Roth Recharacterization

Submitted by Brad King on Tue, 2015-08-25 16:42

I have a client, age 52,with income too high to directly contribute to a Roth IRA. So I did a “backdoor” Roth for her. But I created an income tax problem for the client and I am now looking to reverse the process to try to get rid of the problem. The timeline and type of contributions are as follows.

The client opened a Non-Deductible Trad. IRA on 3/17/2015 with $6500 for the 2014 tax year.
Then we opened a SEP IRA with $52,000 deductible contribution on 4/13/2015 for the 2014 tax year. This is her only other IRA.
On 4/28/2015, I converted the Non-Deductible IRA to a Roth, for the 2015 tax year.

Now we want to Recharacterize the Roth back to the Non-Deductible Trad. IRA, using the same account number we converted from. Since I didn’t consider the SEP IRA as being a personal IRA at the time of the conversion, therefore subject to the Pro Rata rule, about 88% of the conversion is taxable. The client doesn’t want to pay any taxes, so the Recharacterization is the next step.
But I have some questions I need answers to before doing the Recharacterization.
Will the cost basis of $6500 follow back in a Recharacterization to the Non Deductible Trad. IRA even though the market value is currently less than $6500?
And if the client decides to then close the Recharacterized IRA, would the Pro Rata rule still apply and make a large portion of the account subject to income tax if she closes the Non Deductible Trad. IRA after the Recharacterization? Or will that IRA stand alone with its own Cost Basis, in effect disregarding the SEP IRA? In sum, does the entire Cost Basis go away upon closure?
Would closing the Non Deductible Trad. IRA trigger any penalty since she is under age 59 1/2?
If the client does the Recharacterization to the NonDeductible Trad.IRA and then decides to NOT close the account, I still need to know if the SEP IRA impacts the NonDeductible Trad. IRA Cost Basis.
At this time, I am not sure if the client filed an 8606 form with her 2014 taxes. The way I understand it, if a Conversion and a Recharacterization are done in the same tax year, and 8606 form isn’t required for a complete Recharacterization.
I would appreciate some help on this since this is outside of the area of tax law of a few accountants I have talked to.



Submitted by Alan - IRA critic on Tue, 2015-08-25 17:43

  1. The 6500 cost basis is returned to the TIRA as a result of the recharacterization. The conversion will not be reported on the 2015 return if fully recharacterized and that will leave the 6500 basis reported on the 2014 8606 intact. (but see 3 below).
  2. After the recharacterization, client can request a return of the 2014 contribution, but the deadline for that is 10/15/2015, so prompt action is now required. Client must specifically request a return of the 2014 contribution, not just ask for a distribution of that IRA account. By dealing with the specific contribution only, pro rating with the SEP IRA is avoided.
  3. The result of the returned contribution is that the basis reported on the 2014 return is eliminated, and that return would have to be amended to delete that 8606.
  4. The returned contribution will have no penalty unless there are gains on the contribution . If there are gains the value of the IRA would be above 6500 when return of contribution is processed. With a loss, no tax or penalty.
  5. If the return of contribution is NOT processed by the deadline, then the 8606 basis will continue and any conversion or distribution would be pro rated with the SEP IRA making it mostly taxable.
  6. You are correct, if the conversion is recharacterized and the 2014 contribution returned by 10/15, the 8606 for 2014 is not needed. If it was not filed to begin with, then no 1040X is needed for 2014 either.
  7. NOTE: Had client established a solo 401k instead of the SEP IRA. then this would not have been a problem because there is no pro rating with 401k plans, just with other pre tax IRA accounts like a SEP or SIMPLE.


Submitted by Brad King on Tue, 2015-08-25 17:50

I appreciate your help.  For #2, what is the procedure, or difference, between “specifically requesting a return of the 2014 contribution, not just ask for a distribution”?



Submitted by Alan - IRA critic on Tue, 2015-08-25 18:13

This return of contribution must include any allocated earnings (or net of any losses), and can only be done up to the extended due date of 10/15 of the year following the year the contribution is for. IRA custodians usually have software to calculate the earnings and the earnings calculation is only done on the IRA account that the contribution resides in (eg earnings in the SEP IRA are disregarded). This transaction also has a special code in Box 7 of the 1099R identifying the return of contribution AND the year the contribution being returned applies to. Coding for other distributions are coded differently and are only based on dollar amounts with no earnings calculation. Tax would be due on these other contributions under the pro rate rules of Form 8606. You are correct in planning to recharacterize the conversion first, then request the return of contribution. Client cannot bypass the recharacterization and try to have the contributions returned from the Roth IRA to avoid the two step approach. If the custodian provides forms to be filled out, the return of contribution option should be clearly specified on the form.



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