YOUR MONEY-Avoiding panic from Roth conversion glitch

Mon Jun 18, 2012 10:52am EDT

By Amy Feldman

NEW YORK, June 18 (Reuters) - Did you receive a notice about taxes due on your 2010 Roth conversion from the Internal Revenue Service? Don't worry, you are not alone - and you likely do not actually owe any extra cash.

Thousands of these frightening notices went out this spring to taxpayers who converted tax-deferred retirement money from a traditional IRA to a Roth IRA, in which income taxes are paid upfront and not owed later.

The problem stems from the complexities of the 2010 Roth conversion - in which for one special year only, taxpayers could choose to spread the taxes due over two years, rather than paying them all at once.

Add to that a glitch between some of the tax software programs and the IRS. It adds up to a lot of taxpayers who converted their traditional IRAs to Roths in 2010 receiving IRS notices that they owed more taxes (and penalties).

If you received one this spring, you do need to respond, but it is not a reason to panic.

"People freak out about anything they get from the IRS," says Bill Fleming, of PwC's private company services practice. He says he has received a number of these notices for clients. "The software providers and the IRS had a disconnect."

With a traditional IRA, you pay taxes when you withdraw money, but with a Roth you pay the tax when the money goes in and then do not owe income tax again. So if you converted a traditional IRA to a Roth - a move that had been restricted but was opened up to taxpayers at all income levels in 2010 - you had to pay taxes on the conversion.

While most Americans have long since moved on from thinking about tax year 2010, the IRS is only now sorting its way through the massive volume of 2010 returns and trying to find discrepancies that resulted in taxpayers not paying what they owed. Its computer system tries to match documents in the more than 100 million individual tax returns to find errors, and when it discovers a discrepancy it sends a notice to the taxpayers.

"They are running a regular matching for 2010, and they don't know it's a Roth conversion. They are just looking for a distribution from a retirement account. For whatever reason, they are not picking up," PwC's Fleming says. "They are saying, 'Oh, there's a massive under-reporting of IRA distributions. There must be a problem.'"

Details of any Roth conversion appear on Form 8606, rather than on the main 1040 return, making it more difficult to match the information, Fleming notes. A glitch in the e-filing systems of some of the large tax software firms meant some data about these Roth conversions never made it to the IRS.

CCH Inc, one of the large professional tax software firms, sent a note to clients about the issue, noting that some electronic returns were missing page 2 of Form 8606.

"CCH alerted the IRS to the issue and has been working with them on a resolution," according to the notice, which adds that the erroneous notices were halted in late April.

Thomson Reuters Corp, the global information company, another provider of professional tax software, had a similar issue: Its GoSystem Tax product did not signify taxpayers' intent to defer the tax on the 2010 Roth conversions, as permitted for that year only, on returns filed electronically.

"When the IRS later ran validation checks, these e-files were flagged and the affected taxpayers were sent notices," said David Wilkins, a spokesman for the tax and accounting business of Thomson Reuters. "We resolved the issue. Also, the amount of tax owed by these taxpayers was not affected and they were not required to pay penalties."

It is unclear whether consumer tax software was also affected by glitches, or whether most people who did Roth conversions chose to seek out accountants - and thus relied on the professional software - for help. H&R Block Inc spokesman Gene King said that his firm had not seen or heard of the problem in its consumer tax software. A TurboTax spokeswoman did not respond to requests for comment.

The IRS did not respond to a request for comment.

TAXPAYER RESPONSE

This all may sound technical, and it is, but for taxpayers receiving the notices about large phantom tax bills, it is also a big deal. On the Bogleheads.org online investing advice forum, posters have been freaking out about dunning notices that sometimes reached into the tens of thousands of dollars.

If you are among the taxpayers who received one of these notices, and you did everything right on your Roth conversion, you shouldn't worry. However, you cannot just ignore the notice and hope it goes away. Instead, you will need to respond (or have your accountant do so) and mail Form 8606 to the IRS. Doing so "resolves the notice and closes the matter without further action or impact to the taxpayer," the CCH notice states.

Of course, none of this means you avoid paying the regular taxes that you do owe in 2011 and 2012 on those Roth conversions done in 2010. If you converted a traditional IRA to a Roth in 2011, you also owed tax on that this year; and if you do a conversion this year, you will owe the tax on it next April. That all means that you will want to run the numbers closely - especially if you are paying quarterly estimated taxes - so that you are not surprised by the tax hit when it comes due.

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