Accidental Traditional IRA Rolloiver

[macheung]

Looking for some advice on this unfortunate situation.  I took distributions from 3 different Prudential traditional IRA annuities with the intention of converting them to my Vanguard Roth IRA.  These were indirect rollovers as the proceeds were deposited into my checking account.  Rather than transferring the funds from my checking account bank to Vanguard, I wanted to use funds that were already available in my Vanguard after-tax brokerage account to complete the conversion. When I called Vanguard to do this yesterday, they said the easiest way to accomplish this was to transfer the conversion amount from my brokerage account into a traditional IRA account that I already had at Vanguard, and then convert the funds from that traditional IRA to my Vanguard Roth IRA account. They were able to process the transfer over the phone.  It wasn't until this morning that I realized that there's a major problem with this approach.  Only one indirect rollover is allowed by the IRS in any 12 month period, and this transaction would be considered 3 rollovers based on the IRS aggregation rule for indirect IRA rollovers. Had the transfer been made directly into my Roth account (which is what I had originally planned on doing!) I wouldn't have had a problem as Roth conversions are unlimited.  I've yet to call Vanguard to address this (they're only open weekdays and today is a Saturday) but I'm wondering if anyone has any thoughts on how this can be resolved with no or minimal negative tax implications.  The conversion amount is almost 6 figures so any negative tax implications could be significant.  Can the transfer into my traditional Vanguard IRA be withdrawn as an excess contribution, or recharacterized as a Roth IRA conversion?    I've got plenty of time before the 60 day indirect rollover window closes. Next time I convert to a Roth, I will go with a direct transfer to avoid any problems like this!

Thanks for any advice you can provide.

[VolvoGirl]

I don’t know about your whole question but wouldn’t taking it from your brokerage account also involve a sale to report on 1099B?  So that’s another taxable event.  

[macheung]

Just wanted to clarify that the funds are still sitting in my traditional Vanguard IRA and that the conversion to my Roth hasn't happened yet.

[macheung]

The funds from my brokerage account were in a money market fund, so no tax implications.  Thanks.

[VolvoGirl]

What’s happening to the first 3 distributions in your checking account?  Those are 3 taxable distributions (even if you put them in the ROTH).  Then if you do the conversion from the Vanguard IRA that will also be a taxable event making your tax DOUBLE!  Plus the 1099B from the Brokerage account.  Sounds like a big mess and you end up paying too much tax.    @dmertz 

[VolvoGirl]

I keep re reading your post.  Yes the contribution from Brokerage to IRA is definitely an excess contribution.  You can’t do that.  Weird they would even suggest that to you.  

Plus another wrinkle is if you are under 59 1/2 and if some of the amounts taken out are considered a distribution and not a conversion there is a 10% Early Withdrawal Penalty.  

Here’s an idea…….You may have to start completely over and put the 3 annuity distributions Back into the annuity IRA accounts (if you can).  You have 60 day to roll them back.   

[macheung]

If the IRS only recognizes 1 of the 3 distributions from the Prudential IRAs as a rollover to another traditional IRA, then yes, I'd be paying double taxes on the other 2 distributions if I were to convert them to a ROTH.  And if I don't convert them to a ROTH then I (or my heirs) would be paying taxes on those 2 distributions again when they are finally withdrawn from my traditional Vanguard IRA. Either way, not a good outcome.  The funds are in cash in my brokerage account so no capital gain/loss and no impact on my 1099B.  I am really ticked off that Vanguard led me down this path and am hoping that they can fix things. I am also mad that I let myself get into this predicament.

[macheung]

Vanguard said the transfer of funds from my brokerage account into my traditional IRA would be treated as a rollover of the Prudential IRA distributions, not a contribution.

I'm 70 years old, so no early withdrawal penalty.

Rolling the original withdrawals back into the annuity IRAs won't work as the 1 rollover per 12 months rule also applies to rollovers back into the IRAs from which they came.  Thanks for the suggestion anyway.

[macheung]

I'm hoping that Vanguard can reverse the entire transfer into my traditional IRA (since it only happened one business day ago) and allow me to move those funds directly from my brokerage account into my ROTH account, which is what I originally asked them to do.  I'm calling them on Monday.

[dmertz]

Good that you caught this.  That the Vanguard rep suggested rolling these over to a traditional IRA first suggests inadequate training on their part.  Even if there was no limitation on rollovers, there was no reason to turn one transaction into two.

One of the distributions from the original Prudential traditional IRAs was eligible for rollover (assuming no other previous rollovers within the limitation period), so I think that one should stay in the Vanguard traditional IRA to be converted from the Vanguard traditional IRA to the Vanguard Roth IRA;  I don't think that a permissible rollover is permitted to be distributed as a return of contribution.  Because the other two distributions from the Prudential IRAs were ineligible for rollover due to the limitation on rollovers, these two constitute regular traditional IRA contributions that will need to be distributed by an explicit return of contribution.  Within 60 days of the distributions from Prudential you'll need to complete the indirect conversion of these other two distributions from Prudential IRAs directly to the Vanguard Roth IRA as you originally planned, independently of the returned contribution, using whatever source of funds you choose.

[macheung]

Appreciate the input, dmertz. What you suggest makes sense to me. I'm just hoping that Vanguard will be able to return the excess contribution. I'll update my post after I contact them in Monday. 

[macheung]

I spoke to Vanguard this morning.  The retirement specialist that I spoke to told me that since 2 of the 3 Prudential IRA distributions were taken on the same day, the IRS will consider those as one distribution as they aggregate all my IRAs into a single IRA.  That's the good news.  The bad news is that the only thing Vanguard can do is return the 3rd distribution to my brokerage account as an excess contribution, but that would be taxed again (it will already be taxed as a distribution from my Prudential annuity IRA).  Vanguard suggested I contact a tax advisor to see if the IRS will allow the third distribution as a rollover since it was taken only 5 days before the other two distributions.  I will try to do that but if the cost and hassle of trying to resolve this in advance with the IRS is significant, I may just bite the bullet and pay the additional tax (roughly $8K) on the returned contribution.

Lesson learned, only do direct ROTH conversions. 

[dmertz]

"The retirement specialist that I spoke to told me that since 2 of the 3 Prudential IRA distributions were taken on the same day, the IRS will consider those as one distribution as they aggregate all my IRAs into a single IRA."

It seems that is not uncommon to get bad information like this from Vanguard.  Having taking the distributions on the same day (or nearby days) is irrelevant.  If the three distributions came from three different IRA accounts as you have described, that's three separate distributions, only one of which is eligible for rollover and under no circumstances are any combination of these permitted to be treated as a single distribution.  As I stated before, two of the deposits originally classified as rollovers must be reclassified as regular contributions and removed from the Vanguard IRA by explicit returns of contributions.

With an explicit return of contribution (code 8 included in box 7 of the Form 1099-R), only any attributable investment  gains required to accompany the returned contribution.  With the recent marked downturn, it's unlikely that there will be any gains unless the funds are presently in a fixed-income account, in which case the gains will be small.

Because the rollover or conversion of the two distributions ineligible for rollover has not yet been accomplished, you have 60 days following the dates of receipt of those two distributions to complete indirect Roth conversions of those two distributions (regardless of what you do with regard to your Vanguard traditional IRA).

[macheung]

Are you saying that if the two withdrawals ineligible for rollover are removed as excess contributions, they would not be included as taxable income in the 1099R I receive from Vanguard? And that only any investment earnings associated with those funds would be taxed?

[dmertz · Accepted solution]

Correct.  With a proper, explicit return of contribution, only investment gains that are attributable to the excess contribution that are required to accompany the returned contribution are taxable.  If at the time of this distribution value of the account is less than or equal to what it was immediately following the deposit of the excess contribution, there will be no taxable gains to distribute.  The returned contribution itself is not taxed.

Given the bad information from Vanguard that suggests inadequate training, make sure that they process a return of contribution that will be coded with code 8, not a regular distribution coded with code 1 or code 7.