I contributed to Traditional in 2019, but not able to deduct due to AGI limit

[imbhavik]

HI,

In Jan 2019, I contributed $6000 to 2019 Traditional IRA account. In Jan 2020, when I started to file my taxes, I realized that my AGI is above $203,000. Due to that, I am not able to get deductions for Traditional IRA contributions I did in 2019.

So, now, what should I do with this investment? 

Will I get any penalties because I contributed to traditional IRA account and was not able to deduct it?

If No penalty, what will happen to this contribution at the time of retirement, will I still owe taxes on it? (even though I did not get deduction)

What are the other options for this contribution?

[fanfare]

you can remove an excess contribution by the due date of your return 

if you don't take the deduction,

and you tell the custodian to remove it for you.

If your funds made any money, you'll get that back too and pay income tax on it

[AlexanderS08]

I recommend you look into a backdoor Roth IRA.

It will allow you to convert the excess contribution to a Roth IRA. Also, if you do not take the money out (or do a backdoor Roth) then you will have a penalty on the excess contribution. You can avoid the penalty as long as you address the excess contribution by April 15, 2020. Here is more info on the backdoor Roth process:

 Backdoor Roth IRA

[imbhavik]

Thanks for the quick response. 

In order to do backdoor Roth IRA, is there a timeline in which I need to transfer to be considered as rollover and not recategorization? 

I contributed in Jan2019 and now if I move it to Roth IRA, will it be considered as recategorization or rollover?

Will there be any tax penalties if I move to Roth IRA?

While filing the taxes through Turbotax,  I did not get option to specify that I contributed to IRA traditional but then rollover to Roth IRA. It provides only option for recategorization and in that, it says that I have to pay 6% tax penalty for excess contribution. 

Thanks.

[macuser_22]

Keep two things in mind.

1) A recharacterization is done in the Traditional IRA contribution section that says you changed your mind and applied the contribution to a Roth IRA instead.   It simply means that the Traditional IRA contribution never occurred but the contribution was to a Roth IRA instead.  Only the trustee of the Traditional IRA can preform the recharacterization.  HOWEVER, if your Traditional IRA deductions are limited by your MAGI, then probably your MAGI is too high to even make a direct Roth contribution.

2) Hence, this is where the "backdoor Roth" comes up.    A Backdoor Roth is a way to make a NON-DEDUCTIBLE Traditional IRA  contribution and then to immediately convert the Traditional IRA to a Roth IRA so that the non-deductible distribution from the Traditional IRA offsets the tax on the Roth conversion thus gets the money into the Roth just as if you made a direct  Roth contribution (that you cannot)

There is a HUGE pitfall to this if you have any existing Traditional, SEP or SIMPLE IRA accounts. 

This so-called “back-door Roth” method ONLY works if you have NO OTHER Traditional IRA accounts. If you do, then the non-deductible part must be spread (prorated) over ALL accounts and cannot be withdrawn by itself. Only if you started with NO Traditional, SEP & SIMPLE IRA and ended up with a zero amount in ALL Traditional, SEP & SIMPLE IRA accounts will this Roth conversion not be taxable. 

[imbhavik]

HI,

Sorry for the late response as I was out..

1. In this case, when I convert fund from Traditional IRA to Roth IRA and its considered as Backdoor Roth IRA or Rollover Roth IRA and NOT recategorization of Traditional IRA to Roth IRA, then when I am filing the taxes for 2019, how do I show rollover to Roth IRA in tax return for 2019? OR do I really need to show anything?

2. I read in your response as well as in other post online somewhere that Once I have contributed to Traditional IRA, I have to immediately rollover to Roth IRA to be considered as Backdoor Roth IRA. What is the duration required for the term "Immediately"? Is there any time limit in which I have to rollover?

FYI... I had contributed in Jan 2019 for 2019 Traditional IRA and now it is Feb 2020.

Thanks.

[macuser_22]

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@imbhavik wrote:

HI,

Sorry for the late response as I was out..

1. In this case, when I convert fund from Traditional IRA to Roth IRA and its considered as Backdoor Roth IRA or Rollover Roth IRA and NOT recategorization of Traditional IRA to Roth IRA, then when I am filing the taxes for 2019, how do I show rollover to Roth IRA in tax return for 2019? OR do I really need to show anything?

2. I read in your response as well as in other post online somewhere that Once I have contributed to Traditional IRA, I have to immediately rollover to Roth IRA to be considered as Backdoor Roth IRA. What is the duration required for the term "Immediately"? Is there any time limit in which I have to rollover?

FYI... I had contributed in Jan 2019 for 2019 Traditional IRA and now it is Feb 2020.

Thanks.

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1) Since you make a 2019 Traditional IRA contribution that is not deductible, you enter that contribution  into the IRA contribution section and if the interview question asks if you want to deduct it mark it non-deductible (that question will not come up if your MAGI prevents a deduction).  That will automatically produce a 2019 8606 form with the non deductible amount on line 1.

If you had the Traditional IRA converted to a Roth before Dec 31, 2019 the you should have a 2019 1099-R to enter on your 2019 tax return to report it.

If you are doing the conversion in 2020 the  you will report the conversion and 2020 1099-R next year on your 2020 tax return

2) "Immediately"  just means that any earnings that the contribution earns will be taxable when converted.  There is no time limit as long as you understand that there could be some taxable earning converted if there are earnings. 

(Most people doing a true backdoor Roth conversions make the non-deductible contribution and then do the conversion at the same time with the account trustee so there can be no earnings, but you can wait as long as you want.)

[imbhavik]

Thank you for the answer.

So for the 1st point, as I am planning to do Roth IRA rollover in 2020, in 2019 tax return, I just specify 2019 Traditional IRA contribution and at the end of the interview questions, it shows the message that my contribution is NON-DEDUCTIBLE. That is all I need to do for 2019, correct?

And when, 2020 tax filling season comes, at that time, I need to enter the details about 1099R details and they will apply any taxes on the earnings I had on the contribution from Jan 2019 (that is when I contributed) till Feb 2020 (that is when I plan to rollover) correct?

For point#2, It is cear now about Immediate factor. In my case, I need to bear the taxes on the earnings which I will be paying in 2020 tax return right?

[macuser_22]

Correct on all points.

[imbhavik]

Thank you for the confirmation.

I thought all questions covered, but then last one popped up...

When I do backdoor Roth IRA (legal term Roth IRA conversion), I have to convert $6000 which I contributed in 2019 OR $6000 + any earnings happened on $6000 from Jan 2019 till the date when I convert to Roth IRA?

If I have to do $6000 + earnings, then how would we determine earnings?

I did talk to the firm holding my account and they said that I have to determine earnings by myself for conversion. If I were to do recharacterization  or excess removal, then they can calculate it for me, but NOT for Traditional IRA to Roth IRA conversion.

Thanks.

Thanks,

Bhavik

[imbhavik]

HI,

I have been reading multiple posts online to see what option makes better for me.

I have some amount (e.g. $50,000) in IRA which I deducted for tax in the past years. I have $6000 in IRA which originally meant for deduction but it would be considered NonDeductible due to AGI limit.

Now, if I do the Roth IRA conversion (backdoor Roth IRA), after tax amount gets considered only little aprx. $500 and rest $5500, I have to pay taxes next year when I receive 1099-R form.

That means, even though I am converting ONLY NonDeductible amount, due to aggregation rule, it considers all my IRA amount and only considers $500 as tax free amount.

So, I do not see much benefit in doing conversion.

That being said, now, I am thinking more to keep the NonDeductible amount in the IRA account AS-IS... But, will there be any tax penalties or any issues in the future? 

Thanks,

Bhavik

[macuser_22]

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@imbhavik wrote:

Thank you for the confirmation.

I thought all questions covered, but then last one popped up...

When I do backdoor Roth IRA (legal term Roth IRA conversion), I have to convert $6000 which I contributed in 2019 OR $6000 + any earnings happened on $6000 from Jan 2019 till the date when I convert to Roth IRA?

If I have to do $6000 + earnings, then how would we determine earnings?

I did talk to the firm holding my account and they said that I have to determine earnings by myself for conversion. If I were to do recharacterization  or excess removal, then they can calculate it for me, but NOT for Traditional IRA to Roth IRA conversion.

[One point to clarify:  You originally stated that you could not deduct your Traditional IRA contribution because your MAGI was above $203,000.   That is the limit to *contribute* to a *Roth* IRA.  The deduction MAGI for a Traditional IRA is $123.000 but ONLY if you are covered by a retirement plan at work (box 13 checked on W-2 form) or a self-employed retirement plan.  If not covered but a spouse is covered then the limit is $203.000. If neither spouse is covered then there is no limit.]

Your MAGI of $203,000 would prohibit any direct Roth contribution which would also prohibit a characterization to a Roth so that is not an option as I pointed out above.

If the ONLY money in your Traditional IRA is the $6000 contribution plus any earnings, then  when  you convert ALL the money in the Traditional IRA to a Roth, however much more than the $6,000 would be the earnings.   The earning will be a taxable conversation - there is no need to have to calculate the earnings.

As I pointed out above in "huge pitfall", if the Traditional IRA already has other money in it and/or has a year end value more then zero after the conversion,  then the backdoor Roth will not work and only a small amount will not be taxable.

[macuser_22]

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@imbhavik wrote:

HI,

I have been reading multiple posts online to see what option makes better for me.

I have some amount (e.g. $50,000) in IRA which I deducted for tax in the past years. I have $6000 in IRA which originally meant for deduction but it would be considered NonDeductible due to AGI limit.

Now, if I do the Roth IRA conversion (backdoor Roth IRA), after tax amount gets considered only little aprx. $500 and rest $5500, I have to pay taxes next year when I receive 1099-R form.

That means, even though I am converting ONLY NonDeductible amount, due to aggregation rule, it considers all my IRA amount and only considers $500 as tax free amount.

So, I do not see much benefit in doing conversion.

That being said, now, I am thinking more to keep the NonDeductible amount in the IRA account AS-IS... But, will there be any tax penalties or any issues in the future? 

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Exactly.  As I pointed out above the "Backdoor Roth" only works of the Traditional IRA value is zero at the start and zero at the end.

You can NEVER withdraw ONLY the nondeductible part - it must be prorated over the entire value of ALL Traditional IRA accounts which include SEP and SIMPLE IRA's. (For tax purposes you only have ONE Traditional IRA which can be split between as many different accounts as you want, but for tax purposes they are all added together).

For example using rough figures: if you had $60K of nondeductible contributions in an IRA with a total value of $600K (10:1 ratio), then when you take a $60K distribution from any IRA account $6,000 would be nontaxable and $54,000 would be taxable (same 10:1 ratio) , with the remaining $54K of basis staying in the IRA for future distributions. As long as there is any money in the IRA, there will be some basis.

TurboTax will ask for your non-deductible "basis" and then the *Total Value* of *all* Traditional IRA, SEP and SIMPLE accounts as of Dec 31, of the tax year. That is so the prorating of the basis can be properly proportioned between the current years distribution and the remaining IRA value. That is done on the 8606 form.

[macuser_22]

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@imbhavik wrote:

That means, even though I am converting ONLY NonDeductible amount, due to aggregation rule, it considers all my IRA amount and only considers $500 as tax free amount.

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If you have $50,000 in the IRA to start then:

$6,000 * $6,000 / ($50,000 + $6,000) = $624.86 tax free and $5,357.14 taxable.