Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

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m2go
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Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by m2go » Wed Sep 12, 2018 12:49 pm

I have been doing a Mega Backdoor Roth for many years. At some point, I understood that the 401(k) roll over of an in-service distribution of the after-tax 401k portion to a traditional IRA was no longer necessary? Instead, I could just deposit the proceeds of the in-service withdrawal directly into a Roth IRA without the intermediate step of depositing into a traditional IRA and then converting said traditional IRA to a Roth. Is that correct, or did I screw up?

I now received a tax notice to pay 10% early distribution penalty on the taxable amount of amounts I directly moved from a 401k to a Roth IRA. HR Block never computed an early distribution penalty, because it lined up with amounts that had been deposited into a Roth IRA after the in-service withdrawal of the after-tax contributions to our 401k accounts.

retiredjg
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by retiredjg » Wed Sep 12, 2018 1:23 pm

m2go wrote:
Wed Sep 12, 2018 12:49 pm
I have been doing a Mega Backdoor Roth for many years. At some point, I understood that the 401(k) roll over of an in-service distribution of the after-tax 401k portion to a traditional IRA was no longer necessary? Instead, I could just deposit the proceeds of the in-service withdrawal directly into a Roth IRA without the intermediate step of depositing into a traditional IRA and then converting said traditional IRA to a Roth. Is that correct, or did I screw up?
I don't know the entire history, but to my knowledge the rollover has never been required to go through tIRA.
I now received a tax notice to pay 10% early distribution penalty on the taxable amount of amounts I directly moved from a 401k to a Roth IRA. HR Block never computed an early distribution penalty, because it lined up with amounts that had been deposited into a Roth IRA after the in-service withdrawal of the after-tax contributions to our 401k accounts.
Sounds like a mistake?

I wonder if this is one of those things that requires you to include an explanatory comment on your tax form?

Alan S.
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Alan S. » Wed Sep 12, 2018 1:34 pm

m2go wrote:
Wed Sep 12, 2018 12:49 pm
I have been doing a Mega Backdoor Roth for many years. At some point, I understood that the 401(k) roll over of an in-service distribution of the after-tax 401k portion to a traditional IRA was no longer necessary? Instead, I could just deposit the proceeds of the in-service withdrawal directly into a Roth IRA without the intermediate step of depositing into a traditional IRA and then converting said traditional IRA to a Roth. Is that correct, or did I screw up?

I now received a tax notice to pay 10% early distribution penalty on the taxable amount of amounts I directly moved from a 401k to a Roth IRA. HR Block never computed an early distribution penalty, because it lined up with amounts that had been deposited into a Roth IRA after the in-service withdrawal of the after-tax contributions to our 401k accounts.

Did you report the direct rollover correctly on Form 1040? The total amount rolled over should have gone on line 16a and only the taxable amount on 16b. While amounts on 16b would usually be subject to penalty, the code G in Box 7 tells the IRS that a direct rollover was done of the full amount and there is never a penalty with a direct rollover. You do not owe the penalty. Send the IRS a copy of the 1099R with code G circled and also a copy of Form 5498 that you received in May showing a rollover of the same amount as shown on the 1099R to your Roth IRA. That should take care of this.


Another reason for this confusion from the IRS is that they are used to looking for Form 8606 for Roth conversions. But when you go direct from your 401k Form 8606 does not apply. So this is an IRS error, not your error. It would probably have been a very costly mistake if you had rolled this money into a TIRA first, since that would have triggered the pro rata rules of Form 8606 when you converted from the TIRA.

Topic Author
m2go
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by m2go » Wed Sep 12, 2018 2:22 pm

Alan S. wrote:
Wed Sep 12, 2018 1:34 pm
m2go wrote:
Wed Sep 12, 2018 12:49 pm
I have been doing a Mega Backdoor Roth for many years. At some point, I understood that the 401(k) roll over of an in-service distribution of the after-tax 401k portion to a traditional IRA was no longer necessary? Instead, I could just deposit the proceeds of the in-service withdrawal directly into a Roth IRA without the intermediate step of depositing into a traditional IRA and then converting said traditional IRA to a Roth. Is that correct, or did I screw up?

I now received a tax notice to pay 10% early distribution penalty on the taxable amount of amounts I directly moved from a 401k to a Roth IRA. HR Block never computed an early distribution penalty, because it lined up with amounts that had been deposited into a Roth IRA after the in-service withdrawal of the after-tax contributions to our 401k accounts.

Did you report the direct rollover correctly on Form 1040? The total amount rolled over should have gone on line 16a and only the taxable amount on 16b. While amounts on 16b would usually be subject to penalty, the code G in Box 7 tells the IRS that a direct rollover was done of the full amount and there is never a penalty with a direct rollover. You do not owe the penalty. Send the IRS a copy of the 1099R with code G circled and also a copy of Form 5498 that you received in May showing a rollover of the same amount as shown on the 1099R to your Roth IRA. That should take care of this.
Thanks for the clarification - the rollover was not direct. We can only get a check made payable to us for in-service withdrawals. Thus, I received a check made payable to me (after withholding) which I deposited into my checking account, and then wrote a new check for the full amount (replenishing the withheld tax amount).

Box 7 codes "1", "Early distribution, no known exception" as it has in years past when there was no problem with the IRS claiming an early withdrawal penalty was due.

Spirit Rider
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Spirit Rider » Wed Sep 12, 2018 2:43 pm

retiredjg wrote:
Wed Sep 12, 2018 1:23 pm
I don't know the entire history, but to my knowledge the rollover has never been required to go through tIRA.
The Pension Protection Act of 2006 effective 1/1/2008, first allowed direct rollovers from qualified plans to a traditional Roth IRA. Prior to 1/1/2008, you had to rollover to a traditional IRA and then do a Roth conversion.

Alan S.
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Alan S. » Wed Sep 12, 2018 2:48 pm

m2go wrote:
Wed Sep 12, 2018 2:22 pm
Alan S. wrote:
Wed Sep 12, 2018 1:34 pm
m2go wrote:
Wed Sep 12, 2018 12:49 pm
I have been doing a Mega Backdoor Roth for many years. At some point, I understood that the 401(k) roll over of an in-service distribution of the after-tax 401k portion to a traditional IRA was no longer necessary? Instead, I could just deposit the proceeds of the in-service withdrawal directly into a Roth IRA without the intermediate step of depositing into a traditional IRA and then converting said traditional IRA to a Roth. Is that correct, or did I screw up?

I now received a tax notice to pay 10% early distribution penalty on the taxable amount of amounts I directly moved from a 401k to a Roth IRA. HR Block never computed an early distribution penalty, because it lined up with amounts that had been deposited into a Roth IRA after the in-service withdrawal of the after-tax contributions to our 401k accounts.

Did you report the direct rollover correctly on Form 1040? The total amount rolled over should have gone on line 16a and only the taxable amount on 16b. While amounts on 16b would usually be subject to penalty, the code G in Box 7 tells the IRS that a direct rollover was done of the full amount and there is never a penalty with a direct rollover. You do not owe the penalty. Send the IRS a copy of the 1099R with code G circled and also a copy of Form 5498 that you received in May showing a rollover of the same amount as shown on the 1099R to your Roth IRA. That should take care of this.
Thanks for the clarification - the rollover was not direct. We can only get a check made payable to us for in-service withdrawals. Thus, I received a check made payable to me (after withholding) which I deposited into my checking account, and then wrote a new check for the full amount (replenishing the withheld tax amount).

Box 7 codes "1", "Early distribution, no known exception" as it has in years past when there was no problem with the IRS claiming an early withdrawal penalty was due.
OK - but the tax program would still report the rollover on lines 16a and 16b as indicated above and indicate "rollover" next to 16b.

You would not need to provide the IRS a copy of the 1099R, but should provide a copy of the 5498 showing the rollover of the full amount to your Roth IRA, and that should resolve this. There is never a penalty for rollovers to a Roth account.

Sounds like your return was correct, but the IRS was just looking at the Code 1, not realizing that the rollover went to a Roth IRA.

retiredjg
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by retiredjg » Wed Sep 12, 2018 3:29 pm

Spirit Rider wrote:
Wed Sep 12, 2018 2:43 pm
retiredjg wrote:
Wed Sep 12, 2018 1:23 pm
I don't know the entire history, but to my knowledge the rollover has never been required to go through tIRA.
The Pension Protection Act of 2006 effective 1/1/2008, first allowed direct rollovers from qualified plans to a traditional Roth IRA. Prior to 1/1/2008, you had to rollover to a traditional IRA and then do a Roth conversion.
Thanks!

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Earl Lemongrab
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Earl Lemongrab » Thu Sep 13, 2018 12:34 pm

m2go wrote:
Wed Sep 12, 2018 2:22 pm
Thanks for the clarification - the rollover was not direct. We can only get a check made payable to us for in-service withdrawals. Thus, I received a check made payable to me (after withholding) which I deposited into my checking account, and then wrote a new check for the full amount (replenishing the withheld tax amount).
The law requires the plan to support direct rollovers. The only difference is that the check would be made payable to the new custodian instead of you.

Spirit Rider
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Spirit Rider » Thu Sep 13, 2018 8:29 pm

Earl Lemongrab wrote:
Thu Sep 13, 2018 12:34 pm
m2go wrote:
Wed Sep 12, 2018 2:22 pm
Thanks for the clarification - the rollover was not direct. We can only get a check made payable to us for in-service withdrawals. Thus, I received a check made payable to me (after withholding) which I deposited into my checking account, and then wrote a new check for the full amount (replenishing the withheld tax amount).
The law requires the plan to support direct rollovers. The only difference is that the check would be made payable to the new custodian instead of you.
@Earl Lemongrab is correct. If the amount is eligible for rollover, the plan must allow a direct rollover.
@m2go, maybe you should educate your plan that they are in direct violation of IRS regulations.

26 CFR 1.401(a)(31)-1 - Requirement to offer direct rollover of eligible rollover distributions; questions and answers.
Q-1: What are the direct rollover requirements under section 401(a)(31)?
A-1: (a) General rule. To satisfy section 401(a)(31), added by UCA, a plan must provide that if the distributee of any eligible rollover distribution elects to have the distribution paid directly to an eligible retirement plan, and specifies the eligible retirement plan to which the distribution is to be paid, then the distribution will be paid to that eligible retirement plan in a direct rollover described in Q&A-3 of this section. Thus, the plan must give the distributee the option of having his or her distribution paid in a direct rollover to an eligible retirement plan specified by the distributee.

Alan S.
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Alan S. » Thu Sep 13, 2018 10:04 pm

It has been reported that several of these plans will not do a direct rollover to a Roth IRA, and instead require that the mega back door Roth rollover be made to the designated Roth account (in plan Roth rollover or IRR).

As indicated by spiritrider and Earl, a distribution made to the participant and declination of a direct rollover to a Roth IRA appears in conflict with Reg. 1.401(a)-31 since the plan obviously considers these amounts to be distributable.

While not the case with the OP, I think that a plan that ONLY offers an IRR as a rollover option would have to amend the plan to make the after tax sub account non distributable while still employed. By making that account non distributable, the plan could restrict IRRs to ONLY non distributable amounts which would block distribution to the participant or to a Roth IRA. But an IRR could still be done as outlined in IRS Notice 2013-74.

Again, in the OPs case a distribution was made to the OP as the only option, apparently in violation of the Reg and the OP might want to challenge the plan if they want a direct rollover done bad enough. The above paragraph does not apply to the OP, but would become an issue when ONLY an IRR was offered. So I don't think a plan can restrict to IRRs only unless they make the after tax sub account NON distributable.

Thoughts?

Topic Author
m2go
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by m2go » Fri Sep 14, 2018 12:24 am

Is there anything wrong with doing a deposit followed by a redeposit, other than evidently being more involved, involving the risk of IRS, getting compulsory withholding that one has to replenish, and so forth...?

I actually left that employer, so it is no longer my battle to fight (although I have two more years of tax returns to contend with). Regrettably, my new employer does not offer after-tax accounts, so the Mega Backdoor will be closed for me in the future :-(

Was fun (and profitable) while it lasted!

Spirit Rider
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Spirit Rider » Fri Sep 14, 2018 4:27 pm

I just thought of one thing that might have been relevant to the OP and be relevant to others following this thread

A plan may, but is not required to do the split-rollover of after-tax contributions -> Roth IRA and after-tax earnings -> traditional IRA or other pre-tax accounts.

However, you can partially get around this. They must allow a direct rollover of one and a distribution of the other.

For example, they must allow a direct rollover of the after-tax contributions -> Roth IRA and a distribution of the after-tax earnings. You can then do an indirect rollover of the earning to a traditional IRA, one-participant 401k, etc...

Indirect rollovers between a qualified plan and IRA are not included in the one IRA rollover limit.

Topic Author
m2go
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by m2go » Sat Feb 16, 2019 6:28 pm

So, I just heard back from the IRS, and they reiterated the response.

To recap, we took an in-service distribution of after-tax 401(k) contributions and rolled that amount over into a Roth IRA. The IRA sent us a letter saying an early distribution penalty was due, we answered that we rolled over the 401k distribution, and so we did not owe any early distribution penalty.

So, they now wrote that they do not see why we would

Specifically, they write "The information that you entered on your electronically filed tax return matches our record and indicate a distribution code of '1' (early distribution. "

Further, they write "We do not have record of or documentation supporting the reason why the 10% early distribution penalty would not apply from the distributions from Fidelity Investments."

What now? Call them? Resend the response?

Alan S.
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Alan S. » Sat Feb 16, 2019 11:04 pm

The penalty does not apply does not apply due to the "Rollover" exception in the following list of penalty exceptions:

https://www.irs.gov/retirement-plans/pl ... tributions

Did you indicate "rollover" on your tax return on line 16b? This is critical because when the IRS sees any taxable amount on 16b they may not understand that you did a rollover, in this case technically a "qualified rollover contribution". Not showing rollover next to 16b might trigger this IRS inquiry.

This is another way to approach the IRS since they apparently failed to understand that the G coded 1099R signifies a direct rollover. So you might have to cover two bases:
1) Provide reference to this penalty exception chart
2) Show that you actually did a rollover beyond the G coding by providing a copy of the 5498 and the 1099R.

You aren't working with brain surgeons here.

Topic Author
m2go
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by m2go » Thu Feb 21, 2019 1:19 pm

I just had a call with the IRS, and the lady insisted that in and of itself because the amount was coded '1' (early distribution), and I showed it as taxable, it accrues early distribution penalty, sayying if it were a Rollover, it would not be taxable at all.

To answer the question whether I indicated ROLLOVER on Line 16b, I did not. I completed this with HR Block, and it did not fill in that word for the 2016 return, as it had done in previous years.

I assume filing an amended return that adds the word ROLLOVER is too late?

Thanks for the reference chart of penalty exceptions. => https://www.irs.gov/retirement-plans/pl ... tributions

When I talked to the agent, she referred me to form 5329 which lists a number of items on page 4 - I am trying to cross reference it to the table provided in the instructions for form 5329 on page 4 ( https://www.irs.gov/pub/irs-pdf/i5329.pdf ), but can only come up with "other". If I use this form, but I don't have one of the codable reasons, am I heading into dangerous territory by providing a form that seems to imply this is not a listed permissible reason on this form?

Do you agree this is the right form to file with the selection of other, and refer to that table while coding the explanation for line 2 as reason "12" - "Other" ? (The items for form 5329 "other" do not include the "in-plan Roth rollovers or eligible distributions contributed to another retirement plan or IRA within 60 days (also see FAQs: Waivers of the 60-Day Rollover Requirement)" from the table the IRS has online.

Final questions:
  • Did I use the right procedure, by getting a check from Fidelity, and then depositing the amount (including adding any amount withheld by Fidelity) into the Roth IRA by writing a check from my bank account? I've used the word 'direct rollover' here a few times to refer going from a 401k to a Roth IRA without an intervening step of a traditional IRA, but I think "direct" is interpreted as going from trustee to trustee without the person getting the checks.
  • I've done multiple of these 401k to Roth transactions. However, unlike IRA rollovers, I don't believe a 401k to IRA rollover is limited to one transaction per year, from what I understand? Is this correct?

Alan S.
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Alan S. » Thu Feb 21, 2019 5:15 pm

I am not sure how many references she needs, but here are 4 more:

1) Direct tax code Sec 408A(d)(3)(A):
(3)Rollovers from an eligible retirement plan other than a Roth IRA
(A)In general Notwithstanding sections 402(c), 403(b)(8), 408(d)(3), and 457(e)(16), in the case of any distribution to which this paragraph applies—
(i) there shall be included in gross income any amount which would be includible were it not part of a qualified rollover contribution,
(ii)section 72(t) shall not apply
Note: Sec 72t is the section that levies a 10% penalty

2) IRS Notice 2008-30, Q 3:
Q-3. Does the additional tax under § 72(t) apply to a qualified rollover contribution from an eligible retirement plan other than a Roth IRA?

A-3. No. Pursuant to § 408A(d)(3)(A)(ii), the additional tax under § 72(t) does not apply to rollovers from an eligible retirement plan other than a Roth IRA. However, as with conversions, if a taxable amount rolled into a Roth IRA from an eligible retirement plan other than a Roth IRA is distributed within 5 years, § 72(t) applies to such distribution as if it were includible in gross income. See § 408A(d)(3)(F).
3) Then for those who prefer IRS explanations in common language, there are the IRS Pubs. The following is copied from Pub 575, p 32:
Rollovers to Roth IRAs.

You can roll over distributions directly from a qualified retirement plan (other than a designated Roth account) to a Roth IRA. You must include in your gross income distributions from a qualified retirement plan (other than a designated Roth account) that you would have had to include in income if you hadn't rolled them over into a Roth IRA. You don't include in gross income any part of a distribution from a qualified retirement plan that is a return of contributions to the plan that were taxable to you when paid. In addition, the 10% tax on early distributions doesn't apply.
4) Form 5329 Inst, p 2:
The additional tax on early distributions doesn’t apply to any of the following.
• A qualified 2017 disaster distribution. See the 2018 Form 8915B for more details. • A qualified HSA funding distribution from an IRA (other than a SEP or SIMPLE IRA). See Qualified HSA funding distribution under Health Savings Accounts in Pub. 969 for details. • A distribution from a traditional or SIMPLE IRA that was converted to a Roth IRA. • A rollover from a qualified retirement plan to a Roth IRA. • An in-plan Roth rollover.
So now you have 4 IRS sources stating that the Sec 72t penalty does not apply. It is possible that she thinks you did not really roll over this distribution, so if you have Form 5498 from the Roth IRA custodian showing "rollover contribution" for the same amount, you could include a copy of that.
Given this woman's lack of basic training and the overall condition of the IRS right now in filing season, I would simply provide copies of this data and send it back to the IRS with the notice you received. Frustrating, because this issue is Tax 101. Wouldn't file anything new, no 5329 or 1040X.

Topic Author
m2go
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by m2go » Sun Mar 10, 2019 6:12 pm

Thanks so much for this explanation, this is very helpful!

In putting together a response to the IRS to their last letter, I find that the amount we rolled over is listed under Roth Conversion amount (box 3) rather than rollover contribution (box 2). I'm wondering whether that is the "third rail" in our response? While the act of contributing a Roth conversion amount to a Roth IRA and the act of contributing a rollover contribution to a Roth IRA is the same (just write a check), I wonder whether having it characterized as Roth conversion can trigger the IRS to do two things:
1 - force us to withdraw an "incorrect Roth IRA conversion"
2 - make the entire 401(k) contribution taxable, including a 10% early distribution penalty.

I'm hesitant how to proceed here. I don't know if I have enough documentation to make the broker change the form 5498 (These transaction were made 3 years ago, and I disposed of deposit slips, and don't have a copy of the check.), and even whether they can or will at this point.

I wonder whether a pragmatic solution may be to just pay and assume if we cough up the several 100 $, it would stop any closer look that might trigger a much more horrible outcome (which I don't think is warranted because the revenue code uses words like "the entire amount received is paid into an IRA"... that seems to make the classification in form 5498 irrelevant?)

Alan S.
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by Alan S. » Sun Mar 10, 2019 6:32 pm

m2go wrote:
Sun Mar 10, 2019 6:12 pm
Thanks so much for this explanation, this is very helpful!

In putting together a response to the IRS to their last letter, I find that the amount we rolled over is listed under Roth Conversion amount (box 3) rather than rollover contribution (box 2). I'm wondering whether that is the "third rail" in our response? While the act of contributing a Roth conversion amount to a Roth IRA and the act of contributing a rollover contribution to a Roth IRA is the same (just write a check), I wonder whether having it characterized as Roth conversion can trigger the IRS to do two things:
1 - force us to withdraw an "incorrect Roth IRA conversion"
2 - make the entire 401(k) contribution taxable, including a 10% early distribution penalty.

I'm hesitant how to proceed here. I don't know if I have enough documentation to make the broker change the form 5498 (These transaction were made 3 years ago, and I disposed of deposit slips, and don't have a copy of the check.), and even whether they can or will at this point.

I wonder whether a pragmatic solution may be to just pay and assume if we cough up the several 100 $, it would stop any closer look that might trigger a much more horrible outcome (which I don't think is warranted because the revenue code uses words like "the entire amount received is paid into an IRA"... that seems to make the classification in form 5498 irrelevant?)
While the 5498 is incorrect as it should have reported a rollover contribution, that shouldn't result in levying any penalty since if it had been a conversion (IRA to Roth IRA) it also would be penalty exempt under Point #1 posted earlier. You can also easily show that the IRA box was not checked on the 1099R reporting the qualified rollover contribution if asked. Therefore, I agree that the 5498 error is irrelevant to the penalty. I certainly would not pay a penalty you do not owe. A written response will likely find someone more knowledgeable that the agent you have been dealing with.

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m2go
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by m2go » Sun Sep 29, 2019 10:01 am

This got resolved, and I have the IRS notification that everything is fine.

Thanks so much for your advice and support in answering these questions and formulating the response.

retiredjg
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Re: Mega Backdoor question - from 401(k) to Roth IRA without intermediary traditional IRA?

Post by retiredjg » Sun Sep 29, 2019 10:09 am

Thanks for the update.

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