Roth to Traditional IRA rollover
My daughter makes monthly contributions to her Roth IRA thru payroll deduction. But with her husband’s bonus check at end of 2021 year they went over the max AGI for being able to contribute to a Roth. She talked to the custodian who said it would be easiest if they transfer her contributions plus associated earnings to her bank account, where she can then rollover that amount to her Traditional IRA if done so within 60 days. I have no idea why they didn’t recommend a recharacterization, unless they don’t think it can happen by tax filing deadline. A couple of questions:
Does she have to do the rollover by tax filing deadline for it to count for 2021 contribution, or does she simply have to complete the rollover to the TIRA within 60 days and it still counts for 2021?
If she only need meet the 60 day deadline but this puts her past April 18, will she have to do an extension, or since this is not a taxed event, can she then just file the 8606 separate after she’s already filed her return, again, providing this occurs within the 60 day rollover period?
Thanks
Permalink Submitted by Alan - IRA critic on Wed, 2022-04-06 18:59
SInce there are multiple solutions to excess contributions, custodians do not want to take the time of determine which one works best for the taxpayer due to the number of variables. Return of the contribution is the simplest solution, but not necessarily the optimal one. In this case, they are also using the wrong terminology because the return of excess is NOT eligible for rollover as such, but could be used to fund a new regular contribution of the desired type. From now until 4/18 she could make a new IRA contribution for either 2021 or 2022 to the appropriate IRA type for each year. A TIRA contribution for either year would likely be non deductible.
Payroll deduction contributions are applied for the year of contribution. In other words, her automatic contributions were likely changed from 2021 contributions to 2022 contributions for the 2022 paydates, and therefore the income limit problem could repeat for 2022.
If she has the money available, she could make her new TIRA contribution for 2021 before receiving the return of Roth excess.
She could adopt an annual back door Roth strategy if she has no pre tax IRA balance. She could recharacterize the Roth excess as a ND TIRA contribution and convert it, or if the Roth is being returned, she could make a new 2021 ND TIRA contribution by 4/18 and immediately convert it tax free if she has no pre tax TIRA balance and will not have one before 12/31.
If the 2021 Roth returned contributions includes earnings, she will be taxed (and/or penalty) on the returned earnings on her 2021 return. However, if she recharacterized instead and then converted, there would be no 2021 tax on earnings or penalty, but the 2022 conversion would include tax on the gains, but no penalty. If she has not yet filed for 2021, filing an extension may be needed if the excess is being returned, as the extension will provide time to include the earnings returned with the 2021 return. If recharacterization is being considered, she must either file her 2021 return or file an extension by 4/18 to free up another 6 months (to 10/17) to complete the recharacterization.
If she files 2021 without an 8606 showing a ND contribution, she can file that form later. She will need an 8606 whether she recharacterizes the Roth contribution or makes a new TIRA ND contribution by 4/18, since a 2021 TIRA contribution will be non deductible either way.
Of course, if she had very large gains on her 2021 Roth contributions, another solution is to leave the excess in. This will eliminate tax and perhaps penalty for an earnings distribution and will substitute a 6% excise tax instead. If the gains are upward of 25%, the excise tax will be less than the tax and penalty on the gains. But with monthly contributions, her average contribution date would be mid year and as such her gains may not be large enough compared to an early 2021 lump sum Roth contribution.
These rather complex options and timing issues around tax time explain why custodians do not get into all the options available – too many variables.
Permalink Submitted by BruceM on Wed, 2022-04-06 19:55
So to summarize, when removing an excess Roth contribution, she has two options:
1. Withdraw excess contribution + earnings. Earnings are income and subject to 10% early withdrawal penalty (she’s in her 40s). She can then make a TIRA contribution for 2021 if done by April 18 without extensions. This withdrawal of excess + earnings can be extended if filing date is extended.
2. Do a Roth-to-TIRA recharacterization of excess + earnings by tax filing deadline + extensions. No tax.
Rollover does not apply here.
The third option would be to carry forward the excess + earnings, pay the 6% excise tax on the excess and designate the contribution for 2022. But this likely wouldn’t work as her husband’s earnings future (at a computer chip wafter manufacturer) looks good so the liklihood they’ll be under the max AGI limit is unlikely.
The earnings withdrawn will count as income for the 2021 return, not the 2022 return (?)
I haven’t talked to her yet (she sent me info by text msg), so I can’t confirm the withdrawal of contribution + earnings has been done yet. If it has, can it be reversed, or once out = no return it to Roth?
Permalink Submitted by Alan - IRA critic on Wed, 2022-04-06 20:54
Return of earnings or recharacterization deadlines will be 10/17/2022 if an extension is filed OR if the actual return is filed by 4/18. 10/17 is known as the “extended due date”.
Correct. No tax for the recharacterization, but the earnings that are transferred will be taxed at the time of the conversion. Only the IRA basis (Form 8606 basis) will be non taxable upon conversion.
Some IRA custodians can process a returned contribution, but hold the funds to make an entirely new regular contribution of the desired type, avoiding actual return of money. All tax reporting remains the same as if the removed contribution was actually returned and then resubmitted as a new contribution.
With respect to Option 3 – payment of excise tax, there are two ways to cure the excess. The first is by “absorption” which is applying to the following year, but this will not work in your case. The second is by distribution of the excess, but not the earnings. A non corrective distribution of the excess amount not including earnings would be requested late in 2022, and this would limit the excise tax to 2021 only. The income tax distribution of the excess would be reported on Form 8606, but it would be non taxable since the distribution could be coming out of the regular Roth IRA Contribution balance. Both the absorption and the distribution methods of curing the excess are reported on Form 5329. DIstribution requires contacting the custodian to request the distribution, absorption does not and is reported solely on the 5329.
Earnings which are actually withdrawn (1099R) must be reported in the year the contribution was made, not necessarily the year the contribution was for. In this case, the earnings would be reported on the 2021 return since the contribution was made in 2021 and the 1099R would be coded in Box 7 to indicate which year the earnings would be taxable and subject to penalty.
If the excess has been distributed with earnings, the money could fund a ND TIRA contribution by 4/18, and if no pre tax TIRA value, the ND 2021 TIRA contributions could be immediately converted to Roth with only the earnings being taxable, and no penalty. This is the back door Roth strategy that can be applied annually by those expected to be over the Roth income limit every year.
However, if the Roth contribution was recharacterized as a TIRA contribution, it could also be converted with the same taxable impact as above. Note that if the Roth was recharacterized to TIRA, and then she discovered that they were not over the Roth limit after all, it could not be recharacterized back to Roth – it would have to be converted, paying tax on the gains.