In Plan conversions gone crazy

[ejohnke]

I have a client with a solo 401(k) plan. Upon the recommendation of his CPA, he converted about $400,000 of pre-tax plan monies to Roth. The problem is that instead of moving the funds to a Roth account within the 401(k) Plan the funds were moved to a traditional IRA, then converted to a Roth IRA, where the funds currently are being held. The taxation for 2025 is correct and the funds are still invested. We explained to the client that this was an ineligible distribution and the funds need to be returned to the Plan, adjusted for earnings. When they reached out to the Custodian to request that they needed to "undo" it all, they stated that they can't move the Roth IRA funds to a Roth 401(k) account because Roth IRAs can only roll into Roth IRAs. Any suggestions or insight on how to get the Custodian to correct the error? Outside of "undoing" it, what corrective options do they have?

[Artie M]

 

The last time I looked at it an accidental rollover from a 401(k) to a Roth IRA cannot be reversed or recharacterized.  I haven't looked at this recently so the law could have changed but I don't think so.  This could be done prior to 2017 or so but the Tax Cuts and Jobs Act of 2017 eliminated the ability to "undo" or recharacterize Roth conversions making this error irrevocable. You must treat the distribution as a taxable event, which will generally be reported on your tax return for the year the rollover occurred.  So this will have to be included in gross income for the tax year the transaction took place.  Not sure of the Form that should be used to this 4852 or 5498.  Also, could be subject to early withdrawal penalty if an exception does not apply.  Bottom line is the funds can’t be moved back into the 401(k) or into a traditional IRA.  Once the  month money is in the Roth IRA, under current law, it stays

[ejohnke]

This client isn't looking to reverse or recharacterize the funds. They really do want the pre-tax funds to now be Roth and intended to pay the taxes. The funds weren't eligible to leave the Plan. This transaction was supposed to be an In Plan Roth Conversion. They should have rolled into a Roth 401(k) account inside the Plan...not a Roth IRA outside of the Plan. I am struggling with the Custodian to return the funds to the 401(k) Plan since they never should have left.

[Artie M]

Don't know of anything that can help.  To repeat, it is my understanding that once the money is in the Roth IRA, it is not coming back.

[Peter Gulia]

If the custodian of the non-Roth IRA received an amount presented as a rollover-in contribution in circumstances in which the custodian did not know, and would not suspect, that the payment was not the employment-based retirement plan’s distribution, that custodian might not have erred.

If the amount the employment-based retirement plan paid was not an eligible rollover distribution and so was not the source of the non-Roth IRA’s rollover-in contribution, the individual might want one’s lawyer’s advice about whether an IRA, and which of them, might have an excess contribution and, if so, what income and excise tax consequences might result from that excess. After considering that advice, the individual might want one’s lawyer’s advice about the probability or improbability of the IRS detecting tax-return positions that there was and is no excess.

If the individual, the employment-based retirement plan’s administrator (if other than the individual), or a service provider can cut past a usual customer-service worker to someone who not only can recognize what happened but also can decide what the custodian is willing to do, there might be a fleeting and limited opportunity to persuade everyone on a complete undo, including correcting or adjusting all 2025 tax-information reporting.

(In my experience, getting a custodian’s attention might turn on its desire to earn or maintain good will with the requester or presenter; even with a listening audience, even clear merits might not be enough to get a custodian’s favorable response; and a presenter’s ability to teach the custodian how to implement an undo often is a deciding factor in the persuasion.)

If there is no unraveling from the IRAs, the individual might want one’s lawyer’s advice about whether the plan administrator’s failure to apply the plan’s provisions tax-disqualifies the employment-based retirement plan; if so, whether the defect can be corrected; and, if not corrected, how likely or unlikely it is that the IRS would detect the defect.

This is not advice to anyone.

ejohnke, how confident are you that the individual was not entitled to a distribution from the employment-based retirement plan?

[C. B. Zeller]

Peter's info (as he is clear to remind us, not advice) is thorough and excellent as always.

It sounds like the client is happy with the current tax situation, and ejohnke is just looking to correct the potential disqualifying defect of allowing a distribution that shouldn't have happened. Is that accurate?

If the individual could have had a distributable event, but the plan didn't allow the distribution, could the plan be retroactively amended to permit it? For example, the participant is 60 years old, so amend the plan retroactively to 2025 to permit in-service distributions at age 59-1/2. Problem solved.

If there really is no possible distributable event (don't forget that employer money sources can have much more liberal distribution restrictions than 401(k) deferrals), then you might still be able to get relief for the distribution (and leave the money in the Roth IRA) through VCP.

[ejohnke]

CB Zeller--> EXACTLY what we are trying to do for them. We simple need to fix the operational failure they currently have. 

We can do a retro active amendment to allow for an any age in-service distribution for the wife's distribution. She has more than enough vested employer contribution to cover the amount. But she is not age 59.5 and would be subject to the early distribution penalty.

The husband has substantial funds in his rollover source in the 401(k) plan, which are available for distribution at any time. I think his money movement is okay and he will not be subject to the early distribution penalty even though he is also under age 59.5. 

Am I missing anything that might prevent the early distribution penalty for the wife? An early distribution penalty seems contradictory to the penalty's intent since they moved the funds from one investment account to another and didn't actually take any cash.

[Peter Gulia]

If the plan sponsor amends, with retroactive effect, the plan to legitimate what was paid out, would that distribution be an eligible rollover distribution? And if so, might the payment into an IRA have been a satisfactory rollover? If so, doesn't that mean no too-early tax no matter the distributee's age?

[R Griffith]

Just an off the wall suggestion, and this is not advice to anyone and not suggesting to may be fully available.  But have you thought of using a brokerage window for the plan and us the new Roth IRA as the brokerage window and make that a part of the plan assets?  Not sure if the custodian would be on board, but if they would be on board to rename the account into the name of the plan, might you consider that to still be an in-plan rollover?  I would for sure not go that route without actual advice from ERISA Counsel and of course the custodian would have to agree as well.  Just something to ponder...

[ejohnke]

@Peter Gulia I'm glad you mentioned that. I was going back and forth on if legitimizing the distribution made it an eligible rollover distribution and therefore no longer subject to the early distribution penalty. 

@R Griffith This plan is already at brokerage accounts and the Custodian doesn't seem to want to assist with any part of the correction. I get the impression that renaming the Roth IRA is NOT an option.