Backdoor Roth without earned income
Participant thought that he had earned income but did not (lots of business income but none earned). Pursued the backdoor Roth strategy for two tax years but now must unwind it. However, TJIA eliminates the ability to do recharacterizations on Roth conversions. How should this be unwound?
History: In Feb 2024, contributed $7,500 for 2023 and $8,000 for 2024 to TIRA (15,500 total). TIRA balance before contribution and after conversion was zero. In April 2024, TIRA was converted entirely to Roth. The amount converted was $15,900 ($400 gain after contribution). This was added to an existing $60,000 Roth IRA. Current Roth IRA balance is $78,400, so $2,500 of gain since the conversion ($78,400 – $75,900).
The participant will get a 1099 for the TIRA conversion for $15,900, of which $15,500 was thought to be basis. How is the 1099 addressed? With a side letter?
The excess earnings need to be removed. How should the earnings be removed? Is this calculation correct? The prorata portion of the gains… Total amount in Roth the day of conversion was $75,900 ($15,900 + $60,000). Current value of $78,000. The prorata calc of contrib versus existing Roth = $15,900 div $ 75,900 = 21%. The gain since conversion is $2,500, and 21% of that is from converted amount ($525). So, are the amounts to be removed from Roth a combination of a) conversion of $15,900 and b) earnings of $525? What is needed to accomplish this removal (just a straight distribution?)?
Thanks for your help!
Permalink Submitted by Alan - IRA critic on Wed, 2024-09-04 20:04
Now that recharacterizations of conversions are disallowed, this situation presents two nasty problems, those being correcting the excess and also reporting of deviations from the conversion 1099R and of correcting 1099R forms. This is about the worst mess that could be created under current law.
Before considering the awkward correction strategy, there are two possible easier cures. Will the participant have earned income in 2025 and 2026 that could absorb the TIRA excess, or perhaps are they filing jointly with a spouse that has earned income to support these TIRA contributions?
A third possibility exists if the IRA custodian is aware of a back door fix for this particular situation such as replacing the conversion with a recharacterization of the contributions as Roth contributions, which could then be removed by the extended due dates. Probably extremely unlikely, particularly if the custodian is not a large broker.
Assuming all of the above do not pan out, perhaps the simplest solution is to eat the excise tax for 2023 for the 2023 contribution, then take a regular Roth IRA distribution of 7,500 before year end and after 10/15, ie eliminating the excess by distribution on Form 5329. Then in 2025, do the same for the 2024 excess of 8000. The 6% excise tax on 7500 would be due on a 2023 5329, and also on 8000 on a 2024 5329.
While the excise tax hurts, all the gains generated on these excess contributions get to remain in the Roth, so there are no earnings calculations to be done because the excess contributions are treated as corrected after the respective due date for those two years. Those 5329 forms would also require an explanatory statement regarding the excess removal being done from the Roth IRA because there was no balance left in the TIRA to remove.
Permalink Submitted by Bro Has on Thu, 2024-09-05 12:57
Alan, thank you for your help. Good double check on spousal and future income, but neither applies.
We can check with the custodian (it is a large one). But, even if you could somehow could say that the contributions went into the wrong account (should have gone directly to Roth instead of the TIRA first), the existing funds still have to come out of the Roth. I don’t see how you can separate the “should have happened” from what actually happened. That was difficult to write, but hopefully that makes sense…
Regarding the 6% excise tax and timing… Is there a reason to take distribution for the Roth of $7500 before 10/15? In theory, if it is “removed” before 10/15 then the excise tax is avoided. It also seems odd to wait a year to fix the 2024 amount. Since an explanatory statement is needed either way, could both amounts ($7500 + $8000) be removed before 10/15 and then explain the lack of options and explain participant took prompt action? I know you are not the IRS but does that somehow make it worse to do it earlier? It’s kind of like a missed first year RMD… “I figured it out and fixed it asap, so please don’t penalize me?”
Thank you!
Permalink Submitted by Alan - IRA critic on Thu, 2024-09-05 18:13
Yes, check with the large custodian to see if they have any suggestions other than “see you tax advisor”. Being large, their tax Dept may have had some past advice from the IRS on this problem.
Removal of the excess from the Roth IRA is the only good faith action available because there simply is no balance left in the TIRA from which to take a corrective distribution. But something must be done because annual excise taxes continue to accrue for up to 6 years using the new 1040 filing deadline.
Recharacterization of the conversion could be done if this was considered to be a “failed conversion”, such as converting an RMD. IRS regs indicate that a failed conversion is not a conversion, rather is treated as a taxable distribution from the TIRA and a regular (not conversion) contribution to the Roth IRA. As a regular Roth contribution, it could have been recharacterized as a TIRA contribution, moving the funds back to the TIRA, from which they could be removed prior to the due date with allocated earnings. That would eliminate a 5329 filing and the 1099R forms would all line up to be reported as issued. However, I find no tax code provision which indicates that simply converting an excess contribution is a “failed conversion”, therefore the custodian is probably not going to agree to recharacterize. But it may be worth asking them about this approach.
If they have no answer, won’t recharacterize as a failed conversion, and won’t agree to treating this as a Roth contribution excess, that would appear to leave the last resort as a good faith distribution from the Roth IRA of the amount of the excess. If done after the extended due dates for each year, there would not have to be any earnings calculation, just the 15,500 removed. That would be totally within the Roth owners control, but the excise tax for one year would be due. The Roth distributions would be tax free coming from the regular Roth balance, so there would be no income tax except for the 400 gain prior to conversion. The excise taxes on Form 5329 would be 6% of 7500 on 2023 5329 and 6% of 8000 on 2024 5329, with the excess amounts cleared by the distribution method with distributions also reported on the 5329 forms line 20. The Roth distributions would go on Form 8606 but would be income tax free.
Your final paragraph is also a possible solution if IRA owner wants to avoid all excise taxes. But the 1099R will not be coded as a corrective distribution, so that would have to be part of the explanatory statement to the IRS.
Permalink Submitted by Bro Has on Sun, 2024-09-08 19:56
Thanks Alan, we appreciate your insights.