FORM 1099-R

What could possibly be wrong with your Form 1099-R? It comes from the Defense Finance and Accounting Service (DFAS), and they’re part of the govern- ment, right? Well, for those who recently retired or for retirees who filed an updated disability claim with the VA, your Form 1099-R quite possibly could be incorrect. The potential for mistakes

originates with two facts: 1) vet- erans’ disability benefits can be awarded retroactively, and 2) they are tax-free. For those who are retired and less than 50-per- cent disabled, a tax consequence is associated with a retroactive benefit. Specifically, Form 1099-R of a retired military officer who received retroactive VA benefits (rated less than 50 percent) will overstate the retiree’s taxable in- come. When you receive your ret- roactive disability determination, DFAS doesn’t go back in time and adjust your 1099-R to reflect the correct taxable income. All is not lost, though. Under the Strickland Decision, codified in Revenue Ruling 78-161, a retired veteran has the right to adjust taxable income reported on Form 1099-R to reflect the reduction in retired pay that should have been calculated. As a reminder though, this tax benefit only af- fects those who are rated less than 50-percent disabled. (Those rated 50-percent or more disabled receive Concurrent Retirement Disability Pay, which is taxable income, effectively leaving their taxable retired pay unchanged.)

FORM 1099-R (AGAIN)

This potential garbage-producing situation involves your 1099- R from your individual retirement account (IRA) “company” and the “backdoor Roth conversion.” The backdoor Roth conversion is used by taxpayers who can’t contribute to a Roth IRA because their income is too high ($193,000 for married filers/$131,000 for single filers). Many retired officers working in a second career or active duty of-

ficers with another source of income such as a business or an income- earning spouse will have income too high to contribute to a Roth IRA. Enter the backdoor Roth conversion. To use this technique, a taxpayer contributes money (up to the an- nual limit) to a nondeductible traditional IRA. At some point in the future, the taxpayer will convert the traditional IRA to a Roth IRA, hopefully with little tax due (because the traditional IRA contribution was nondeductible). When the taxpayer executes the conversion, the IRA custodian will generate a 1099-R documenting the conversion. Potential for garbage occurs if there is more than one traditional IRA.

Under IRS account aggregation rules, you must count all IRA assets owned by the taxpayer when calculating tax due on a Roth conversion. But suppose when you retire, you transfer your Thrift Savings Plan

balance of $45,000 to a traditional IRA. (We’ll call that IRA No. 1.) To execute the backdoor Roth conversion, you open a second traditional IRA (we’ll call it IRA No. 2), and you make a $5,000 nondeductible contribution to it. You execute the conversion from IRA No. 2 and give the 1099-R, which shows a distribution/conversion of $5,000, to your tax preparer and figure you’re covered and don’t owe any taxes. The IRS sees it differently. Here is how they will calculate it (regard- less of where the funds actually come from):

Total IRA Balance: $50,000 ($45,000 IRA No. 1 + $5,000 IRA No. 2)

Conversion Amount: $ 5,000 ($4,500 IRA No. 1 + $500 IRA No. 2)

Taxable Amount $ 4,500

Tax Due (25% Rate) $ 1,125 That’s some expensive garbage.

MO

— Curt Sheldon, CFP®, EA, is a retired Air Force offi cer and fi ghter pilot. He owns a tax and fi nancial planning business that serves current and previous military members across the U.S. and overseas. His last feature article for Military Offi cer was “4 Tax Law Misperceptions,” February 2015.

FEBRUARY 2016 MILITARY OFFICER 59