That's a really good point, I didn't even think about the company deducting it on their end. I'll definitely tell him to keep all the settlement paperwork and document everything. Would you recommend he send in any specific documentation with his tax return, or just keep it all on hand in case of questions?

I wouldn't send any extra documentation with the return itself. The IRS doesn't want that unless they specifically ask for it. Just have him keep all the settlement documents, correspondence, and proof of the payment amount in a safe place for at least 7 years (the extended audit timeline). Also, when he reports it on Schedule 1, Line 8z, he should write a brief description like "Breach of contract settlement" next to it. That shows transparency and makes it clear he's not trying to hide anything.

Sometimes companies refuse to issue 1099s for settlements because they don't want to admit liability. I had this happen and my accountant said to just report it anyway. The IRS cares more that YOU report income than whether THEY issued the proper form.

This is really helpful! The company classified me as an independent contractor (hence the 1099-NEC), but I'm wondering if the treaty might view it differently since I only work for this one company. How do I figure out if I'm considered an employee or contractor under the treaty specifically?

The treaty doesn't specifically define employee vs contractor, so it generally follows the classification principles of each country. The IRS looks at factors like behavioral control, financial control, and relationship of the parties. Since you only work for one company, that's a factor that could potentially point toward employment, but there are many other factors. Do they control when and how you work? Do you use your own equipment? Do you have the opportunity for profit or loss? These all matter for classification.

There is indeed a totalization agreement between the US and Canada! If you're paying into the Canadian social security system (CPP), you generally don't have to pay US self-employment taxes. You'll need to get a certificate of coverage from the Canadian authorities though.

Is there a time limit on recharacterization though? OP is talking about a 2021 contribution which was over 2 years ago. I thought recharacterization had to be done before the tax filing deadline?

You're absolutely right, and that's a critical point I should have clarified. Recharacterizations do need to be completed by your tax filing deadline including extensions (typically October 15th of the year following the contribution). For a 2021 contribution, that deadline has long passed, so recharacterization isn't an option anymore. At this point, the return of excess is indeed the only way to correct the issue. Thanks for pointing this out - I should have been clearer about the timing limitations.

That's a dangerous approach to take. Yes, the excess contribution penalty is 6% per year, but it continues EVERY year until you fix the problem. So it's not just a one-time $270 penalty - you'd pay that $270 every single year indefinitely until you correct the excess contribution. Plus, having known excess contributions in your account could potentially cause issues if you ever get audited. The IRS might view it as an intentional violation once you're aware of the problem. Better to fix it now and just pay the penalty for the years it was already in there.

That makes sense, I didn't realize the penalty continues every year! Definitely not worth saving a little hassle now to keep paying penalties forever. Thanks for explaining that - I'll call Vanguard tomorrow to start the process of removing my excess contribution too.

Thanks for bringing this up! We're in Pennsylvania - do you know if we'd have to use the same filing status for state as federal? I didn't even think about how this might affect our state taxes.

Pennsylvania doesn't actually have married filing jointly or married filing separately options like the federal return does. PA has a flat income tax where each person files their own return reporting their own income, regardless of federal filing status. You'll each file your own PA-40, reporting just your individual income. This is actually good news for your situation because your state tax situation won't be affected by whatever you decide for your federal return. But definitely double-check with a tax professional about your specific situation, as local taxes might have different rules.

The student loan interest deduction isn't the only thing to consider though. Child tax credits, education credits, and retirement contribution limits all have different phase-out thresholds too. At their income level, they need to look at the whole picture.

That's a good point! I did confirm with my plan administrator that they accept IRA rollovers, but I'll double-check there aren't any special restrictions. Our 401k plan actually has pretty decent investment options (Vanguard institutional funds with low expense ratios), so I'm not too worried about that part. The main goal is clearing out the pre-tax money so I can do backdoor Roth contributions without dealing with the pro-rata rule mess every year.

Glad to hear you've already checked on the rollover acceptance! That's great that your plan has good investment options too - that makes the decision much easier. You're absolutely right to focus on clearing out the pre-tax money for clean backdoor Roth contributions. The pro-rata rule calculations are a pain to deal with annually. I've had clients who avoided backdoor Roth conversions for years simply because they didn't want to deal with the paperwork complexity of having mixed funds.

This varies by 401k plan, so you'll need to check your specific plan documents. Most plans that have minimum balance requirements apply those rules to all money in the plan, including rollovers. The $5,000 threshold is pretty common. However, they typically can't "cash you out" of rollover funds the same way they might with small employer contribution balances. Instead, if your balance falls below their minimum, they might roll it to an IRA automatically rather than sending you a check. If you're actively employed and making contributions through payroll, you'll likely stay above any minimum threshold naturally as your contributions come in.