Rollover Distribution Request processed as cash distribution

Hi!

A plan participant requested a rollover of his $40,000 account balance.  Due to a processing error on the TPA side, the distribution was coded as a cash distribution when entered, so federal and state taxes were withheld when the recordkeeper processed the distribution.  The net amount was paid directly to the IRA Custodian, and taxes were remitted to the IRS and state.

The distribution was processed in December 2021 and the participant notified us in March when he received his 1099-R's that something did not seem correct.

We contacted the recordkeeper with fingers crossed that the entire transaction could be reversed, but they said it could not, as it crossed tax years and the taxes had already been remitted to the IRS.  And, since it was not their error, they could not "front" the tax funds back to the participants account as it could not stay on their books.

The original 1099-R was issued showing the $40,000 as a cash distribution with taxes withheld, and since the participant is age 35, the form was coded with a 1, so the 10% early withdrawal penalty also applies.

The participant had not yet filed his taxes, so the recordkeeper reissued the 1099-R as two separate forms:  one shows the amount that was deposited in the IRA as a non-taxable distribution, coded as a rollover; the second shows the amount of the taxes withheld as a taxable distribution coded as a 1.

There has been a lot of discussion now regarding how to make the participant whole, and talk about how this will play out with his taxes regarding whether he gets a full refund of the taxable amount, and what will be due for the penalty.  To me, the participant should wind up with the full amount in his IRA that he asked to be deposited in his IRA.

Does anyone know a way this can be accomplished?  Should a 1099-R have been issued to show the full amount of the distribution, zero should have been taxable, show the actual taxes withheld and code as a G so no early penalty?  Will this result in the taxes being returned?  

The participants broker also feels that since the participant never actually received any funds, the 60 days does not apply for the participant to change his mind and deposit the tax amount into his IRA.  I do not even know if the participant has access to enough cash to be able to deposit the amount withheld for taxes.

I am hoping someone has had this situation and it came to a happy resolution.

Thank you!

Tell the recordkeeper they're wrong and that they will fix it.  Returns can be amended.

Thursday edit:  Sorry, I didn't see the part about it being the TPA's error rather than the recordkeeper's.  TPA should do a make-good for the guy until he can get his big tax refund!

Hi Bri,

This was not caused by the recordkeeper, and they have said that they cannot reverse the transaction.  If it had been their error it would have been easier to do as they could have had a credit with the taxes withheld, but they cannot hold that on their books.  Their solution was to revise the 1099-R into two separate forms.

Without admitting any mistake was made, the TPA might want to contact their E&O insurance.

The people who screwed up need to pay the taxpayer the amount of taxes that the taxpayer was required to pay to Federal and State taxing authorities as a result of their negligence and breach of fiduciary duty - computed at his marginal (next dollar) tax rate. 

There is no need to think to hard on this one.  The damages to the taxpayer need to be made whole by the party(ies) at fault.  And if he has to hire a lawyer to sue and collect, the legal fees will also be paid by the party(ies) at fault.   See 29 USC Section 1132(g), and 28 USC Section 1927, and FRCP 11(c), and Chambers v. NASCO, Inc., 501 U.S. 32, 44–46 (1991) outlining the court's inherent power to assess fees especially when a party is litigating in bad faith.  

And, BTW, the Plan Administrator is responsible for the conduct of the TPA so at the end of the day the liability is on the Plan Administrator as the principal as well as the TPA as the agent. 

If  anyone thinks this can be corrected somehow by refiling, then the Plan Administrator and the TPA better hire and pay for a lawyer for the their victim and cover all the costs necessary to fix it. 

The good news is that you are only dealing with $40,000.  Thank whoever you pray to that it wasn't $400,000. 

If I were the guys attorney I would send a press release to the Wall Street Journal among others. 

David  

I'm assuming that "distribution" apart from the funds that were withheld for taxes was rolled into an IRA? If that's the case, then I agree with what the recordkeeper is doing for the tax reporting, 2 separate 1099R, one for the amount that was rolled over with a tax code G (box 2a should be 0) and the other 1099R, box 1 reflecting the total of the taxes, box 2a showing all of it taxable, and box 7 with a tax code 1. The simplest way to fix this is for the participant to make up the taxes withheld, put it into the IRA and do the self certification for the missed 60 day. Unfortunately, this situation isn't unusual and that's how other people have corrected this. 

It sounds like $8000 was withheld and submitted for taxes, and $32,000 rolled over?  So the $8000 is taxable.  As JOH suggests, it is worth trying to roll over the $8000 and ask for a waiver on the 60 day limit. Not everyone has $8000 sitting around though and I doubt the other parties want to be involved in lending $8000 to get off the hook.

Failing that, then someone is definitely liable for the 10% ($800) penalty.  Some taxes would be due at some point so also paying all of the taxes at the marginal rate would be overcompensating, IMO. 

Just my thoughts: You need to write a check to the rollover entity so that it matches the whole amount that should of been transferred as a pre-tax contribution - to make your client "whole". No tax document should be issued for amount your company writes. Sorry, but this is a cost of doing business.

You also need to work with the client by voluntarily reviewing his tax returns and to see the true cost this incident had on him. 20% likely won't cover his additional tax and penalty due at the fed level, and you should also review his state tax filing as there is likely an amount costing him there too with the penalty and taxable income increase.

This will be much cheaper to fix it this way than going the attorney route, which you've admitted is your error and will end up costing you anyway. Do you best to correct it!

You may even want to compensate him for the hassle too.

Plan Administrator or TPA need to issue payment to IRA for balance due to bring the gross deposit up to $40k.  Recordkeeper needs to file amended 945(IRS) and whatever state form to get back taxes incorrectly withheld.  Corrected 1099's need to be issued, showing 40k rollover, and 0 cash distribution with 0 taxes.  Returned taxes can be paid to whoever fronted the corrective deposit.  TPA and Plan Administrator can then bicker over fees and responsibility.

Basic tenant of any correction, put the participant in the position they should have been in without the error, without harm.  That would mean 40k in the IRA, and no tax shenanigans!!

18 hours ago, Brian said:

You also need to work with the client by voluntarily reviewing his tax returns and to see the true cost this incident had on him. 20% likely won't cover his additional tax and penalty due at the fed level, and you should also review his state tax filing as there is likely an amount costing him there too with the penalty and taxable income increase.

You're going to fund the IRA and pay the taxes? That's a windfall; I wish someone would screw up my finances that way.

Before establishing "blame", it might be prudent to have an independent review of all statements.  For example, the original post said, "processing error on the TPA side", and all subsequent comments have assumed that to be accurate.  It might not be.

17 hours ago, Nate S said:

Plan Administrator or TPA need to issue payment to IRA for balance due to bring the gross deposit up to $40k.  Recordkeeper needs to file amended 945(IRS) and whatever state form to get back taxes incorrectly withheld.  Corrected 1099's need to be issued, showing 40k rollover, and 0 cash distribution with 0 taxes.  Returned taxes can be paid to whoever fronted the corrective deposit.  TPA and Plan Administrator can then bicker over fees and responsibility.

Basic tenant of any correction, put the participant in the position they should have been in without the error, without harm.  That would mean 40k in the IRA, and no tax shenanigans!!

Right! This needs to be done yesterday.