Certified public accountants across the country who are preparing 2011 tax returns are seeing clients who don't have the money to pay the first half of the 2010 Roth conversion tax now due.
As a result, they need options to present to their clients.
As you probably remember, a special provision of the tax law allowed individuals who made Roth conversions in 2010 to split that conversion income equally over 2011 and 2012. That was a great tax deal.
However, as some clients and financial advisers are finding out, this seemingly favorable provision is causing tax problems for clients whose financial situations have taken a turn for the worse. The sudden loss of employment or an unforeseen expense has caused some clients to deplete their assets faster than expected, leaving them unable to pay the tax owed on the conversion, as originally planned.
During years in which the “normal” conversion rules apply, this is not a problem, thanks to the ability to re-characterize.
Roth conversions can be re-characterized, or undone, up until Oct. 15 of the year following the calendar year of conversion. If a full re-characterization is made, the full tax burden created by the conversion is nullified.
But the same is not true for 2010 Roth conversions that took advantage of the two-year deal. The deadline to re-characterize a 2010 conversion was Oct. 15, 2011.
WHAT TO DO
At this point, it isn't about turning a bad situation into a good one; it is about keeping a bad situation from getting worse.
Here are four options to consider:
Beg or borrow. Maybe mom and dad can give Junior a portion of his inheritance while they are still living. Or perhaps some other individual with whom the client has a close relationship can be asked for some financial assistance.
If a personal loan or gift isn't an option, clients might consider going to a bank or credit union for a more formal loan. One silver lining for clients in this position is that interest rates are at historic lows, so this option is as good as it may ever be.
Take a distribution from the Roth IRA. If your client can't qualify for a loan or doesn't want to borrow, another option (and a last resort) is to consider is taking funds out of the Roth IRA. Generally, this is not an advisable strategy, for a number of reasons, but if there is no other source of funds, what choice does the investor really have? Taking money out of the Roth IRA not only will reduce its value but may trigger early-withdrawal penalties and, in rare cases, additional income tax.
Clients over 591/2 on the date that a distribution is made from a Roth IRA never have to worry about the 10% penalty for early withdrawals. On the other hand, if a client under 591/2 takes a distribution of converted funds within five years of the conversion, the 10% penalty for early distributions is triggered (unless an exception to the 10% penalty applies). As we are within five years of 2010, any 2010 conversion amounts withdrawn this year will be subject to the 10% penalty.
However, clients who have other, non-2010 Roth conversion or contribution funds in a Roth IRA may be able to avoid a penalty on all or a portion of their distribution used to pay the tax due.
Try for a private-letter ruling. The regulations allow Internal Revenue Service to grant extensions for Roth re-characterizations. However, this option is expensive and may not work in this situation. The PLR request likely will be denied absent a compelling reason that prevented a timely re-characterization from occurring, such as a severe illness or bad advice. The regulations describe a number of circumstances that would allow a late re-characterization, and none of them is: “I ran out of money and need a break.” To date, the IRS hasn't granted PLR relief due to a taxpayer's being unable to pay the tax due.
Set up a payment plan. If your client can't pay their full tax liability at once but has the ability to pay over a period of time — say, perhaps, with income earned from employment — it might be beneficial to consider an installment plan with the IRS, which recently streamlined these procedures for those who owe less than $50,000.
In addition, on March 7, the IRS relaxed the penalty rules on late payments for certain unemployed taxpayers. This grants these taxpayers a six-month grace period on failure-to-pay penalties, though interest is charged at the current 3% rate.
Ed Slott (irahelp.com), a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace.
