March 01, 2010 | Written by: Mark D. Olander, EA, USTCP
When a tax return is audited, most of the time the examination occurs two to three years after the tax return was originally filed. It can be a big headache trying to remember what was done and why. This month’s case illustrates how having an experienced audit representative available to help you unravel what you did on a long ago tax return can help save you from becoming unraveled yourself!
The taxpayers received a bill from the IRS for retirement plan income that they had failed to include on their tax return three years earlier. They had reported taking a 401(k) distribution of $15,000, but the IRS’s document matching program was reporting that $17,380 had been withdrawn from the members’ retirement accounts.
During the first contact with the member, the Audit Representative learned that both members had closed their Roth accounts during the tax year in question. The husband had reached the age of 59 ½, but the wife was a couple of years younger. The IRS notice was assessing taxes on the wife’s entire Roth distribution amount.
The members were anxious. They had closed their Roth accounts because the IRAs had been losing value and also because they had needed the money to live on. Their financial advisor had told them there would be no tax consequences since it was a Roth, and they didn’t understand what they had done wrong. Their financial situation had not improved in the past two years, and $874 was a lot for them to come up with. They were concerned that interest was accruing with each day that passed without a resolution.
The Audit Representative got straight to work. He advised the members that what they needed was something to prove that the value of the Roth had decreased and that therefore they had only withdrawn their contributions and not any earnings. He went on to explain that Roths are distributed in a certain order: (1) participant contributions, (2) conversions and (3) earnings if the taxpayer is below the age of 59 ½. “If we cannot substantiate that the distribution is just from contributions, a portion of it may be taxable,” he told them.
The members found the documents proving that the wife’s original Roth contributions had been $3,500. The Audit Representative submitted the information to the IRS, explaining that the value of the account had declined and that the distribution was all from contributions made to the Roth and it was therefore not taxable. The IRS sent a letter back showing no amount due.
The members were relieved that they didn’t have to pay the $874 to the IRS. Below is an excerpt from the letter they sent to their Audit Representative after hearing from the IRS:
We have received the Closing Notice from IRS, informing us that issues was resolved in our favor — we owe no taxes and case is closed. We want to thank you for your work in our behalf and are very pleased with outcome in this matter.
Thank you for the job well done.
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