Inadvertent early IRA distribution from botched IRA-to-i401k rollover

[zncu]

Seeking advice regarding a botched IRA-to-i401k direct rollover by Vanguard. In Dec 2021, I effected a rollover from my (entirely pre-tax) SEP-IRA to an i401k, both at Vanguard.

Only recently while working on my taxes did I look closely at my 1099-R, and saw to my disbelief that VG had marked all the rollover funds from the IRA as “Taxable amount”, with 10% federal tax withheld.

They acknowledged the error and sent me an updated form 1099-R with taxable amounts as 0, but with the 10% withholding still intact. Vanguard claims that the withheld amount has been already sent to IRS and there is nothing they can do about it.

I can presumably get the money back as a tax refund, but I am concerned about the following:

1. This is, in effect, an early distribution from my IRA (isn't it? I am indeed below 59.5 years).  I didn’t want it or ask for it, but the IRS doesn’t know that. Is there a way to explain that this was due to an error on the custodian's part? Does the IRS care? What reporting is needed, and can I avoid the penalty?

2. I would very much like to return that money to my retirement accounts, and was told that the way to do this is through a process called "self-certification". Does this future intent have any bearing on anything to be done while filing taxes right now?

[dmertz]

What is the code in box 7 of the Form 1099-R provided by Vanguard?

Did they change the code in addition to changing the taxable amount?

Regardless, the "corrected" Form 1099-R seems worse than the original.

[zncu]

> the "corrected" Form 1099-R seems worse than the original

Uh oh.. that's worrisome, why do you say that?

In the original, which declared the entire amounts taxable, the code for each line (with taxable amount as well as tax withheld) was "02".

In the "corrected" one, the code for the tax withheld lines (amounts same as before) is "G", and the taxable amounts are all zero (two lines, each with amount 0, one coded "02" and the other coded "G". One exception is one single line with gross distrib and taxable amount $32.43, coded "02"). Finally, there is also a gross distribution and taxable amount for $6,000 coded "02", but this corresponds to my backdoor Roth conversion and I believe that code is correct. All lines are designated IRA/SEP/SIMPLE.

[dmertz · Accepted solution]

Well, the corrected Form 1099-R isn't really any worse since the original is worse than I suspected.

Code 02 (actually just code 2, there is no zero code) makes no sense for any distribution from IRA that includes tax withholding; code 2 is really only used by IRA custodians to report Roth conversions.  It seems that they processed this as if it was an indirect rollover and should have used code 1, not code 2, to indicate that.

A code G From 1099-R is not permitted to show any tax withholding.  Code G indicates a direct rollover, meaning that the entire gross amount went directly to the receiving account.

I assume that there was no state tax withholding.  What they need to do is to correct the code G Form 1099-R again to show in box 1 just the amount that was directly rolled over to the 401(k) and should have zeros in boxes 2a and for the tax withholding.  The tax withholding must be reported on a separate code 1 Form 1099-R in boxes 1, 2a and 4.

Because of this financial institution error, you should be able to self-certify that you would qualify for a waiver of the 60-day rollover deadline due to financial institution error, allowing you to roll over the amount withheld for taxes to continue to defer taxes on that portion and to avoid the early-distribution penalty.  You'll have to come up with the funds to complete that rollover and you'll recover those funds as part of your tax refund or reduction in balance due when you indicate on your tax return that the amount of the tax withholding was rolled over.

I would find a different IRA custodian for doing your new traditional IRA contributions and Roth conversions.  This one is clearly incompetent.  Sounds like a bank; banks rarely adequately train their employees regarding IRA transactions.  I've had mistakes made by nearly every bank IRA custodian I've ever dealt with.

[zncu]

Thank you @dmertz for this crystal clear explanation. This was my first rollover, and I was quite ignorant about reporting mechanics.

Re: IRA custodian -- I do agree now, but this was Vanguard! With its storied history, and blue-chip pedigree! And I wasn't doing anything exotic. Yet, not only did they bungle this seemingly straightforward rollover; they were not helpful at all in trying to resolve the situation. I spent hours on hold trying to reach someone who might point out a solution, before posting here.

Note to self and other novices: scrutinize with eagle eyes the funds transferred into the target plan when you do a rollover. Had I caught the missing 10% then, I could have pursued it with VG and they might have rectified it. Instead I just eyeballed the transfer and thought it "looked about right". Would've saved a lot of time and a modest amount of panic in the run up to tax day.