Reversing 2019 Roth Conversions

Submitted by Todd Martin on Wed, 2020-04-01 21:44

Hello,

I have a client under age 50 that had been contributing $250 semi-monthly into her Roth IRA in 2019 ($6,000 annual). When we met for her review in December she informed me that she had received a significant signing bonus that brought her MAGI for the year over $164,000. As she is a single tax filer, she exceeded the phase-out limit for making Roth IRA contributions in 2019.

To amend this contribution we re-characterized her 2019 Roth IRA contributions into Traditional IRA contributions before year-end. Because she did participate in an employer sponsored 401(k) plan these were considered after-tax IRA contributions. Next, without considering her pre-tax Traditional IRA funds which totaled around $205,000 as of 12/31/2019, we converted the re-characterized after-tax funds from her Traditional IRA back into her Roth IRA. Our intention was to complete back door conversions on after-tax dollars effectively causing no taxable transaction.

Now as my client is filing her 2019 taxes, she is running into an issue of basis causing roughly 97% of the conversion to be taxable. This was not our intention. My B/D advised that we complete a return of excess contribution from her Roth IRA account for the converted amount but they could not advise if this would resolve the issue that 97% of the $6,000 converted is taxable. Can anyone tell me if completing a return of excess contribution, in a new tax year, would eliminate this conversion from being taxable like it never happened? I also don’t want their to be any basis carrying forward in the future?

Thank you – Todd



Submitted by Alan - IRA critic on Wed, 2020-04-01 23:55

She cannot avoid the tax bill, but she can get her non deductible TIRA contribution back adjusted for earnings. There was no actual excess contribution, since the Roth excess was eliminated by the recharacterization and the resulting non deductible TIRA contribution is allowed. But she can still request a return of her TIRA contribution whether it is excess or not. If so requested, she receives the 6000 back adjusted for gain or loss (probably a loss due to market crash). She does not file Form 8606 reporting a non deductible TIRA contribution for 2019. But the conversion remains (reported on Form 8606) because it cannot be recharacterized and it cannot be treated as solely a conversion of after tax money by Form 8606, as she had plenty of pre tax money to convert regardless of the recent contribution. Actually, if she requests a return of the contribution, then 100% of the conversion will be taxable instead of 97% but will no longer have any IRA basis..

Submitted by Todd Martin on Thu, 2020-04-02 18:54

Thank you Alan for your response to my question. To clarify what you are saying you recommend taking a return of excess premium from the traditional IRA as this removes the after-tax contribution from being ‘commingled’ in the account with pre-tax dollars? This in no way causes a taxable distribution or 1099-R being generated for 2020?I also interpreted your response as there is no way to undo the roth conversion. By returning the excess contribution from the TIRA it makes the conversion 100% taxable and removes the concern of basis having to be accounted for in the future?Thanks again for your help. It is greatly appreciated.

Submitted by Alan - IRA critic on Thu, 2020-04-02 19:26

It is a return of the 2019 contribution, but it is not an excess contribution because she fully qualified to make a non deductible TIRA contribution. However, a return of a non excess contribution is handled the same way. I highly doubt that this contribution has generated any gains in this market situation, but if there were any, they would be taxable on her 2019 return, because that is the year in which she made the contributions. Removal will generate a 1099R next January coded to show that any gains would be taxable in 2019. Return of the 2019 contribution will eliminate the basis in her IRA and eliminate pro rating and future 8606 forms. The trade off is the conversion will be 100% taxable instead of 97%.

Submitted by John Heckendorn on Wed, 2020-04-08 13:33

Alan, we have a similar situation to which the discussion above mostly applies. In 2019, MAGI unexpectedly grew to be above the Roth contribution limit for a person with a employer retirement plan, so $7000 needs to be removed from the Roth before April 15th to correct this. There is over $7000 in cash in the Roth, which has lost substantial value overall since last year. The plan is to recharacterize $7000 to a new non-deductible IRA. So some questions. Because the dollars for the original Roth contribution were after-tax, and non-deductible IRAs are, by definition, funded by after-tax dollars, would there be any taxes due now or later on this transaction? If the transaction is done before the 2019 tax return is filed, should the reversed contribution be accounted for in any way on that return, or any specific form(s) included with the return? Same question for the 2020 return when it is prepared next year. Will the non-deductible IRA contribution from the recharacterization be considered a 2019 or a 2020 contribution (or do we have a choice)? Thank you!

Submitted by Alan - IRA critic on Wed, 2020-04-08 13:52

  • Such a recharacterization would not be currently taxable, but Form 8606 should be filed with the 2019 return to report the 2019 non deductible contribution. Also, an explanatory statement should be included with the return indicating the date and amount of the Roth contribution, and the amount recharacterized with date and amount and finally how much transferred to the TIRA (well less than 7000).  The 8606 still would show a 7000 nd contribution despite less being transferred to the TIRA.
  • 7000 is still a 2019 nd contribution. Since the recharacterization will be explained with the 2019 return, there will be nothing to report on the 2020 return with respect to this contribution. However, if this contribution is the entire non Roth balance, it should be converted back to Roth tax free and that would be reported on the 2020 return Form 8606. This would be a back door Roth transaction (recharacterization then conversion).  If taxable income will be down in 2020 as it will be for many, it may be worthwhile to consider a larger conversion if there are pre tax TIRA values in addition to the 7000 less earnings.
  •  While the recharacterization should be done ASAP, it does not have to. Person has until 10/15 to recharacterize a 2019 contribution, but the explanatory statement could not include the amount transferred if it is done after filing the 1040. The 1040 is due this year on 7/15, or 10/15 if an extension is filed.

Submitted by John Heckendorn on Wed, 2020-04-08 14:27

Thanks for the quick reply, Alan. Just repeating back to make sure I understand…

  • The recharacterized funds moved from the Roth as a result of the 2019 excess contribution can/should be indicated on the 8606 filed with the 2019 return as a 2019 ND-IRA contribution. One question about the amount: I thought that the excess amount removed from the Roth had to be the amount overcontributed, plus any appreciation since those funds were invested (and unless the entire Roth is liquidated, no capital losses factor in). Are you saying that if the overall value of the Roth declined by, say, 25% since that contribution was made last year, we are required to remove only $5250 from it to correct the excess contribution? I guess I don’t understand how the IRS would account for this: The 8606 still would show a 7000 nd contribution despite less being transferred to the TIRA [the TIRA in this case being an ND-IRA]. I can’t imagine the IRS saying something like, “If the contribution last year had been to an ND-IRA rather than a Roth, its value would have declined to the point in time the excess contribution was corrected. Therefore we will overlook the original cash amount contributed if a lesser prorated amount is moved to a ND-IRA.”
  • The back-door transaction moving funds to the Roth from the ND-IRA would be tax-free *only* if the ND-IRA is the only non-Roth IRA. Otherwise, the pro rata rule would be applied at the end of 2020, based on the year-end value of all the IRAs, to determine the taxes due on the transaction on the 2020 return?
  • Understood that we have a more relaxed time frame this year for making the changes and doing the paperwork, but we’d like to wrap up the 2019 tax year as expeditiously as possible.

Thanks again!

Submitted by Alan - IRA critic on Wed, 2020-04-08 15:00

  • The tax code requires that for either a return of contributions or recharacterized contributions, the NIA (net income attributable)  must be distributed or transferred with the contribution. If there is a loss, then the amount transferred will be less than the contribution, with a gain more will be transferred.  With recharacterization, the end result is that this taxpayer is treated as if the original contribution (7000) was made to a TIRA instead of a Roth IRA. The loss that occurred in the Roth IRA is likewise transferred and becomes a loss in the TIRA. Example below:
  • “ExampleA Roth IRA originally contains $4,000. At the beginning of a new fiscal year, an additional contribution of $5,000 is made, which brings the total balance to $9,000. At the end of the fiscal year it turns out that the IRA holder exceeded the contribution limits (for example, due to an unexpected salary raise) and that only a partial contribution of $3,000 was allowed for that fiscal year. The excess amount of $2,000 needs to be removed from the account to avoid tax penalties. However, after the original $5,000 contribution was made, the investments in the IRA sharply declined in value due to unfavorable economic conditions. At the time of the excess removal the total value of the account is only $6,000. The NIA for the $2,000 excess contribution is: 2000 × 6000 − 9000 9000 = − 666. 66 ¯ {displaystyle 2000times {frac {6000-9000}{9000}}=-666.{overline {66}}} The $2,000 excess contribution effectively generated a net loss of $666.67 which must be excluded from the excess removal. To bring the IRA back within the contribution limits, only $1,333.33 instead of $2,000 need to be removed ($2,000 – $666.67 = $1,333.33). ” The example shows why an explanatory statement is required. When the IRS sees that (eg 5250) was transferred they have no way of knowing whether a partial or full recharacterization was done or how much of a gain or loss there was. The explanation confirms the amount of the original contribution recharacterized (7000) AND the amount that 7000 was worth at the time of the transfer (5250). You are correct about the back door, the pro rate rules apply using the total TIRA balance at year end to determine the taxable amount of a conversion. 

Submitted by John Heckendorn on Wed, 2020-04-08 16:49

Alan, one last question regarding computation of NIA, referencing the definitions/computation/process at The Retirement Dictionary (https://retirementdictionary.com/definitions/netincomeattributablenia). For purposes of the discussion, let’s use the following hypothetical:

  1. An overnight $7000 contribution was made to the Roth on July 1, 2019 (this later became a disallowed contribution due to final 2019 MAGI).
  2. The next day, at market open, before the $7000 was deposited in the Roth, its total asset value was $20,000. The $7000 was invested into securities which, as we will see below, lost considerable value when 
  3. In February 2020, a back-door cash contribution of $7000 from a ND-IRA was moved into the Roth (taxes due will be computed based on IRA value at the end of 2020 using pro rata rules).
  4. There have been no distributions FROM the Roth IRA.
  5. To correct the excess contribution, an amount will be moved from the Roth to an ND-IRA after market close on April 9th. The total asset value of the Roth at market close is $24000 (i.e., before any funds moved to the ND-IRA).

So based on the definitions re. NIA at The Retirement Dictionary, some questions:

  • If the computation period is between July 2, 2019 to April 9, 2020, is the Adjusted Opening Balance $34,000 ($20K + the two $7K contributions)?
  • Is the Adjusted Closing Balance $24,000?
  • When I run the NIA calculation from the Retirement Dictionary, I get -$2059. Therefore, to correct the excess contribution, I would recharacterize $4941 to the ND-IRA (i.e., $7000-2059)?

Thanks again for taking the time to help me understand how this all works!

Submitted by David Mertz on Wed, 2020-04-08 17:38

  • The amount *recharacterized* would be $7,000.  The loss-adjusted amount *transferred* to the traditional IRA would be $4,941.
  • There is no such thing as a “nondeductible IRA.”  There are only nondeductible contributions to your traditional IRAs in aggregate.

Submitted by Alan - IRA critic on Wed, 2020-04-08 19:05

  • Are you getting Retirement Dictionary?  I haven’t been for a month now, and thought Denise took it down, but maybe not??? Anyway, I can use IRS Reg 1.408-11 to see the formula.
  • Your adjusted opening value is correct (34k), and closing value does not need any adjustments and is therefore 24k. Therefore, 4941 is to be transferred to the TIRA.
  • It is good to know how this should calculate out, but most custodians have software to handle this and prefer to run it themselves, but you now know the amount that should be transferred. Every so often in complex situations where there were transfers between different custodians, the taxpayer will be asked to do the calculation and provide the result to the custodian.

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