Roth IRA recharacterization and conversion each year
I’ve made the max contribution to my wife and I’s Roth IRAs since 2009. Beginning with tax year 2018, we exceeded the income threshold for a Roth contribution. For both tax years 2018 and 2019, I contacted Vanguard to have them recharacterize the Roth contributions as Traditional contributions. This occurred in the year following the tax year — so 2019 and 2020, respectively. Weeks later, I then converted these Traditional contributions back to Roth contributions (backdoor Roth). I then ensure that our Traditional IRA balance is $0 by the end of each year.
This triggered Vanguard to send 1099-Rs, which I reported on each return for 2018 and 2019 via Form 8606 for both of us. My understanding is that these forms are cumulative, which it appears my tax software accounted for in 2019 by specifying 2018’s traditional IRA basis on line 2. It appears I am paying tax on any earnings that take place between the recharacterization and the conversion.
My tax software also had me attach an explanation statement to line 4a of our Form 1040 indicating the recharacterization from Roth to Traditional — date of recharacterization, amount recharacterized, amount transferred (recharacterization plus earnings/losses) and a short description indicating the reason (Excess Roth IRA contributions).
My question is, am I doing this correctly? It appears we will be over the income threshold again for 2020, and if it is correct, I would like to follow the same procedure I’ve been following.
If it is not correct, what steps should I take to correct the 2018 and 2019 returns? What steps should I take for 2020?
If it is correct, are there any pitfalls I should watch out for? For example, will I need to wait at least five years before making withdrawals against contributions that were converted from backdoors to avoid paying taxes on them? I’m not sure how or if the “5-year rule” applys here.
Permalink Submitted by Alan - IRA critic on Mon, 2021-01-04 17:16
Your procedure is correct. Note that when you convert the non deductible TIRA contributions, the earnings included are those generated both in the Roth prior to recharacterization and in the TIRA prior to conversion. The 8606 filed for each year should include non deductible contribution made FOR that year and conversions done IN that year. Your 8606 forms for each year are probably correct, but you might take a look at them to be sure.
Since your MAGI is either to high, in the phase out range, or under the range but close to it, you might as well make ND TIRA contributions from the start and convert them right away. That will eliminate the time and effort spent on recharacterizing. While not necessary, everything will be simpler if you can get to the point where your ND TIRA contributions are made (and converted) in the current year rather than contributions made for the prior year. That will remove your MAGI from being an area of concern, you just need to be sure you will have the earned income for both spouse’s contributions.
You would never owe taxes again on conversions if you complete Form 8606 correctly if you take non qualified Roth distributions. This involves keeping track of your Roth IRA basis, both your regular contribution basis and your conversion basis. You also need to keep track of the amount of each conversion done in the last 5 years, and which portion was taxable. With back door Roths, each conversion will be mostly non taxable and the 10% penalty for distribution of conversions only applies to the taxable amount which would be small. In fact, with typical back door conversions, even if you withdraw them before 5 years the penalty is so small that the completion of Form 5329 to REPORT the penalty is the larger hassle than the penalty itself.
So if you do not have a tally of your Roth IRA basis, you should make one now and keep it current each year. Your basis is reduced if you take a distribution, but most people are able to avoid taking Roth distributions before 59.5 when the Roth becomes fully qualified and tax free. Your prior recharacterized and converted distributions will not count as regular Roth contributions, they are conversion contributions for the total amount converted even though they were initially regular Roth contributions that were erased by recharacterization.