How to prove Roth IRA basis for IRS audit | Ed Slott and Company, LLC

How to prove Roth IRA basis for IRS audit

I have a widowed client that inherited her former husband's Roth IRA in 2014. She opted to treat it as her own as she didn't plan to touch it. However, in 2017 when she was 58 she did withdraw $40,000. Her basis was not known, so her tax preparer filed it as nontaxable and apparently hoped for the best. The IRS is now auditing her for 2017 and says she owes $18,000. Her husband had the account with multiple firms over the years which has made tracking the history difficult.

She has copies of checks for Roth contributions from 2007 to 2012 totaling $29,000. She may be able to find brokerage statements to support this. She has not found proof of contributions prior to 2007, but knows that he did start contributing to a Roth in the late 1990's. His contributions easily exceed the amount that was distributed and therefore should be nontaxable. Proving it is the hard part.

Any suggestions on what is needed to satisfy the IRS in this situation?

  • Sounds like the return was not prepared correctly, perhaps Form 8606 was not even filed. That error is usually the source of any IRS inquiries. What amount was shown on line 22 of Form 8606? If it was equal or more than 40,000 it would be extremely rare the IRS would question it.
  • Now that the IRS has questioned the amount of basis, there is no single way to determine the figure without adequate records, usually meaning Form 5498 issued by the custodian for every year of contribution. The IRS has all these forms, but good chance they are not tracked by the IRS in any orderly fashion. Another source of Roth basis is conversions, which would be reported on any prior tax return, also on Form 8606. Does she have several years of prior returns?  If prior taxes were done by the same preparer, the preparer might have records of some contribution activity since their annual return organizers ask for all IRA contributions made, even though regular Roth contributions are not reported on those returns. I think if she requests copies of all 5498 forms under his SSN, the IRS can go back about 10 years.  It may be a case of mix and match at this point, and the IRS asks so infrequently about Roth basis, I don't know what "circumstantial" docs they would accept. Remember, even contributions made can be returned or recharacterized, so even a 5498 is not fully conclusive.

  • Even if the preparer included the required Form 8606 in the 2017 filing (which seems unlikely if they did not know the amount how much contribution basis to report), when Roth IRA basis is inherited from a spouse and the surviving spouse chooses to treat the Roth IRA as their own, to substantiate the adjusted basis reported on line 22 of 2017 Form 8606 an explanation statement describing the adjustment to the surviving spouse's basis would generally have been required since this was the first time the surviving spouse took a nonqualified distribution.
  • Even without the explanation, had the preparer included Form 8606 with at least $40,000 on line 22 of Form 8606, even if the amount was not entirely accurate, it seems likely that the IRS would not be questioning the reporting of a taxable amount of $0.
 

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