Improper Distribution from After-Tax 401k to Roth (Mega Backdoor)

Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills
Post Reply
fufgirl
Posts: 6
Joined: Thu Sep 20, 2018 8:39 am

Improper Distribution from After-Tax 401k to Roth (Mega Backdoor)

Post by fufgirl » Fri Sep 21, 2018 5:07 pm

I received a notice from Fidelity this past week stating that I received an "improper distribution" last year from my 401k account and asking me to return the amount of the distribution (another form was included to account for there being any gains/losses on that amount that is being returned). In 2017, I did 2 separate after-tax rollovers from my Fidelity 401k to my Roth IRA at Vanguard, and Fidelity claims that I was really only supposed to be able to do 1 per calendar year. (I did 2 in 2016 they apparently have no issues with, but that is besides the point.) I made the max IRA contribution outside of this "improper distribution" for tax year 2017 already. I am also far from being 59 1/2.

I am trying to determine the best course of action to take. Ideally I manage to somehow put everything back where it was and don't end up with any tax/penalty/fee, but I do not think that is possible here. After speaking with both companies and researching on my own, it looks like the "improper distribution" principal will be taken out and put back in my after-tax 401k account at Fidelity along with the gains attributed to it. Can someone confirm that I am not supposed to have to pay the 6% tax on the "improper distribution" principal yet, because it is NOT technically an overcontribution to an IRA until after the October extension deadline? (I filed by the April deadline in 2018 already, but I read there is a special rule that doesn't require you to have originally requested an extension when it comes to IRA overcontributions. (Is it an overcontribution or isn't it??)

The penalty (or tax/excess fee if applicable) then is then paid as due for the 2017 tax year correct? (sucks brackets are lower this year) Does this mean there is interest? I hope the worst is that there is just a penalty on earnings payable for 2018. I really hope its all just undone completely and the principal is put back, and the earnings are considered after-tax earnings, which I would be taxed on when rolled out in the future.

Unfortunately I am 99.9% sure I cannot just do nothing. Fidelity sent out "corrected" tax forms, with the improper distribution having code E for administrative error, while the 1st rollover amount in 2017 still has the proper code G. My understanding is that as far as Fidelity is concerned, it is no different that I put the money into a Roth or spent it, it simply wasn't supposed to come out according to the plan, and ultimately, I am left with an excess contribution in my Roth for 2017 unless I do something. This is not something I want to have to deal with 20 years from now (as I understand the IRS can go back as far as they want on IRA issues) with 6% penalties stacked a mile high among other things.

I need that tax form from Fidelity with code E to go away, I believe and have just the 1st rollover from 2017 sent out as "corrected". I am still not sure what Vanguard will do to report when withdrawing.

I am a long time lurker, and apologize for this surely basic question. However, this is not a situation I thought I would ever have to deal with and it appears to be time sensitive.

User avatar
Duckie
Posts: 6020
Joined: Thu Mar 08, 2007 2:55 pm

Re: Improper Distribution from After-Tax 401k to Roth (Mega Backdoor)

Post by Duckie » Fri Sep 21, 2018 7:36 pm

fufgirl, welcome to the forum.
fufgirl wrote:In 2017, I did 2 separate after-tax rollovers from my Fidelity 401k to my Roth IRA at Vanguard, and Fidelity claims that I was really only supposed to be able to do 1 per calendar year.
What do your plan documents say about number of rollovers per year? How much was the second after-tax rollover?

Alan S.
Posts: 7806
Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: Improper Distribution from After-Tax 401k to Roth (Mega Backdoor)

Post by Alan S. » Fri Sep 21, 2018 10:02 pm

If it turns out that the plan only allowed one such distribution per year from the after tax sub account, and then requested the additional distribution to be returned, then any taxable amount shown in Box 2a on the E coded 1099R should be reversed once the plan is repaid. That said, it is possible that the plan will refuse to amend that form, as there has been some confusion over how this issue.

The rollover to the Roth IRA is treated as an excess regular Roth IRA contribution and must be corrected in the usual manner no later than the extended due date of 10/15/2018. Therefore, time is getting short. The corrective distribution would produce tax and penalty on any earnings while the Roth held this rollover amount.

I assume the original G coded 1099R was corrected to only show the amount of the first direct rollover. If so, the 2017 return must be amended to conform to that revised G coded 1099R.

User avatar
celia
Posts: 8492
Joined: Sun Mar 09, 2008 6:32 am
Location: SoCal

Re: Improper Distribution from After-Tax 401k to Roth (Mega Backdoor)

Post by celia » Fri Sep 21, 2018 10:34 pm

It appears you will have to ask Vanguard to un-do the second rollover (matching the 1099-R coded E) including the Roth IRA growth which is up to them to calculate. Vanguard needs to know that this is correcting an administrative error so that when THEY issue a 2018 1099-R for the "un-do", they will use the correct code and not just treat is as a new rollover. (If they treated it as a regular rollover, you would then have 2 errors to fix).

I assume some growth in the After-tax 401K rolled over to the Roth IRA for each rollover, separate from the growth that occurred in the Roth IRA. The growth that rolled over to the Roth was (supposed to be) taxed on your 2017 return. Since you now need to amend your 2017 return (for un-doing the second rollover), there is now less 401K growth that needed to be taxed for 2017, meaning your tax liability will decrease. I don't know if any penalties will kick in because of this second (invalid) rollover, but the sooner you correct the error and your tax return, the lower the penalty, if any.

fufgirl
Posts: 6
Joined: Thu Sep 20, 2018 8:39 am

Re: Improper Distribution from After-Tax 401k to Roth (Mega Backdoor)

Post by fufgirl » Sat Sep 22, 2018 7:34 am

That's an interesting question about the plan documents. I must have missed it or something, because when I was trying to confirm what I was being told about the in-service rollovers a couple of years ago, I couldn't find anything about them. So, I'm honestly not that surprised, but I would have thought the IT would be set up properly to ensure these things don't happen, even if a rep misunderstands. As far as the amount, it is only just a bit over 2k. Luckily the first one of the year appears to be safe. However, I am now concerned because I did a very large one in 2018 and plan another (after-tax already in the account) in 2019. When I called to confirm the number of these rollovers I had in 2018 in Jan 2018 I was told 2. When I did my first rollover this year in 2018, I tried to confirm again and they said nope its only 1 allowed. I thought it was bad to change it mid year...little did I know!

Also, about the code E on the form...there is 0 listed as the taxable amount. I have't tried putting it in tax software myself yet but from what I can see that usually means there is a tax associated with that amount. I think as far as Fidelity is concerned, its not taxable due to the "you may have rolled it over or not", it only is because I did put it in a Roth, which happens to cause me to over contribute, and they don't know whether I did that or not. I guess if I didn't max my IRA in 2017, there wouldn't even be an issue, I could just leave it and call it a normal contribution.

The "improper distribution" actually didn't make it to Vanguard until 2018, as this was done close to the end of 2017. I don't know if that makes any difference, but I think it should for the "gains" as it was in limbo between years from the time it was distributed and at the new custodian.

Edit: I am sending the Fidelity forms to Vanguard after speaking with them. Also, with the amount being considered an overcontribution in my case, it is best that something be done to correct (withdraw) the overcontribution by Oct. 15, 2018 and it falls under the "automatic" extension to correct an excess. I keep looking at things that suggest there is no 6% penalty on the distributed amount as long as it gets done by the extension deadline this year. There is still the issue of gains/penalty of course.

Alan S.
Posts: 7806
Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: Improper Distribution from After-Tax 401k to Roth (Mega Backdoor)

Post by Alan S. » Sat Sep 22, 2018 4:07 pm

fufgirl wrote:
Sat Sep 22, 2018 7:34 am
That's an interesting question about the plan documents. I must have missed it or something, because when I was trying to confirm what I was being told about the in-service rollovers a couple of years ago, I couldn't find anything about them. So, I'm honestly not that surprised, but I would have thought the IT would be set up properly to ensure these things don't happen, even if a rep misunderstands. As far as the amount, it is only just a bit over 2k. Luckily the first one of the year appears to be safe. However, I am now concerned because I did a very large one in 2018 and plan another (after-tax already in the account) in 2019. When I called to confirm the number of these rollovers I had in 2018 in Jan 2018 I was told 2. When I did my first rollover this year in 2018, I tried to confirm again and they said nope its only 1 allowed. I thought it was bad to change it mid year...little did I know!

Well, you will have to be persistent to get to the bottom of this since you will not want to go through this type of fallout every year. If you are actually limited to one distribution per year, try to time it as close to when your contributions are made as possible. You may also have some flexibility in determining the dates and amounts of your after tax contributions.

Also, about the code E on the form...there is 0 listed as the taxable amount. I have't tried putting it in tax software myself yet but from what I can see that usually means there is a tax associated with that amount. I think as far as Fidelity is concerned, its not taxable due to the "you may have rolled it over or not", it only is because I did put it in a Roth, which happens to cause me to over contribute, and they don't know whether I did that or not. I guess if I didn't max my IRA in 2017, there wouldn't even be an issue, I could just leave it and call it a normal contribution.

With respect to the 0 in Box 2a, no taxes are being reported as due. This reflects one of two possible reasons, first that there were no earnings generated on your AT contributions at the time of the rollover, OR the plan anticipates that you will be returning the total distributed so you should not be taxed.

The "improper distribution" actually didn't make it to Vanguard until 2018, as this was done close to the end of 2017. I don't know if that makes any difference, but I think it should for the "gains" as it was in limbo between years from the time it was distributed and at the new custodian.

Normally, such a rollover contribution would be reported on Form 5498 in the year actually received. In this case, your comment regarding how this tainted rollover is treated was spot on. Since a failed rollover is treated as a regular contribution, you CAN choose to keep that contribution if you qualify. For a regular Roth contribution, your MAGI cannot be too high, ie the MAGI for the year the contribution was actually deposited and for which the Roth custodian will issue the 5498. If you do not qualify or choose to have the tainted rollover treated as an excess contribution, again because it was made in January you can either treat it as a regular contribution for the prior year or the year it was actually deposited. If you elect to treat it as contributed for the deposit year, then you have until 10/15/2019 to remove it. Since the 5498 for 2018 rollovers has not been issued yet, the custodian may be willing to report it as a regular contribution they understand that is how you must treat it, or their systems may not be able to change it from a rollover contribution. Due to the strange combination of events here, I would not spend much time trying to change the custodian reporting. With respect to your 2017 return, if the total box 1 and 2a amounts are the same as you originally filed, you should not bother to file a 1040X. All the IRA related issues are for 2018, not 2017 UNLESS you see some reason to treat the 2k as a prior year 2017 Roth contribution.


Edit: I am sending the Fidelity forms to Vanguard after speaking with them. Also, with the amount being considered an overcontribution in my case, it is best that something be done to correct (withdraw) the overcontribution by Oct. 15, 2018 and it falls under the "automatic" extension to correct an excess. I keep looking at things that suggest there is no 6% penalty on the distributed amount as long as it gets done by the extension deadline this year. There is still the issue of gains/penalty of course.

Right, if you treat it as an excess contribution and remove it in time, there is no excise tax, just regular tax and penalty on any earnings generated in the Roth IRA on the removed contribution.

fufgirl
Posts: 6
Joined: Thu Sep 20, 2018 8:39 am

Re: Improper Distribution from After-Tax 401k to Roth (Mega Backdoor)

Post by fufgirl » Wed Oct 17, 2018 2:35 pm

I had Vanguard remove the "excess contribution" and earnings a couple weeks ago. They would not reverse this or do the rollover themselves, so I had to get a cashier's check to send to Fidelity. I sent it certified return receipt, and although it was received on 10-9-18 by Fidelity, it has not been applied to my after-tax 401k. Hopefully I have a better update soon.

I understand I need to amend my 2017 taxes as I would have put in a larger 1099-R that has code G. I believe Fidelity needs to send a new corrected 1099-R after this amount is applied again, or I have a ton more research to do about the portion they changed to "E" on the latest 1099-R.(I guess there has to be something between 2017/2018 explaining the earnings withdrawn??) I should not have to pay any penalty/tax on the actual amount of the initial rollover in 2017. It does appear, that since the money wasn't supposed to be able to be rolled over (and was received by Vanguard in 2018) that I will have a penalty on the earnings portion for 2018, which is not due yet. I'd ask for input as it is welcome, but I guess I am putting the cart before the horse here with waiting for the funds to be back in the account. At least they were withdrawn prior to 10/15/18 (so if it is considered a 2017 rollover), that is done...

Thank you everyone for your help with this.

Post Reply