2-step Rollover/Conversion

[gwhoopee]

I received a distribution less 20% for withholding taxes ($40,000 less $8,000) from my former employer’s 401k on 14Dec2020.  I asked my Roth IRA account holder (Morgan Stanley) to transfer the full distribution of $40,000 from my checking account to my Roth IRA.  They indicated that they needed to rollover the $40,000 to my Morgan Stanley Standard IRA first and then transfer and convert the full amount to my Morgan Stanley Roth IRA.  Both the rollover and the conversion were completed within the 60-day time limit however the conversion from the Standard IRA to the Roth IRA took place in calendar year 2021 on 08Feb2021. 

Question: 

•  Can I complete the 2-step rollover/conversion from 401k to Roth IRA and pay the taxes in tax year 2020 ? 

or,

• must I show a rollover from the 401k to Standard IRA in tax year 2020 with no taxes paid and then show a conversion from Standard IRA to Roth IRA in tax year 2021 and pay the taxes in 2021?

My preference is to show the 2-step rollover/conversion all in tax year 2020 and pay the taxes in my 2020 tax return accordingly. 

[dmertz · Accepted solution]

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They indicated that they needed to rollover the $40,000 to my Morgan Stanley Standard IRA first and then transfer and convert the full amount to my Morgan Stanley Roth IRA.

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That was a false statement by the Morgan Stanley rep.  The Pension Protection Act of 2006 changed the tax code to allow a distribution made after December 31, 2007 from a 401(k) or similar qualified retirement plan to be rolled over to a Roth IRA without having to pass through a traditional IRA.  Their error in not permitting you to roll the 401(k) distribution directly into the Roth IRA has resulted in a Roth conversion that is taxable on your 2021 tax return, not on your 2020 tax return.  Had they properly permitted the rollover of the 401(k) distribution to be made to the Roth IRA, the distribution from the 401(k) would have been taxable on your 2020 tax return instead.

See IRS Notice 2008-30 which clarifies the tax code change which allows distributions from traditional accounts qualified retirement plans to be rolled over to a Roth IRA without first doing an intervening rollover to a traditional IRA and subsequently converted to a Roth IRA:  https://www.irs.gov/pub/irs-drop/n-08-30.pdf

There is additional information on this in IRS Notice 2009-75:

https://www.irs.gov/pub/irs-drop/notice_2009-75.pdf

There is likely nothing that can be done to correct to correct this to make this be taxable on your 2020 tax return instead of on your 2021 tax return.  If it's worth the time and expense, you might have have a legal dispute with Morgan Stanley for their faulty guidance that potentially will have caused you to pay more tax on this than necessary (or at least delay your opportunity to move more funds from traditional to Roth and stay within your tax bracket).

As it stands, the distribution from the 401(k) must be reported as entirely rolled over to the traditional IRA when entering the Form 1099-R for this distribution from the 401(k) plan .  The Roth conversion will be reportable on your 2021 by entering the 2021 Form 1099-R (code 2 or code 7 depending on your age) that you will receive next year.