@thegoodreturn wrote:
@Opus 17
Quick follow-on question: if I had originally contributed $6,000 to the Roth instead and had $500 of earnings, would the $500 of earnings still be taxed? It's not about the amount over the IRA contribution max ($7,000), but the issue of earnings, correct?
The $500 will be taxed sooner or later.
Let's assume for simplicity that you have no other traditional IRA accounts. If you do the recharacterization, the custodian moves the entire $6500 to a traditional IRA. The $6000 contribution becomes a contribution in the IRA, and the $500 becomes non-taxable earnings. If you don't take a tax deduction for the $6000 traditional IRA contribution, then you have a $6000 basis in the IRA.
Now, if you leave it alone for the rest of your life and withdraw it when you retire, the $6000 non-deductible portion is not taxed, but the earnings ($500 now plus anything else over the years) is taxed, like any normal IRA.
If you do a backdoor Roth conversion the next day, you would convert the entire $6500. $6000 is not taxable, since it is your non-deductible basis, but the $500 earnings is taxable, because that's how Roth IRA conversions work. That $500 is not allowed to be in the Roth in the first place, because it is the fruit of an unallowable contribution. You move it to the traditional IRA tax-free, then pay tax when you convert it back to the Roth. (If you only converted $6000 to a Roth, the pro rata rule means that $5540 of the conversion would be tax free, $460 would be taxable, and you would be left with $500 in the traditional IRA of which $460 would be non-taxable basis.)
Now, there is a way to leave all the funds in the Roth, and never pay tax on the $500 earnings. That would be by paying a 6% penalty on the ineligible contribution ($360). Then you pay an additional 6% every year that the ineligible contribution remains in the Roth IRA. Suppose your income is lower in 2025 and you are allowed to make a Roth contribution in 2025. The limit is $7000. You could contribute $1000, and treat the $6000 excess from 2024 as a 2025 contribution, "using up" the excess so you would not be subject to further penalties. That way all the Roth money stays in the Roth until you withdraw it tax free after age 59-1/2. However, I'm not sure paying a $360 penalty is worth avoiding $125 of income tax on the converted earnings.
