@thegoodreturn wrote:
I called my custodian today. It looks like there are capital gains.
Can you help me understand why I need to pay taxes on the gains if we are taking it out of the Roth IRA just to essentially put it back in?
I'm having a hard time wrapping my mind around the concept: a direct Roth IRA contribution would not be a taxable event. A direct Roth IRA contribution recharacterization to traditional and back into Roth IRA has tax liability. In the end I'm still moving the same amount of money, but one has tax implications?
They are both taxable, but at different times.
Recharacterization:
You recharacterize the Roth contribution as a traditional IRA contribution. The gains are moved to the IRA without tax. Assuming you don't take a tax deduction for the IRA contribution, you now have a basis in traditional IRAs. You can now do a "backdoor" Roth conversion (convert the traditional IRA back to a Roth IRA). The non-deductible contribution is not taxed but the gain is taxable, because the earnings are always taxable on such a conversion.
For example, you contributed $7000, it is now worth $7500. You recharacterize the contribution to a Traditional IRA, the custodian moves $7500. The recharacterization is not taxable. Then you do a Backdoor Roth conversion, you convert the entire $7500. The $500 of earnings is taxable as part of the conversion.
Removal and recontribution.
You "remove" the $7000 from the Roth IRA as an excess contribution. The custodian must also return the earnings, and they are taxable at that time. Then, you make a new $7000 contribution to a Traditional IRA, and do a backdoor conversion that is not taxable.
For example, you contributed $7000, it is now worth $7500. You remove the $7000 excess contribution, the custodian sends $7500 and $500 is taxable. Then you make a new contribution of $7000 to a Traditional IRA and do an immediate Backdoor Roth conversion, you convert $7000 which is not taxable, as long as there was no growth or interest for the couple of days it sat in the account.
Either way, the earnings are taxable.
Remember, both of these plans only work if you have no other deductible funds in any traditional IRA (even at a different bank). If you have a pre-existing IRA with tax-deductible contributions, we have a whole different problem to work through.
