IRS Guidance on Failed Roth IRA Conversion

In 1998, taxpayer T attempted to convert his traditional IRA to a Roth IRA. T believed that he was eligible to convert to a Roth IRA because his 1998 modified adjusted gross income (MAGI) was less than $100,000. T chose to include the income from the traditional IRA over a four-year period. On April 15, 2000, the IRS issued an underreporter notice to T for 1998, such that T's 1998 MAGI exceeded $100,000. T filed an amended return for 1998, seeking a refund of the taxes paid on the failed Roth IRA conversion. T stated that he could not take advantage of the opportunity to correct the failed conversion before 2000, because he did not know of the increase to his AGI until April 15, 2000.

The Service informed T that there was a failed Roth IRA conversion, resulting in a distribution of the traditional IRA in 1998. The distribution from the traditional IRA was includible in his 1998 income. Further, T had to treat the transaction as a contribution to T's Roth IRA, subjecting it to the 6% excise tax under Sec. 4973, to the extent that it exceeded the amount of T's regular IRA contribution, up until the time withdrawn. Further, T is subject to an additional 10% tax on early distributions under Sec. 72(t) for the distribution from the traditional IRA.

Analysis

Taxpayers are permitted to convert IRAs to Roth IRAs. The amount converted is included in gross income to the extent that a distribution from the traditional IRA would have been included in gross income were it not part of a Roth IRA conversion (Sec. 408(d)(i)). The taxable portion of the distribution is fully taxable in the year distributed from the traditional IRA, unless the year of distribution is 1998. If the conversion were made in that year, the taxpayer could have reported the income from the distribution over four years; see Regs. Sec. 1.408A-4, Q&A-8.

If a failed conversion were not recharacterized, the distribution from the traditional IRA would be treated as a regular distribution from it and subject to the 10% additional tax on early distributions (unless an exception applies). The amount the taxpayer attempted to convert is treated as a regular contribution to the Roth IRA and is subject to the 6% excise tax under Sec. 4973 (to the extent it is an excess Roth IRA), until it is withdrawn from the Roth IRA.

Many taxpayers made Roth IRA conversions in 1998, despite the fact that they were not eligible to do so because their MAGI for that year was more than $100,000. However, taxpayers were allowed to recharacterize failed conversions for the 1998 tax year until Dec. 31, 1999 (Ann. 99-104). After 1999, a taxpayer wishing to recharacterize must obtain an extension of the deadline to recharacterize under Regs. Sec. 301.9100-3. The procedure involves filing a request for a letter ruling and paying the applicable user fee.

Conclusion

If a failed Roth IRA conversion is not recharacterized, the amount that a taxpayer attempts to convert is treated as a regular distribution from a traditional IRA, including imposition of the 10% additional tax on early distributions (unless an exception applies). The conversion is also treated as a regular contribution to the Roth IRA, subject to the 6% excise tax on excess accumulations to the extent it is an excess Roth contribution.

If a taxpayer made a failed Roth IRA conversion and the due date to recharacterize the failed conversion passed, the taxpayer would have to submit a request for a letter ruling that extends the due date to recharacterize the failed conversion under Regs. Sec. 301.9100-3.

IRS Letter Ruling (SCA) 200148051 (9/20/01)

REFLECTIONS: In general, the National Taxpayer Advocate has authority to assist taxpayers in resolving many problems with the IRS. However, because the determination of whether the requirements for recharacterizing a failed IRA conversion have been met is substantive in nature, it is beyond the scope of the authority currently accorded to the Taxpayer Advocate.