A few days ago we received a correspondence audit letter from the IRS. My wife, who generally does not get involved in filing our taxes, knew instantly that the large envelope from the IRS was likely not a good thing. A correspondence audit though is the least daunting of the types of audit. Usually this type of audit examines one or two specific items on the return.
In our case, the audit disputed our income for 2007, stating that we received a normal 403(b) distribution and owed both taxes and a penalty on that distribution. We had executed a rollover distribution from Fidelity to my wife’s new 401(k) that year. Strangely it took a lot of effort to get the rollover figured out. My wife had a lot of trouble with Fidelity, to the point where she had to get T. Rowe Price and Fidelity on the phone at the same time to work this out. This isn’t consistent with our usual experience with Fidelity, but perhaps because it was a 403(b) and not an IRA or 401(k) we were talking with the black sheep of the company.
Fortunately enough for us, the error was not ours but was Fidelity’s. They had placed a distribution code of 1 on the 1099-R instead of a G, indicating that it is a normal distribution. This is really something that I should have caught (which I did) in 2008 when I was filing the taxes. It was also something I should have corrected (which I did not) at the same time. In fact, using Turbo Tax I was able to use distribution code 1 and still identify it as a rollover from Turbo Tax’s perspective.
Looking back on this whole effort, what are some of the things I should have done better when filing 2007 taxes and what are some additional lessons learned from this?
- Correct Mistakes Immediately
- Avoid Mistakes by Filing Electronically
- Keep Good Records
- Don’t Cash Out your Retirement Accounts Early
- Don’t Fear the Audit (At Least Not Right Away)
Correct Mistakes Immediately
This probably seems obvious. However I filed our taxes through Turbo Tax and because I was able to convince the software that it was a rollover, I brushed this off as a minor mistake. If we had called Fidelity immediately this would have been addresses pretty quickly and the audit would have been avoided. Ironically we had significantly less trouble getting Fidelity to fix this mistake and send a corrected 1099-R than we had trying to get the rollover in the first place.
Avoid New Mistakes by Filing Electronically
If you do your taxes yourself, and use software — don’t depend entirely on the software. Know the relevant portions of the tax code and triple check your work. If you don’t use software, consider using it. On-line tax filing is free for those with Adjusted Gross Incomes (AGI) less than $56,000 (for 2008). That offer is well worth the benefits of filing electronically, which while it would not have caught our 1099 error, it can catch many other mistakes.
Double and triple check everything, including the forms sent from employers, investment firms, and banks. And of course, if you receive a correspondence audit, do not assume it is your mistake!
Keep Good Records
Even though it was difficult to remember back to a previous year’s taxes, keeping all of the records made it easy to investigate what had happened. In this case I had copies of the 1099-R, paperwork from both Fidelity and T. Rowe Price, and a copy of the check that was made out to the qualified plan we were rolling the money into. Although I often try to keep solid records, I admit I don’t always keep as much information as I did in this instance. We even had an entry logging the teleconference my wife had between Fidelity and T. Rowe Price.
For taxes we keep electronic copies of our records and paper copies forver. I will talk more about our “paperless” records system in the future.
Don’t Cash Out your Retirement Accounts Early
Although we were doing a rollover, this correspondence audit gave us an insight into exactly what we would have paid if we simply cashed the money out. And unless we were facing foreclosure or having trouble paying for food, there is no way that it would be worthwhile to cash out the account. The taxes, interest, and penalties in this case was over half of the value of the account. Even the past year’s market crash has been more gentle on the account than cashing it out would have been.
Don’t Fear the Audit (At Least Not Right Away)
Getting the letter from the IRS we were instantly worried, but we did not need to be. My first thoughts were to call an accountant or tax attorney. But after reading through the paperwork and documentation, and realizing what had happened, we calmed down. Depending on the type of audit (whether it is a correspondence audit, IRS office audit, or a field audit) and the complexity of your return, you may need to get assistance from a professional. If we had been requested for an IRS office audit, we would have hired a professional.
Conclusion
We submitted the response this week to the IRS, and we should receive a response within the next couple of weeks. Since we have corrected the root of the problem, we believe the issue will be resolved. But we cannot know for sure whether the IRS will want more documentation. So I will update the status of this in a future post.
