Converting traditional IRA contribution to Roth

[kbda]

I have only recently learned about Roth IRA's and would like to re-characterize my 2023 traditional IRA contribution of $7500 as a Roth IRA contribution instead.  The $7500 was contributed into a Schwab traditional IRA in January 2023 and has made minimal gains since then. I checked with Schwab regarding a same-trustee transfer from traditional to Roth and they said they can process the transaction as an IRA recharacterization. I understand that 2023 federal and state income tax will be owed on the $7500 once it's recharacterized as a Roth. I know that we will have enough deductions and tax credits so that the additional $7500 won't make a significant difference, if any (perhaps a slightly smaller refund). However,  I am concerned about unnecessarily complicating our 2023 taxes because of any possible gains (though with recent volatility I think those gains were minimal). Will we just need to file the Form 8606: Nondeductible IRAs when we file our taxes or is there something additional that will need to be completed due to the conversion?  Can the regular Turbotax product handle this conversion or will I need additional help?  I just want to make sure I'm not missing any crucial detail prior to completing this conversion.  If it becomes too complicated, I will likely just wait until 2024 to open a Roth IRA rather than converting this year's contribution.

[dmertz · Accepted solution]

You mention possibly performing one of two entirely different types of transactions:  conversion and recharacterization.  You seem to be proposing a recharacterization and are misusing the word "conversion" to mean recharacterization.

A recharacterization from traditional to Roth makes it as though your original contribution was deposited into a Roth IRA instead of to the traditional IRA, subject to the normal MAGI limitations on making a Roth IRA contribution.  A Roth conversion retains the traditional IRA contribution and involves a taxable distribution and rollover to a Roth IRA.  The difference is in how any investment gain or loss on the earnings is treated and the type of basis created in the Roth IRA.  With a recharacterization the investment gain or loss while in the traditional IRA simply becomes investment gain or loss in the Roth IRA.  With a conversion any investment gain while in the traditional IRA is taxed and becomes conversion basis in the Roth IRA.

Since you'll be doing either of these transactions in 2023 with regard to your 2023 traditional IRA contribution, neither is difficult to enter into TurboTax.  There is no significant difference in the complexity in reporting these two types of transactions except that with a recharacterization TurboTax will prompt you to provide a simple explanation statement describing the recharacterization.

With investment gains while in the traditional IRA, it probably makes more sent to do a recharacterization instead of a conversion to get the advantage of having Roth IRA contribution basis instead of conversion basis in the Roth IRA.  If there was a substantial loss while in the traditional IRA it might make sense to do a Roth conversion instead, saving some in taxes but creating conversion basis instead of regular contribution basis.  Conversion basis would have to remain in the Roth IRA until 2028 before it could be taken out penalty-free before age 59½.

If your MAGI relative to your filing status does not permit a Roth IRA contribution for 2023, conversion is your only option.

Regarding Form 8606, a recharacterization to a Roth IRA does not involve Form 8606.  On the other hand, a Roth conversion must be reported on Form 8606.  TurboTax automatically prepares Form 8606 when your contribution and Form 1099-R entries indicate that it is required.

[kbda]

Thank you for clarifying. Yes, I'm wanting to recharacterize the 2023 contribution as Roth rather than traditional, so this would be a recharacterization, not a conversion. I actually don't know if the $7500 I contributed in January has gained or lost overall, since it's part of a larger traditional IRA.  However, from a tax perspective, our MAGI is well below the Roth limits, so it's not likely to make a difference in our tax bill either way. 
One follow up question: if I perform a recharacterization of the 2023 contribution from traditional to Roth, will this amount be subject to the 5-year requirement prior to taking a penalty-free withdrawal? Or does the IRS essentially consider this contribution as having been a Roth contribution from day one?

Thank you so much for your assistance.

[dmertz]

If you recharacterize, the original contribution becomes a Roth contribution instead of a traditional IRA contribution.  You obtain a distribution of your regular Roth IRA contribution basis anytime, free of any penalty.  Contribution basis comes out of your Roth IRAs first.

[opwave]

Hi, @dmertz,

I have a similar issue that touches on your explanation and I'm hoping you could help me out.

I created a Traditional IRA account in 2023 and deposited $3000 of post tax money into it. Later same year, I converted the account to my roth ira. It appears they actually did a conversation rather than recharacterization because on 1099R they sent me, the code is "2" instead of what I assume should be "N". As a result, TurboTax wants to use he entire distribution as taxable income including the gain ($3500) rather than just $500 gain. Is there a way to fix this? How do I enter it in TurboTax? (I did not see form 8606 in my brokerage tax documents)

[fanfare]

"I converted the account to my roth ira. "

If you asked the custodian for a conversion, that's what they will do.

If you asked for a recharacterization, and they did not do it, that sounds like a trustee error.

@opwave 

[opwave]

@fanfare 

Yeah I think it was a miscommunication error due to my ignorance. Broker indeed converted the account instead of re-characterizing it.

[dmertz]

If the traditional IRA contribution was made for 2022, it needed to be reported on your 2022 tax return.  If nondeductible, that reporting would be on a 2022 From 8606.  If the contribution was made for 2023, the traditional IRA contribution would need to be reported on your 2023 tax return on Form 8606.  In either case, do not say that you "switched" (recharacterized) contribution.

The Roth conversion is reportable on your 2023 tax return, Form 8606.

[fanfare]

if you elect "non-deductible" on your $3,000 , you will pay tax only on $500.

@opwave