Recharacterize or Distribute and Re-Contribute?

Submitted by Amar Patel on Sat, 2013-01-26 16:16

I was married in 2012. It was only after I got married that I started to realized that my income combined with my spouse’s income may eliminate our ability to make 2012 Roth IRA contributions. But I had, to that point in September of last year, made my regular monthly contribution to my Roth IRA.

So I think I’m understanding at least a little of my options. I think the “backdoor Roth” is the way to go but I’ve got some questions. Do I ask my broker to “distribute” what I already contributed in 2012? Or is the “recharacterization” the route to go? Or are they the same?

Also, I read about the possible taxing that takes place if people have traditional IRAs. We do not now, but to do the backdoor, one will be created for each of us. But then after the backdoor procedure, won’t we each have one? Does that make it somehow more challenging to do backdoor Roths in the future, assuming our income doesn’t come down?

Note: we both fully participate in our employer’s retirement plans, and neither of us have any other IRAs other than the Roth IRA.



Submitted by Alan - IRA critic on Sat, 2013-01-26 17:41

  • You are a good candidate for the back door Roth. You would each recharacterize your 2012 Roth contributions as TIRA contributions and then convert them to a Roth IRA. There are no income limits for conversions. Note that if you have earnings on your Roth contributions, ie more dollars than your actual contribution go to the TIRA, when you convert the earnings portion will be taxable in 2013. Your TIRA accounts will have no balance right after the conversion, but you can always make a small TIRA contribution after the conversion to make sure you won’t have to open another account for 2013. In 2013, unless your income drops and you become eligible for a regular Roth contribution, all this will be easier because you will already have the TIRA accounts open and will not have to recharacterize. You will just make your IRA contributions directly to the TIRA account and then convert them. Converting right away means that there will be no earnings to be taxed in the conversion. Remember to report your 2012 non deductible TIRA contributions on separate Forms 8606 for each of you, and you should also include an explanatory statement with your return about the recharacterization (dates and amounts of the Roth contributions, date and amount of the recharacterization to the TIRA).

 

  • NOTE: Having a TIRA account is of no consequence if there is no pre tax balance in it for the conversion math, so what you do NOT want to do is to roll a 401k or similar plan over to a TIRA. That is what will make your conversions mostly taxable.
  • NOTE: I indicated it’s best to recharacterize, but if you happen to have a LOSS on your Roth contributions, instead of recharacterizing, you could ask for a withdrawal of your contribution. You would get back less than you contributed, so nothing would be taxable. You could then open the TIRA, and make a new contribution for the ORIGINAL amount and convert it. You would have more in your Roth because you were able to re contribute the full amount.

Submitted by Amar Patel on Sat, 2013-01-26 22:36

– My 2012 contributions were kept in cash, but I think the Roth itself gained value in 2012 because of gains in my holdings from prior investments.  How is the broker likely to calculate gains or losses on what I recharacterize or withdraw?  And does paperwork typically have to be done for each of the monthly contributions made or one set of papers for all the 2012 contributions?- Once the funds are out of the current Roth, they need to go to a traditional IRA.  And since I don’t currently have one I’ll have to open one.  But the amount from the Roth going to the traditional IRA isn’t a full $5000.  Can I add the balance?  Does this balance and the amount from the Roth both get reported on the Form 8606 as nondeductible?  Do I do a separate Form 8606 for each contribution being routed to the TIRA (either the “new money” or the money from the Roth)?- Once the funds are in the new TIRA, more paperwork is done to convert that amount to a Roth.  Is it “converted in place” within that new account number or routed back to the existing Roth or some other Roth account number I’d have to create?  If it stays in place, can I ultimately combine the multiple Roths just for ease of management instead of various accounts?- Does a conversion out of a TIRA automatically close the account?  If not closed and the balance is kept at zero, then doing future backdoor operations should be free of additional tax confusion, right?- In addition to all this paperwork with the broker, what paperwork is compiled and sent to the IRS either by me or the broker on my behalf?  What if anything is included and/or “attached” to my 1040 to make sure everything is transparent on that front?

Submitted by Alan - IRA critic on Sat, 2013-01-26 23:38

  • The broker may have software that does the earnings calc on each monthly contribution, but for the 1099R and your return, it would be treated as a single recharacterization. If your Roth contribution was less than 5k, then you can contribute the balance to the TIRA as a non deductible TIRA contribution and just report a 5k non deductible contribution on Form 8606. Do not show any earnings as a contribution on the 8606. You can convert into your current Roth since the conversion will be mostly tax free and you probably will not need to recharacterize it even if the value drops. Most brokers will not close empty accounts right away, and you can always make a small 2013 TIRA contribution in it so it has a balance if the broker will not let it stay empty for an entire year.
  • There will be somewhat more reporting the first year because you have the recharacterization to explain. After that, the reporting will be simple. You will report the non deductible contribution on Part I of the 8606 for each year you make one, and report the conversion on another part of the same 8606 in years you convert. This way you will not have to worry about income limits or ending up in the partial contribution MAGI phaseout zone. The custodian will issue a 5498 for each contribution and a 1099R for each conversion and both you and the IRS get a copy. You should save your copies, particularly the 5498 forms. Only for the first year where you recharacterize will you need to include an explanatory statement with your return. On a joint return each spouse has a separate 8606 and makes a separate explanatory statement if one is needed. An 8606 only holds one SSN.

Submitted by Amar Patel on Mon, 2013-01-28 19:54

I think I’m understanding this from a conceptual point-of-view but am getting slightly bogged down in the details of the paperwork required.  Can you check the following on if I’ve got a handle on the paperwork yet?

  • First, I will wait for all W-2s, 1099s, etc.
  • Then I will compute which approach has the smallest combined federal and state tax bill (married filing jointly, married filing separately, maybe one or the other can file as head of household)
  • Upon confirming that married filing jointly is the best route and that the backdoor Roth is the best approach
  • I will contact the broker to do the paperwork needed to recharacterize the old Roth IRA contributions or withdraw the excess without penalty.  Questions: why choose one option versus the other?  And what IRS paperwork is needed for this step in the process?
  • Eventually, money comes out of the Roth IRA.  The original contribution amount and any supplementary contribution up to $5000 needs to go to a TIRA as a nondeductible contribution.  This is reported to the IRS on Form 8606.  Question: what happens to the gain or loss attributable to the Roth IRA contribution that was taken back out?  (Taxed as 2012 income?  Penalized?)
  • Once everything settles in the new TIRA, a conversion is started to send it back to the existing Roth IRA.  Questions: how is this reported to the IRS?  (Form 5498?  Form 5329?)  Would it be better out of an abundance of caution just to open a new Roth for now to make sure things are not accidentally comingled and gummed up if things need to be reversed later?
  • Upon completing these steps, the backdoor Roth process seems complete.  Question: Did I miss anything?

I will have a pile of paperwork for the broker and a pile for the IRS.  Then I would have to finish the 1040 with some sort of attachment.  Questions: How is this attachment written up?  Do I wait for all these 8606s and 5498s and whatever else to get filed before completing the 1040 by the April deadline?

Submitted by Alan - IRA critic on Mon, 2013-01-28 22:56

  • You would probably recharacterize the contribution. Removal of the contribution would only be used if you had a loss on your contribution and wanted to make a new non deductible contributon for the full amount.
  • If you recharacterize the contribution, only the net amount goes to the TIRA. If you have a gain and remove the contribution, you owe tax and penalty on the gains for 2012. If you recharacterize, nothing comes out, it just transfers to the TIRA. If you then convert the TIRA, gains would be taxable in 2013 but no penalty.
  • Once in the TIRA and you convert it, you will report the conversion on Form 8606. You and the IRS receive a 1099R for the conversion distribution, and also a 5498 showing receipt of the contributions. You don’t file either one with your return as the IRS already has copies.
  • You can open a new Roth IRA for the conversion only, but you don’t have to for the purpose of recharacterizing your conversion. You would not recharacterize a tax free conversion as there would be no reason to.
  • For your 2012 return you would file an 8606 to report the non deductible TIRA contribution. This is just an additional tax form filed with your 2012 return. You would also include an explantory statement about your recharacterization, eg “I contribution $x to my Roth IRA in 2012 and on xx/xx/2013 I recharacterized this amount as a traditional IRA contribution, and my contribution was valued at $y when transferred to the TIRA.” You don’t have to wait for anything else once the recharacterization is completed. The 1099R and 5498 for the recharacterization will not be issued until Jan, 2014 and that’s the main reason you need to make the explanatory statement.

Submitted by Amar Patel on Sun, 2013-02-03 02:04

I seem to be getting lost in the paperwork on how to treat my “contributions” versus “gains”.  Publication 590 seems to indicate that both the 2012 contributions to the Roth and the earnings on those contributions must be recharacterized as a TIRA.  But since I’m covered by retirement plans at work and because of income, I cannot deduct either amount from my taxes.  I think I’m following that part so far.  I guess it is the conversion part that is tripping me up.  When I convert that new TIRA to a Roth, Publication 590 seems to indicate that I owe taxes.  But I paid taxes on the monies I put into the Roth in the first place.  And Publication 590 doesn’t seem to indicate what to do with the gains upon the conversion.Can you point to where the language for this might be in Publication 590, Form 8606 (which I’m not sure I understand either, but I can come back to that later)?

Submitted by Alan - IRA critic on Mon, 2013-02-04 04:40

The conversion is reported on Form 8606, and Part I of that form calculates how much is taxable. You show your non deductible contributions on line 1 (Current year) or line 2 (Prior years). The form then pro rates the portion of your TIRA that has already been taxed against the adjusted year end value to determine the taxable part. Therefore, if you are just working with a single contribution that you recharacterized. the original amount of your contribution is not taxed when you convert, only the gains that occurred on your contribution while it was in the Roth IRA or afterward in the TIRA before you converted. If you fill out the forms (or tax software) correctly, you are never taxed twice on the same amounts.

Submitted by Amar Patel on Mon, 2013-02-04 22:22

Thanks for all the help so far.  Little by little I think I’m getting it.  I still have to study the Form 8606 some more, but that will have to wait for another day.  In the meantime, thanks again for all the help!

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