By not making up the shortfall, he is going to see the 1099-R for the money out as the tax withholding you mention "He did not repay the taxes" and Merrill Lynch is going to issue a Form 5498 for the year of the deposit, for money In. That form usually isn't issued until mid-May. It's just informational and not used for taxes. It's your due diligence that he did what he is telling you.

"Right now, with the 1099-R from his wife's employer is showing to be fully taxable."

Because the entity in charge of issuing the money doesn't know what else he did. That's correct. You address it when you enter it for the tax year.