Q: In May 1998, I received a letter from the IRS disallowing contributions I made to a SEP in 1995, 1996, and 1997. Those monies became taxable, the tax owed was approximately $10,000, I didn't have the money, and I told the IRS so.
A: Ouch. That must have been a painful experience. A SEP is a simplified employee pension plan in which each participant has their own Individual Retirement Account, or SEP-IRA, to hold the employer contributions.
The employer makes contributions to the SEP plan based on a percentage of business profits. Employer contributions can be disallowed if the amounts of the contributions are not calculated in accordance with IRS rules and the SEP Plan documents, or if the contributions are not made before the due date of the tax return (including extensions).
Q: I ended up coming up with $2,000 in cash and then took the other $8,000 out of the now-disallowed SEP. The IRS agent told me to put $8,000 down as a distribution on my 1998 return and put zero as the taxable amount, which I did when I filed my 1998 return the following year. When I asked the IRS agent what to do about the remaining money in my now-disallowed SEP, she said I could just leave it there, so I did.
A: That's interesting. Since the SEP contributions were disallowed, I'm surprised the IRS agent didn't tell you to withdraw the disallowed contributions as non-taxable excess contributions and put them in a non-retirement account. The IRS could have also imposed an excise
tax on any excess contributions left in the account after the due date of the tax returns.
Q: Fast forward to 2012 and retirement is a lot closer. How do I go about proving that I have already paid tax on those monies and should be able to withdraw them in retirement tax-free? Yes, I do have all my tax returns, going back to 1987.
A: Since the money has been in the account for so long, I assume you invested it wisely and it has grown in value. At this point, your best bet would be to report the withdrawals the same way you would report withdrawals from any IRA account that holds both nontaxable and taxable amounts. Your disallowed contributions from 1995, 1996, and 1997 are nontaxable and the earnings in the account are taxable. Use IRS Form 8606 to calculate the taxable amount of your withdrawals and attach it to your Form 1040 tax return. You will determine the non-taxable part of your 2012 IRA withdrawals by prorating the withdrawal by the percentage that the nontaxable amounts are represented in the total amounts of all your IRA accounts added together.
You will then report the total distribution and the taxable amount on the front page of your tax return. If the IRS questions you on the amount of your withdrawal that you claim is not taxable, you will need to explain what happened back in 1995, 1996, and 1997 and let them know what the IRS agent told you to do. It is a good thing that you still have the tax returns from those years. Hopefully you also have the IRS correspondence regarding the disallowed SEP contributions.
Kenneth B. Petersen is an investment adviser and principal of Monterey Private Wealth, Inc., in Monterey. Send questions concerning investing, retirement or estate planning to 2340 Garden Road, Suite 202, Monterey 93940 or firstname.lastname@example.org.