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If someone, in the process of leaving a job last summer, rolled over their 401K into a Roth IRA and is now looking at a several thousand dollar tax bill, is there any way to salvage that by transferring the money into a regular IRA?

EDIT: Further details. I submitted our tax return about a week ago and we received our refund yesterday. But it is wrong (the company that handled the rollover sent us an incorrect 1099-R) and I'm going to have to amend the return, give back the ~$2500 refund we got, plus pay ~$5000 in taxes.

In an ideal world, I would just bite the bullet, pay the taxes and get the benefit of withdrawing it tax-free later. However, my wife and I are going through a divorce and cash is tight right now. Plus, it being in a Roth IRA instead of a traditional will complicate divvying up assets.

So, while waiting on the corrected 1099-R to come in so I can submit an amended return, I'm trying to figure out if I can fix this without having to pay close to $8000 that we can't really afford right now.

Kevin
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This used to be possible before 2018, but is no longer possible. Basically, you did a conversion from Traditional 401k to Roth IRA, and one of the several types of "recharacterization" could be used to "undo" a conversion, and treat it as a rollover to Traditional IRA. However, the specific type of recharacterization for undoing a conversion was eliminated under the new tax law. Specifically, undoing a conversion is not allowed for any conversion that took place after December 31, 2017.

user102008
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  • Can you check the information in my edit to see if that changes anything about your answer? I doubt it does, but figured I'd ask – Kevin Apr 17 '19 at 02:31
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Maybe. The deadline to recharacterize an IRA or Roth contribution (to the other) is October 15 if you filed your 2018 taxes by April 15. You would amend your taxes with a 1040X.

But I wouldn't be fighting this. This is a Very Good Thing.

IRS is infinitely patient and their interest rate is 6%. This is way, way, way too soon for IRS to send postal mail about your 2018 taxes. If someone is time-pressuring you, it may be an IRS scam; it's certainly so if they are outreaching by email or phone. (IRS only contacts by postal mail). Scammers hit everyone, claiming you have a tax issue; it just so happens you actually do. IRS is very, very slow. It can take them a year to even contact you, and another year to even start with the telephone. And they only ever want paper checks mailed to the official addresses.

If you are pressuring yourself because you don't know what the consequences are and fear the darkness, relax. It's not that big a deal. The IRS doesn't even mark your credit report.

If I were in your shoes, I would just make the IRS wait. The Roth conversion is such a huge win for anyone under 45 that I'd accept a few postal mails.

The 401K is analogous to a traditional IRA.

The Roth is a far superior type, especially for young people.

Here are the differences:

In a IRA/401K, you use "pre-tax money" and put it into the IRA. You've never paid taxes on this money. The money is invested and compounds. At 7% a year in stocks, it will grow by 3000% (30 times). You pay taxes on IRA/401K money when you take it out. And it's 30 times larger, *so that is a LOT of tax**.

(Granted, you pay the tax going in or going out. And that part at least is a wash if everything goes right; modulo some very serious risks.)

In a Roth, you use "post-tax money" and put it in the Roth. You already paid taxes on this money, so it's tax-free when you take it out. Thanks to Senator Roth, the compounding is also tax-free. That is huge. That is the biggest giveaway in the entire tax code. You paid a measly few grand of tax 50 years ago and now you're homefree.

What you did was equivalent to

  • convert the 401K to a traditional IRA (no problem there) then
  • convert the traditional IRA to a Roth. (super, but gotta pay the tax).

But remember, 401K/Trad. IRAs contain money that taxes were never paid on, and the tax must be paid coming out. That can be much worse if you take it out in a big surge e.g. due to metical issues. Roths can only be funded with money that you had paid taxes on. Therefore, you do have to pay the tax on any money you convert from Traditional to Roth.

This lets you exploit a variety of Roth features/effects. So this is a win for you overall, even if it can be a pinch today. I mean everybody'd rather not pay taxes. But if you have to pay taxes, better a few grand today than $100,000+ when you are in retirement and on a fixed income. (I mean emotionally; it's a wash if everything goes right, but it might not.)

The Roth is a good thing.

Just in the future, try to rig it so you do the Roth conversion in a gap year or years, so your taxes are lower during the conversion. That's another Roth hack :)

Harper - Reinstate Monica
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  • While this may be sound advice for some, it doesn't seem to answer the question. You might also want to answer if the op can actually "salvage that by transferring the money into a regular IRA?" if they still wish to. Additionally, even if the OP were to do a roth conversion. They likely wont want to do it all at once. If one converted say $1,000,000 to a roth in one go by mistake they will pay far more tax than converting a little each year. – Vality Apr 16 '19 at 22:47
  • @Vality good point, edited. OP is motivated by a desire to save some tax today. Every answer is a judgment on the person, and this person I judge to be young enough to be one of the "some" of which you speak. – Harper - Reinstate Monica Apr 16 '19 at 22:53
  • For various reasons I'd rather not discuss, I need to fix this now if at all possible. – Kevin Apr 16 '19 at 23:11
  • No need to discuss the particulars. I've rarely heard the word "now" relating to the IRS. I've always found them to be pussycats. Or more precisely Ent mobsters, they know where you live but they move very, very, very slowly. When I hear "urgent" and "IRS" it makes me think of the various IRS scams. – Harper - Reinstate Monica Apr 16 '19 at 23:48
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    This answer makes it sound as if Roth IRA is inherently and massively better than traditional IRA. This is not necessarily so, and depends on tax rate at the moment of contribution (now) vs. the moment of distribution (retirement). Converting the entire traditional 401k into Roth IRA all in one year is rarely a smart choice. – void_ptr Apr 17 '19 at 00:26
  • @void_ptr On your first point (tax at moment of contribution vs tax at distribution), Roth is a win because gains aren't taxed whereas they are on the IRA. You're talking about $2000 tax today or $60,000 tax later at at time when you're on a fixed income and less able to pay it, remember. Even a lower tax bracket doesn't make that kind of difference OK. Converting the entire amount, depends on the numbers; OP is talking "several thousand dollars" of tax which implies a sensible amount of conversion. – Harper - Reinstate Monica Apr 17 '19 at 00:32
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    It does not matter if you pay $2000 tax today or $60,000 tax later - if your tax rate is the same, you end up with the same amount of money in your pocket. Ultimately this is due to a * b = b * a. This has actually been discussed (in a lot more details) many times, on this site, and elsewhere. – void_ptr Apr 17 '19 at 01:33
  • OP has clarified their notice is from the custodian (1099-R) not claimed to be from the IRS, so IRS scam is not an issue. But to be clear: IRS allows many kinds of payments, and never requires payment by Western Union, iTunes, or similar (that's always a scam), but does require or at least strongly encourage some electronic payments (particularly direct debit for a 'streamlined' installement agreement, and EFTPS for most business taxes) – dave_thompson_085 Apr 17 '19 at 21:16
  • Oh, and although IRS doesn't itself report to credit bureaus, if you have largish debt (about $10k or more) long enough to reach ACS or CFF, they often file a lien notice (NFTL) with your local court clerk, and that does appear on your credit report. (Don't ask how I know.) – dave_thompson_085 Apr 17 '19 at 21:33
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    @Harper you seem to miss the fact that the traditional IRA - given it is pre-tax - has a significantly larger base value on which compounding interest is applied. The easiest way to think about traditional vs Roth is if you consider that (say) 30% of the capital in your traditional account is taxable, and all compound interest on that is also taxable. The other 70% is yours and all compound interest is yours. If the tax rate on investing is the same as tax rate on withdrawal, there is no different between traditional and IRA. – Kirk Broadhurst Apr 17 '19 at 21:50
  • @void_ptr Your fatal assumption is that $2000 now = $60,000 later because that's the rate of inflation. That's wrong. Investments do significantly better than inflation. If that wasn't so, university endowments would not work. They do work. But even more than that, it's a question of paying taxes during your working years, or paying taxes in retirement when on a fixed income and facing spiraling medical expenses. – Harper - Reinstate Monica Apr 17 '19 at 22:37
  • @KirkBroadhurst Being pre-tax doesn't buy an IRA anything. That hurts it. You owe tax on all the contribs and gains in the IRA. That doesn't give you more base value, it means the IRA can't hold as much money. Contribute $6000 to an IRA, at 30% $4200 of that is yours and the rest belongs to the gov't, so you only actually got $4200 into the fund. Growth at similar proportion. Earn $8571, pay tax on it (leaving $6000) and put that into a Roth, it's all yours and ditto the growth. Roth has higher savings capacity. – Harper - Reinstate Monica Apr 17 '19 at 22:55
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    @Harper This has nothing to do with inflation. The rest has already been covered in the comments here, and many times before. – void_ptr Apr 17 '19 at 23:39
  • @void_ptr Oh, you mean this? #1 that non-retirement investment of the Trad. IRA excess doesn't actually happen and also has liability exposure in IRA-protected states; and #2 that tax rate is a little optimistic. Retirees make more than you think they do. My parents are in the same bracket they were when they were working, (modulo the Trump Drop), not least because they did a lot of 401Ks and IRAs. It also ignores the ability to withdraw principal from Roths tax free, e.g. Roth is part of your emergency fund, IRA isn't. – Harper - Reinstate Monica Apr 18 '19 at 01:36
  • @Harper would love to see your math. I, and it seems everyone else here, feel that it is established that the only difference are the tax rates at the beginning and end. – Kirk Broadhurst Apr 18 '19 at 12:59
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    @Harper review the first answer to that question. There are differences, especially in marginal tax rate, retirement income, etc. But your claim that "the compounding is also tax-free. That is huge" is wrong. Tax then compound is the same as compound then tax, due to the commutative property of multiplication. – Kirk Broadhurst Apr 18 '19 at 14:46
  • @KirkBroadhurst Trouble is, you're stopping with that commutative property and declaring victory. My large state picked me to represent them in a national math contest. I get it, but math alone does not settle it. Re-read that answer you just linked; it raises very good points including the impact of contrib limits. As for the tax bracket difference, forget it - I am organizing my parent's files, their tax bracket is the same in retirement as working precisely because they contributed so much to Trad IRA/401K. Except now they're on fixed income and the tax burden hits much harder. – Harper - Reinstate Monica Apr 18 '19 at 15:04
  • @KirkBroadhurst By "much harder" take my parents. Medical issues are forcing them to drawdown their tax-deferred 401Ks Very Fast. One guess what that's doing to their taxes, and wouldn't be a problem with Roth. This is one of many "soft factors" that make it so much more complicated than just math, and almost all of them favor Roth. – Harper - Reinstate Monica Apr 18 '19 at 15:11
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    If their tax bracket and marginal rate is the same then there's literally no difference - pay 28% back in 1990 or whatever, or pay 28% today. I agree on the contribution limits. I'm not suggesting that they are identical plans because in most cases marginal rates will differ etc., but I'm pointing out that the compounding is not a factor in any decision and is net neutral. Your answer here implies that the compounding is perhaps the most significant factor, which is extremely misleading. – Kirk Broadhurst Apr 18 '19 at 15:36
  • @KirkBroadhurst That criticism is fair, so I edited. But meet me halfway: Get it out of your head that "this is equivalent". It's not equivalent, for non-math reasons, and there are real risks that smash that plan on rocks and shoals, like my parents pulling out $200k due to a medical crisis. The advantage tips to Roth if anything goes wrong. – Harper - Reinstate Monica Apr 18 '19 at 20:03
  • Let us continue this discussion in chat. – Kirk Broadhurst Apr 18 '19 at 21:18
  • The advantages of the Roth IRA are two: (a) the tax you pay on the conversion is effectively a contribution to the IRA, but it doesn't count against the annual limit and (b) no required minimum distributions. The disadvantage of converting everything is that you cannot take advantage of the low brackets in retirement -- on the Roth contribution or conversion, you're being taxed at your marginal rate. Even if in retirement you're in the same bracket, part of your withdrawals from a Traditional IRA/401(k) are at the lower tax rates. The optimal plan is to have a mix. – Ben Voigt Apr 19 '19 at 06:08