backdoor Roth

[Bimmer]

Received notice from IRA today that I "owe" taxes on amounts I did not include on my return. This involves approx $52,500 in money moved directly from non-deductible IRA to new Roth for my wife and I last year as "back-door Roths". Neither of us has any other IRA of any type. The "income" was reported by Vanguard to them (and me) on a 1099-R form. I use TurboTax and followed instructions there for a Roth conversion. The form states that I owe $18,000 plus $3682 in penalties.

On quick look at my tax returns it appears Turbotax correctly completed two form 8606's with the amount converted to a Roth IRA on line 16 and the correct basis on line 17, with the correct taxable amount difference on line 18, and the correct split between 2011 and 2012 on lines 20a and 20b.

Has anyone else received this? Any suggestions of how to approach? I assume that Vanguard incorrectly reported this to the IRS? My plan of attack is to first call Vanguard to get a notice that I directly converted this money to a Roth, then call the IRS?

Thanks for any suggestions or other experiences with same.

[interplanetjanet]

Received notice from IRA today that I "owe" taxes on amounts I did not include on my return. This involves approx $52,500 in money moved directly from non-deductible IRA to new Roth for my wife and I last year as "back-door Roths". Neither of us has any other IRA of any type. The "income" was reported by Vanguard to them (and me) on a 1099-R form. I use TurboTax and followed instructions there for a Roth conversion. The form states that I owe $18,000 plus $3682 in penalties.

Back up a second. If you have $52.5k of nondeductible contributions in an IRA, you must have been contributing for some time (and almost certainly have some gains). Did you fill out the form 8606 for each year you made nondeductible contributions and have you been tracking the basis?

-janet

[Bimmer]

Janet,
Yes, I filed 8606 each year. Started contributing max to only non-dedictible IRA in 2007. Big market crash after!

IRA #1 converted $26514, basis of $23,000, $3514 difference is taxable, $1757 in each of 2011 and 2012.
IRA #2 converted $26038, basis of $23,000, $3038 difference is taxable, $1519 in each of 2011 and 2012.

-Bimmer

[Mel Lindauer]

My WAG is that you'll come out fine after some aggravation, once the IRS realizes you did everything on the up and up.

[Bimmer]

Thanks Mel. I had a similar situation years ago where a hospital reported income it received under my name. Turned out to be not a big issue. So I'm not super-worried. But still a little nerve-wracking to get that thick envelope from the IRS saying you owe $18,000+ dollars!!

[ted123]

Is it actually an audit, or is it a CP2000 Examination?

I received the latter about a month ago. It said I hadn't reported IRA distributions, when I in fact had reported them as part of the total distributions, but excluded them from taxable distributions, consistent with the instructions and Form 8606.

I checked the box to indicate that I didn't agree with the changes to my return and attached a letter explaining how I correctly completed my taxes. Based on some cursory internet searches, it appears that CP2000 examinations are often easily resolved, and I expect my letter to resolve mine. (I've read that other folks have been able to resolve similar -- but not identical -- CP2000s with phone calls to the IRS, but I'd prefer to communicate in writing.)

An annoying waste of time, especially given that it could have been avoided if the computer had been programmed to look at Form 8606 instead of flagging my return because line 15b didn't agree with my 1099s, but hopefully just a minor waste of time.

If you've actually got an audit on your hands...nevermind.

[ted123]

By the way, Vanguard correctly coded our 1099s as direct rollovers. That wasn't the problem in our case.

[Mel Lindauer]

Thanks Mel. I had a similar situation years ago where a hospital reported income it received under my name. Turned out to be not a big issue. So I'm not super-worried. But still a little nerve-wracking to get that thick envelope from the IRS saying you owe $18,000+ dollars!!

Yeah, I know how nerve-wracking that can be. I got one many years stating that $30,000+ was due, and that was back when $30k was a lot of money.

[Bimmer]

Thanks Ted. Would you mind giving the details of your 1099-R (without distribution amounts) to see if they are the same as mine?

Mine:
Box 1 = Gross Distribution Values = as listed above
Box 2 = Taxable Amount = same value as box 1
Box 2b = Taxable amount not determined = "X"
Box 4 = Federal Income Tax withheld = 0.00
IRA/SEP/SIMPLE = "X"
Box 10 = State Tax Withheld = 0.00
Box 11 = State/Payer's state no. = my state
Box 12 = State distribution = same value as box 1

Thanks.

[ted123]

Thanks Ted. Would you mind giving the details of your 1099-R (without distribution amounts) to see if they are the same as mine?

Mine:
Box 1 = Gross Distribution Values = as listed above
Box 2 = Taxable Amount = same value as box 1
Box 2b = Taxable amount not determined = "X"
Box 4 = Federal Income Tax withheld = 0.00
IRA/SEP/SIMPLE = "X"
Box 10 = State Tax Withheld = 0.00
Box 11 = State/Payer's state no. = my state
Box 12 = State distribution = same value as box 1

Thanks.

What was the distribution code in box 7? It should be "2" (early distribution -- exception applies).

Like I said, mine (which was otherwise the same as yours) had the correct distribution code -- even the CP2000 acknowledged that code.

[Alan S.]

I suspect that the IRS matching program totally overlooked your 8606 forms, and expected the full 1099R amount to show on line 15b of Form 1040. I had this same problem in 2009 and the IRS requested all the supporting information if I disagreed with their billing. Realizing that they did not even read the return and all the forms were there and properly completed, I just replied that there was no sense in sending anything in that they already had - just to look at the 8606 already on file. End of problem, although of course it took several more weeks to advise that they were closing the file.

Have not heard of too many of these letters for 2010 conversions yet with the unique options, and perhaps the the IRS is just now reviewing some 2010 returns. But heck, they only had 5 years to get ready to process 2010 conversions.

[jofij]

Hi there,

Have lurked on this great message board for a while, never had a reason to register until now.

I received the exact same letter yesterday with respect to my Roth IRA conversion in 2010. (Was there something special about March 26, 2012?) The letter was a CP2000 and said I owed $3 K in taxes and penalties for failing to report appropriate income. I had converted $13 K in 2010 from a Traditional IRA to a Roth IRA, and after completing Form 8606, only declared $1074 of that taxable income, since the remaining balance was due to non-deductible contributions I had made in previous years.

Exact same situation as Alan S. Was totally freaked out, but now that I see this appears to be a pattern, I'm less stressed. My only issue is that I used the IRS Free Fillable Forms to do my taxes last year and efiled without ever printing a hard copy of my tax return. I have a tax transcript for the 2010 tax year, but do not have the precise Form 8606 on hand for that year. But I think I have enough information to challenge, especially with copies of past 1099-Rs and Form 5498s. And the IRS should see that this is a pattern.

Cheers.

[Alan S.]

You should be all right just telling them to note the Form 8606 filed with the return. Of course, the free file returns are no longer available for printing after mid October, and you should always keep a hard copy of your returns regardless of the filing program used.

Sounds like you converted your entire TIRA balance so there should be no remaining basis showing on line 14 of the 2010 8606 that would carry forward. Still, if you don't ask the IRS for a copy, you should keep a note with your transcript regarding what you think the numbers would have been on that 8606 in case it ever comes up again.

Could be there are alot more CP 2000s to come if the IRS is just now reviewing matching issues for 2010 conversions. If they don't recognize an 8606, the chances of their reading all the recommended explanatory statements for recharacterizations are probably quite slim.

[Muchtolearn]

It is possible that IRS is going to stop this and has started with individuals who have done this. Clearly the back door ROTH is an intent to do what it does. We all know it is not what it was intended for. I suspect back door ROTH's will be disallowed and penalized. I wouldn't do it anymore if I were you (you being all of you).

[Alan S.]

Don't think so. It's just a flawed IRS computer matching program. There have been numerous reports of the IRS not reading explanatory statements and very few of these are related to back door Roth conversions. In my case, I had not made a non deductible contribution for many years and the conversion was over 90% taxable, and this also had nothing to do with back door Roth IRAs.

If the IRS is going to take a contrary position on this, they will issue a tax Notice, not chip away with CP 2000 Notices.

[ted123]

It is possible that IRS is going to stop this and has started with individuals who have done this. Clearly the back door ROTH is an intent to do what it does. We all know it is not what it was intended for. I suspect back door ROTH's will be disallowed and penalized. I wouldn't do it anymore if I were you (you being all of you).

If so, the IRS is doing it wrong.

My CP2000 didn't challenge the conversion at all. It merely suggested that the amount of the distribution that I reported as taxable was incorrect. The remedy for that would be to pay more taxes on the conversion. Except there's no really a valid argument that I should pay taxes on my basis of nondeductible contributions.

I am fairly sure this is just poor programming. Leaving aside the Form 8606, the form didn't indicate any recognition that the distributions had been reported on line 15a of Form 1040.

[stan1]

The topic is not correct. What is being described is a standard Roth Conversion .... not a Backdoor Roth.
Agree this looks like a bug in the IRS's auditing software.

[ted123]

The topic is not correct. What is being described is a standard Roth Conversion .... not a Backdoor Roth.
Agree this looks like a bug in the IRS's auditing software.

Out of curiosity--what's the difference between a "backdoor roth" and a "standard Roth conversion" where the conversion consists principally of nondeductible contributions?

[Bimmer]

First @ Ted, yes it was distribution code #2 as you described, so same scenario. Thanks.

I called this a "backdoor Roth" because in all the years I contributed to my non-deductible IRA (including 2010) I was above the income limit for making a Roth contribution. In 2011 I made a contribution to my non-deductible IRA because I was above the income limit to contribute to a Roth, and I then "backdoor" converted directly to a Roth since there is no income limit for the conversion.

[norookie]

It is possible that IRS is going to stop this and has started with individuals who have done this. Clearly the back door ROTH is an intent to do what it does. We all know it is not what it was intended for. I suspect back door ROTH's will be disallowed and penalized. I wouldn't do it anymore if I were you (you being all of you).

If its allowed, its allowed

[jofij]

The topic is not correct. What is being described is a standard Roth Conversion .... not a Backdoor Roth.
Agree this looks like a bug in the IRS's auditing software.

Out of curiosity--what's the difference between a "backdoor roth" and a "standard Roth conversion" where the conversion consists principally of nondeductible contributions?

A "standard Roth conversion", as likely intended by the framers of the original legislation, is one where individuals convert Traditional IRAs funded with deductible contributions and/or deductible 401(k) contributions subsequently rolled over into a Roth IRA. Under this scenario, the IRS collects a large tax bill, as you are paying tax not just on the growth in value of the IRA itself, but also the original contributions themselves, since they were made on a tax-deferred basis.

Since 2010, the IRS has collected significant tax revenue as many high worth individuals have converted traditional IRAs with hundreds of thousands of dollars in balancs into Roth IRAs, paying taxes on most if not all of that conversions.

In the case of the back-door Roth, this provides a way for high income individuals to fund Roth IRAs in almost the exact same manner as those who meet the Roth IRA income limits, without paying any additional tax. Hence, the "back-door".

I agree with those who say this was not an intended purpose of the law. However, it is perfectly legal and I doubt all that many folks are taking advantage, which will likely mean it will be allowed to continue.

[ted123]

The topic is not correct. What is being described is a standard Roth Conversion .... not a Backdoor Roth.
Agree this looks like a bug in the IRS's auditing software.

Out of curiosity--what's the difference between a "backdoor roth" and a "standard Roth conversion" where the conversion consists principally of nondeductible contributions?

A "standard Roth conversion", as likely intended by the framers of the original legislation, is one where individuals convert Traditional IRAs funded with deductible contributions and/or deductible 401(k) contributions subsequently rolled over into a Roth IRA. Under this scenario, the IRS collects a large tax bill, as you are paying tax not just on the growth in value of the IRA itself, but also the original contributions themselves, since they were made on a tax-deferred basis.

Since 2010, the IRS has collected significant tax revenue as many high worth individuals have converted traditional IRAs with hundreds of thousands of dollars in balancs into Roth IRAs, paying taxes on most if not all of that conversions.

In the case of the back-door Roth, this provides a way for high income individuals to fund Roth IRAs in almost the exact same manner as those who meet the Roth IRA income limits, without paying any additional tax. Hence, the "back-door".

I agree with those who say this was not an intended purpose of the law. However, it is perfectly legal and I doubt all that many folks are taking advantage, which will likely mean it will be allowed to continue.

Thanks for the response -- it was better than my snarky post warranted.

I disagree with the earlier assertion that this topic is mislabeled. If there's any difference between a "backdoor roth" and the circumstances described by the original poster, I can't see it.

[stan1]

It is semantics, but sometimes words do matter. The Backdoor Roth Contribution term that was first used by TFB means one is making a non-deductible annual contribution to a zero balance Traditional IRA then converting it to a Roth (immediately, or after some period of time). It is a way for someone who is otherwise not eligible to make a Roth IRA contribution to do so through a two step process. Converting an existing Traditional IRA balance to a Roth IRA generates a lot of current year tax revenue -- and is likely what Congress intended -- but this is not what the board now refers to as a Backdoor Roth. It is unclear whether Congress intended to create a "back door" for individuals to fund a Roth IRA who are otherwise ineligible to do so.

One individual who posts on this board expressed concern that the IRS might determine that a Traditional IRA contribution immediately converted to a Roth IRA is an unlawful step transaction that violates the intent of the law limiting who can contribute to a Roth IRA. Based on this line of reasoning TFB modified his recommendation to hold the Traditional IRA for a few months instead of converting it to a Roth IRA immediately. To me, the current law is very clear: anyone can make a non-deductible contribution to a Traditional IRA and anyone can convert a Traditional IRA to a Roth IRA. Saying that you were audited for doing a Backdoor Roth would mean that the IRS is questioning whether you can convert a current year Traditional IRA contribution to a Roth IRA as a way to circumvent the income restrictions of a Roth IRA. That is not what is being described. What is being described is that the IRS sent a question about a Roth conversion. It is semantics, but sometimes words do matter.

[ted123]

It is semantics, but sometimes words do matter. The Backdoor Roth Contribution term that was first used by TFB means one is making a non-deductible annual contribution to a zero balance Traditional IRA then converting it to a Roth (immediately, or after some period of time). It is a way for someone who is otherwise not eligible to make a Roth IRA contribution to do so through a two step process. Converting an existing Traditional IRA balance to a Roth IRA generates a lot of current year tax revenue -- and is likely what Congress intended -- but this is not what the board now refers to as a Backdoor Roth. It is unclear whether Congress intended to create a "back door" for individuals to fund a Roth IRA who are otherwise ineligible to do so.

One individual who posts on this board expressed concern that the IRS might determine that a Traditional IRA contribution immediately converted to a Roth IRA is an unlawful step transaction that violates the intent of the law limiting who can contribute to a Roth IRA. Based on this line of reasoning TFB modified his recommendation to hold the Traditional IRA for a few months instead of converting it to a Roth IRA immediately. To me, the current law is very clear: anyone can make a non-deductible contribution to a Traditional IRA and anyone can convert a Traditional IRA to a Roth IRA. Saying that you were audited for doing a Backdoor Roth would mean that the IRS is questioning whether you can convert a current year Traditional IRA contribution to a Roth IRA as a way to circumvent the income restrictions of a Roth IRA. That is not what is being described. What is being described is that the IRS sent a question about a Roth conversion. It is semantics, but sometimes words do matter.

I'm not persuaded. I think the topic as stated better captures the issues than describing the conversion as a standard one.

I made nondeductible contributions to a Traditional IRA in 2007, 2008, 2009, and 2010, then converted them at a very small gain in 2010. (My wife made similar transactions, but actually had a small loss.) I was not able to make a direct Roth contribution in any of those years. My intention with all of the contributions was to convert to a Roth in 2010, if that option remained available. It's not clear that the OP facts are identical to mine, but I'm guessing they're close.

By your definition, this was maybe a partial backdoor roth contribution and a partial standard conversion. But it was the element that is common to all backdoor roths and only a minority of standard conversions -- the nontaxable basis -- that creates the issue at hand. Describing it as a "standard conversion" would have been less helpful, not more.

(I'm also not convinced that nondeductible IRA contribution in the same year as the conversion is really a necessary part of the definition of backdoor roth, even though it will probably be the more common pattern going forward.)

But as you say, it's just semantics.

[Leesbro63]

Ive been having annual CP-2000 issues with the 529 Plan money I've been taking yearly to pay for daughter's college. It's a PITA and usually requires two back 'n forths (I recommend you use $6 certified mail). It always starts out as an IRA CP-2000 nastygram claiming I owe additional tax on the entire amount. And it's always resulted, finally, in a "no change to your original return" terse letter. No "Gee, sir, we're so sorry we assumed you were a tax cheat and we obviously didn't do our own homework prior to making your guilty before proven innocent". Just a grudgking admission that I did it right to begin with.

So you will be fine. When you reply, stick to the facts, don't ramble, use certified mail and be sure to keep copies of everything. I've heard of many issues resolved with just one phone call, but I prefer not to call even though it takes a lot longer and is more work. I'd rather have it all in writing. And while I do not have anything to hide, I can't see the value in engaging in an interactive chat session with an IRS representative/agentr who has my entire file in front of him and who might start to inquire about this or that other thing.

[ted123]

BTW, I received a letter from the IRS saying that my issue had been resolved and that I do not owe any further taxes.

[egghead]

It's been interesting reading this thread. I could be subjected to this audit or CP2000 process next year based on my rollovers & conversions this year.

My Traditional IRA was a mix of pretax and aftertax (years of nondeductible IRA contributions), and I rolled all my Traditional IRA monies into my 401k, except my aftertax IRA basis (nondeductible contributions). I then made additional nondeductible IRA contributions for 2011 and 2012. Next week I plan to open a Vanguard Roth IRA and convert the remaining balance of my Traditional IRA to the Roth IRA. The tax for this Roth conversion should be very close to $0.

Based on reading threads on this forum and tax forms, I should be able to do the above described rollover and conversion in the same year, which is what I'm doing. It's frustrating to think that if you do everything correct, you can still be subjected to these IRA audit/CP2000 processes. Maybe the IRS will correct their computer issues by next year - it's nice to dream.

[Alan S.]

Correct.

While no guarantees, the most important thing you can do to reduce IRS confusion is to make a very clear explanatory statement on your return regarding the IRA to 401k rollover.

[doublenickel]

Got the same CP2000 notice.

Obviously the IRS didn't review my 8606 filing to see most of their supposed "extra income" was indeed non-deductible contributions, and thus not taxable. I am sending a letter back with a copy of the 8606 as well as the 5498 from Vanguard showing I made a conversion to a Roth. Hope this will suffice!

[MoneyOCD]

Got CP2000 notice yesterday for 2010.

Issue at hand that I rolled over my Traditional IRA into Company qualified 401k plan to clear up plate for back door Roth going forward. Received 1099-R for full amount with code G, listed whole thing on 1040 Line 15a with word "ROLLOVER" next to it (per instruction) and $0 in 15b. Also attached explanation letter.
IRS wants taxes and penalties and interest on whole thing.

I guess no one reads anything and system is automatically spitting out CP2000?
They are asking in case of rollover to provide form 5498 but that form is only for IRA accounts.
401k plans are not sending such forms or any other similar forms. I have confirmation letter from 401k custodian about receiving Rollover check as of 12/31/2010 - will that be good enough for IRS ?

Bracing myself for 2011 CP2000 as I did Roth conversion with zero taxes- back door Roth.

[jofij]

I finally got a letter from the IRS, but only acknowledging they received my letter on April 11th and will respond in due time! It takes them a month to simply acknowledge receipt???

The kicker here is they encourage you to pay your assessed back tax in case you are found that you do owe it -- because they remind you that interest continues to accumulate!

Amazing ...

[Bimmer]

I received similar notice last week that my response had been received.

Today received the following notice:
"Your 2010 Form 1040 inquiry is closed. Amount Due: $0.00"

Ahhhh... relief. Thanks for all the responses and support.

Thinking of sending my 5498 from this year in as an addendum to prevent a similar go-round.

[Alfalfa]

Our inquiry closing letter arrived yesterday as well! I can well imagine all the scrabbling and stress this "programming error" caused in thousands of homes across the country. I suspect this meant wasting a lot of resources at the IRS as well. It is really valuable to know that we weren't alone in this "exercise". I love you guys...

We also received our paper I-bond refund in the mail yesterday, so it was a day of "tax relief" on multiple fronts.

Alfalfa

[G12]

You may find you are dealing with an inexperienced person at the IRS. I recently received a thick envelope from the IRS with ~ 24 pages enclosed regarding our joint filing for 2011 which, long story short, said we could not deduct ~ $6100 in valid expenses and we owed "x" amount more, which was significant because it would have kept us from itemizing expenses. After sifting through the contents it became obvious the tax technician (their term) must believe the terms "estate" and "real estate" are the same, which they obviously aren't, and yes, she was wrong. Don't get worked up about it. I think there is an onus on generating more income from tax payers given the deficit and many filers are receiving incorrect demands from the IRS in 2012.

[amyinnyc]

Hi. I'm doing a story for Reuters about the issue with these notices re-2010 Roth conversions. Bimmer and jofij--I'd very much like to talk with both of you further about your experiences if you'd be amenable. Thanks, Amy Feldman amy(at)amyfeldman(dot)com

[MoneyOCD]

We got letter in the mail on June 4 that IRS received my documents as of May 1,2012 and it will take up to 60 days for them to review. (one month to acknowledge?)
It is end of June already and nothing back yet.
Does anyone know if those 60 days should be counted from May 1 or from day of acknowledgement letter?
I would think it should be from May 1 - then 60 days will be this Friday already
I was looking at everyone else's replies and dates (in this thread and in some other ones) - looks like most got resolution letter much faster than 60 days.

Can anyone provide some data points on time frames? And should I actually expect resolution letter at all? Saw some older comments where people have been saying that they never got anything back from IRS and assumed that all was resolved.

[Alan S.]

The 60 days is from the date of the letter.

Resolutions are not completed in a uniform time period, so this may take more or less than 60 days. 60 is just their target. Hard to guess your chances of getting no letter of resolution at all.

I think that what you have submitted will suffice, but it is frustrating when you submit a clear letter of explanation and they totally ignore it. I certainly would not worry about being taxed in the end since this should be an easy resolution even if not a timely one.

If the IRS has a rational concern rather than just an oversight, one concern might be that even though the IRA distribution check may have been made out to the 401k plan for your benefit and coded G, there are some banks that will incorrectly cash that check if you ask them to. You could then report a rollover on your taxes and end up with a tax free distribution. The other scenario that might concern the IRS would be if they have unearthed cases where the IRA custodian misuses the G coding. Say you asked for an IRA distribution but were surprised to receive a G coded 1099R in January. Then you decided to roll the dice and report a rollover to the employer plan that never occurred.

Those two scenerios might justify further IRS inquiry, but more than likely your case is just a flat out failure to read your explanation rather than an intended area of IRS investigation.

Finally, consider all this in view of the recent IRS study which identified a huge multi million dollar tax gap on IRA distribution administration. IRS agents have obviously been told to increase oversight as the recent article in the WSJ indicates. See thread "IRA Rules get Trickier"...........

[MoneyOCD]

Thanks, Alan, for your thoughtful reply.
Will continue to patiently wait for resolution letter - I supplied all possible documents including copy of the rollover check itself.
Also sent letter from 401k custodian with date of when they received my check issued by Fidelity and deposited it. Those 2 shows time span of significantly less the 60 days - I indicated it on the explanantion letter as well.

Will let you all know if any updates.
Looks like this year flood of CP2000 in regards of IRA transactioan are just beginning.

[MoneyOCD]

Stars did align yesterday for us and IRS letter safely made it to our mail box.
Total Amount Due: $0.00 Case closed
Really appreciate everyone's insights and comments as they helped us to not freak out and send intellegent response on our own.