An IRS Ruling Shows Why It’s Important to Audit Your IRA

IRS Form 5498 is one of the most overlooked but critically important IRA forms. While Form 1099-R usually gets attention during tax time for reporting distributions, Form 5498 plays a behind-the-scenes but equally vital role as it documents contributions, rollovers, Roth conversions, and the type of IRA you own.

A recent IRS private letter ruling (PLR) 202520014 highlights the importance of reviewing Form 5498 by demonstrating how a failure to do so resulted in a taxpayer having multiple taxable transactions when the intent was to make them nontaxable. Thankfully, these errors were made during years when conversions could be recharacterized.

How an IRA Custodian’s Titling Mistake Caused Unintended ‘Roth’ Transactions

The following are key facts from the recent private letter ruling:

• Year 2000: The taxpayer, let’s call her Carla, opened a Roth IRA.
• Years before 2020: Carla made contributions to the Roth IRA. These were properly treated as Roth contributions.
• Year 2007: Carla got married and submitted a request to her IRA custodian to change the registration on her Roth IRA to reflect her married name. When her IRA custodian processed her request, they accidentally removed the Roth label from the title but treated it as a Roth IRA in all other aspects.

That one missing word created years of confusion, as whenever Carla checked her account statement, she assumed that it was a traditional IRA. This assumption is likely because it is common industry practice to label a traditional IRA as simply IRA, but a Roth IRA always includes Roth in the title.

• Year 2010: Carla made a regular contribution to the Roth IRA.
• Year 2012: Carla made two direct rollovers from a traditional employer plan account to the Roth IRA.
• Year 2014: Carla made three direct rollovers from traditional employer plan accounts to the Roth IRA.
• Carla claimed a deduction for the 2010 IRA contribution and treated the 2012 and 2014 rollovers as excludable from income on her tax return, as she assumed these amounts were contributed to a traditional IRA.

The transactions done in 2010, 2012, and 2014 were actually made to a Roth IRA, which technically means that the Roth IRA contribution was not deductible, and the rollovers were taxable as Roth conversions.

The Discovery and the Request for Relief

It wasn’t until 2021 (14 years later) that Carla learned of the mistake during an account review with her financial institution. She realized then that the account is a Roth IRA, despite not having Roth in the title.

Now faced with the unintended Roth contribution and conversions, Carla, with the assistance of her advisor, requested relief from the IRS. Specifically, she requested that the IRS allow her to recharacterize her Roth IRA contributions and rollovers as traditional IRA contributions and rollovers.

Why the IRS Granted Relief

The good news is that the IRA custodian’s back-end systems still treated the account as a Roth IRA. It is this back-end treatment that drives the tax-reporting codes for Forms 1099-R and 5498.

When deciding whether to grant a taxpayer extra time to make an election, such as recharacterizing a contribution, the IRS considers two key questions:

1. Did the taxpayer act reasonably and in good faith?
2. Would granting relief harm the interests of the government?

In Carla’s case, the IRS determined that:

• She acted in good faith, as the error was caused by the financial institution, not by any intentional misreporting on her part.
• She didn’t benefit financially from the error, as the money stayed in the Roth IRA, untouched.
• She discovered the error and filed for relief before the IRS caught the mistake.
• Granting relief wouldn’t reduce her total tax liability for the affected years, which meant that the government would not lose out on taxes owed.

Based on those facts, the IRS issued a favorable ruling, giving Carla 60 days from the date of the ruling to correct the error by recharacterizing the amounts as contributions and rollovers to a traditional IRA, as she had intended when they were made.

How Carla Could Have Used Form 5498 to Catch This Error Sooner

The facts of this case raise an important question: Could these errors have been avoided?

The answer is yes. If Carla had reviewed her 2007 Form 5498, she might have noticed that Roth IRA in Section 7 was checked and could then contact her IRA custodian to correct the title.

What Happens in a Recharacterization

A recharacterization results in:

• A contribution made to a traditional IRA being changed to a Roth IRA contribution and vice versa, and
• A rollover (conversion) to a Roth IRA being changed to a rollover to a traditional IRA for tax purposes.

In its ruling, the IRS allowed Carla to fix the error by recharacterizing the conversion and contribution.

What This Means for You

IRA owners are ultimately responsible for the consequences of any errors, even if the IRA custodian makes those errors. This IRS ruling underscores the importance of IRA owners auditing their IRAs.

Here are three key takeaways to protect yourself:

1. Ensure your IRA is properly titled: A mislabeled IRA can result in inapplicable contributions, improper rollovers, or unintended Roth conversions.
2. Audit Your Form 5498 Annually: Review the activity for all the boxes. See “5 Common Errors to Fix in Your IRA Before the IRS Flags Them.”
3. Retain Your IRA Statements and Forms: Keep a folder with all Forms 5498, 1099-Rs, contribution confirmations, and rollover confirmations. These documents provide critical evidence in case of an IRS audit or correction request.

Don’t Count on Being as Lucky as Carla

One of the most important factors in Carla’s case is that her Roth conversion occurred before 2018. Remember, while regular contributions can still be recharacterized, that is no longer the case for conversions done after 2017. Therefore, if you mistakenly rolled over amounts from a traditional account to a Roth IRA after 2017, you might be stuck with it, as the IRS cannot allow you to recharacterize that conversion. This repeal of the ability to recharacterize Roth conversions makes it even more critical to review your Form 5498 to ensure the account type is correct.

The IRS granted Carla’s request because she met all the requirements for acting in good faith, and there was no harm to the government. In addition, she could afford to pay the IRS its fee and pay the professional she engaged to file the PLR request. But not all taxpayers are so fortunate. To prevent such complications, review your Form 5498 now and verify the accuracy of the information it reports to you and the IRS.