By Andy Ives, CFP®, AIF®
Recently we became aware of a multi-layered tax strategy that we think is a bridge too far when it comes to Coronavirus-related distributions (CRDs). In fact, it may even be outright tax fraud.
As most readers are aware, the CARES Act created CRDs which waive the 10% early distribution penalty on up to $100,000 of 2020 distributions from IRAs and company plans. The tax would still be due, but could be spread evenly over three years. All or a portion of the CRD can be repaid at any time over this three-year period. Subsequently, the original tax bill on the CRD could be reversed by filing an amended tax return.
Not everyone is eligible for a CRD. You must be an “affected individual” as defined by the CARES Act. This includes those people diagnosed with the virus, those whose spouse or dependents are diagnosed, those who experience adverse financial consequences, etc.
The first layer of this tax strategy is not the layer in question as it has become relatively common: a Roth conversion of a CRD. Converting a CRD to a Roth enables the account owner to spread the conversion tax over three years. While we still believe that converting a CRD to a Roth (by an affected individual who has no monetary need for the CRD) violates the “spirit” of the law, the IRS has yet to close this “loophole.” (Should the IRS change course, the only penalty would likely be the conversion tax would all be due in year one.)
It is the second layer of this new strategy that is so concerning. Layer 1: Once a person takes their CRD – say $100,000 – they then convert to a Roth. This allows a 3-year spread of the income tax due. Dubious Layer 2: In a later year, the person then uses the “repayment” feature of the CRD to replenish their Traditional IRA with $100,000. Proponents of this strategy see it as an opportunity to have your cake and eat it too: a $100,000 Roth conversion with a 3-year tax spread, and a repayment of the $100,000 to the Traditional IRA. However, the methodology is flawed, and the strategy will not work within the law.
Why not? The original $100,000 distribution from the IRA will generate a 1099-R. The subsequent conversion to a Roth will generate a 5498. This should close the book on the CRD. However, if an additional $100,000 is then “paid back” to the original IRA as a CRD repayment, it will generate another 5498. The Roth conversion will then subsequently be deemed an excess contribution.
Where tax fraud potentially comes into play is here: $100,000 CRD taken in 2020 and converted to a Roth IRA in the same year. This generates a 2020 1099-R and offsetting 5498. Account owner files Form 8915-E indicating he took a CRD, but does not indicate the repayment. He then waits three years. In 2023 he “repays” the CRD to the original traditional IRA. This generates a 2023 Form 5498. He files Form 8915-E saying he repaid the CRD. The IRS would have to go back three years, identify the conversion in 2020 via the 2020 1099-R and 5498, identify that these were the same CRD dollars that were already “paid back” via the 2020 conversion, and then invalidate the 2023 “extra” repayment.
While this might be a needle in the haystack for the IRS to locate, it sure looks and smells like possible tax fraud to us.