What can you do if you are hit with an underpayment penalty that was due to a conversion from a traditional IRA to a Roth IRA?
Well, in a recent IRS ruling, it appears that the answer is: Nothing! You're stuck with the penalty.
When the Roth IRA was introduced a number of years ago, it was a curious question: When you convert your traditional IRA to a Roth IRA, would the recognition of the additional conversion income trigger the underpayment penalty if the additional tax created by the conversion wasn't covered by withholding or estimated tax payments? It seemed logical that the penalty would apply, but some tax pros seemed to think that this was an "extraordinary" event, and any underpayment penalty assessed by the IRS would be abated by the IRS with the filing of a request for a waiver of the penalty.
The IRS, through the Office of Chief Counsel, was recently asked about this very subject. When the IRS computed the underpayment of tax caused by the Roth IRA conversion, the IRS (of course) issued an underpayment penalty. And that prompted a significant number of requests by taxpayers for abatement of the underpayment penalty.
Well, the Office of Chief Counsel stepped right up to the pitcher's mound and threw a bean ball at the ear of the taxpayers involved. They advised that the IRS cannot abate the underpayment penalty in cases where the penalty is based on the additional income reported because of a conversion from a traditional IRA to a Roth IRA. The Chief Counsel's office noted that the Regulations (Regs 1.408A-4, Q&A-7) expressly provide that any amount that is converted to a Roth IRA is includible in gross income. Therefore, the conversion from a traditional IRA to a Roth IRA constitutes a taxable distribution of income to the taxpayer who makes such a conversion.
That being the case, a taxpayer who makes such a taxable conversion must include the income realized as a result of the conversion in his or her estimated tax computations. If the income isn't included in those computations, any underpayment generated would be subject to the underpayment penalty computations. And if there are no other exceptions to the penalty, the penalty will stick.
As noted above, many folks were submitting a request for a waiver of the penalty, but the Chief Counsel's Office also had something to say about that. While the Chief Counsel's Office observed that the underpayment penalty may be waived in situations in which the underpayment is the result of "casualty, disaster, or other unusual circumstances," it ruled that taxable income generated by a Roth IRA conversion is none of those things. The conversion income is just that: income. Because the conversion from a traditional IRA to a Roth IRA is nothing more than a taxable distribution of income that must be included in a taxpayer's estimated tax computations and payments, the IRS may not abate the estimated tax penalty.
In effect, while making a Roth IRA conversion may not be a common occurrence for the taxpayer, it's not an "unusual circumstance" in the definition required to receive a waiver of the underpayment penalty. The income and the timing of the income is really under the complete control of the taxpayer. That being the case, any income generated by such a conversion should be subject to the rules regarding estimated tax payments and underpayment penalty computations. Ouch.
What does this have to do with you? Well, we now know that any Roth IRA conversion income could trigger the tax underpayment penalty computations. That being the case, you'll want to review your tax situation any time you contemplate a conversion from a traditional IRA to a Roth IRA. Such a conversion will trigger a taxable distribution, and in many cases a very large taxable distribution -- and that distribution could then trigger the underpayment penalty. So if you decide that a conversion from a traditional IRA to a Roth IRA is a good deal for you, you should also take the time to understand the rules and loopholes regarding the underpayment penalty and how it's computed and assessed.
So make sure that you understand the consequences of a Roth IRA conversion, the tax issues involved, and underpayment penalty rules. You'll be very glad that you did!
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.
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