Mistakenly opened Rollover IRA instead of Roth

[Bbrun200587]

My wife mistakenly opened a rollover ira instead of a Roth IRA five years ago. She has funded every year.  We never took a deduction on our taxes. Can we convert this to Roth with out a tax penalty? What are our options?

[fanfare]

if you never took a deduction you can amend to add the correct Form 8606 for those years.

You can convert all or part of your IRA to a Roth IRA.

If the rollover IRA started with any non-zero amount due to a rollover, you won't be able to convert to a Roth without tax impact.

@Bbrun200587 

[fanfare]

If your Rollover  IRA has been growing for five years, as it should, any amount converted will include partly growth (taxable)  and partly non-deductible contributions (not taxable).

See Form 8606. You must use the calculation on Form 8606.

@Bbrun200587 

[fanfare]

"She has funded every year."

Funding allocated to 2024 can be reassigned to a Roth IRA using the recharacterize request to your custodian.

recharacterization: the original amount to the first IRA you report as contribution to the second IRA, earnings move but are ignored.
You must use a trustee-to-trustee transfer before the due date April 15,2025.
You will instruct trustee to calculate the allocable earnings.

@Bbrun200587 

[Bbrun200587]

Do you mean that I will owe taxes on the gains?

[fanfare]

Do you mean that I will owe taxes on the gains?

See Form 8606 for the taxable amount of a conversion.

A recharacterization is not a conversion.

@Bbrun200587 

[fanfare]

It's hard to create a Rollover IRA accidentally.

A Rollover IRA starts out with a deposit from somewhere else.

If the IRA in question is funded entirely by the non-deducted contributions and you convert 100% to a Roth IRA,

then yes you will pay tax on the gains.

@Bbrun200587 

[Bbrun200587]

Thanks for your help. The original story is long but I assure you, it was an oversight. The account started with a zero balance, no money was every transferred, only deposits from her checking account. Last question, would it be taxed as ordinary income or at a capital gains rate? 

[fanfare]

Any distribution  from an IRA is ordinary income.

before converting you would have to give the correct 8606 forms to IRS by amendment as noted in the beginning.

@Bbrun200587 

[Bbrun200587]

Thanks for your insight. 

[fanfare]

The proper way to file Form 8606 is attached to Form 1040-X.
Form 8606 can be mailed by itself only when you are otherwise not required to file a tax return.

You'll have to start with the earliest year since your basis is cumulative

Do you have the correct taxable amount on Form 1040 Line 4b and did not take a deduction? (Schedule 1 Line 20)?
If that is all true then only Form 8606 has to be attached.
After you e-File,
get Form 1040-X from IRS website and mail it in with your 8606, which you can also get in fillable PDF.
Note: when you are not changing any dollar amounts on your amending 1040-X, you can leave all the lines 1-23 EMPTY.

Part III explanation: "on original return, Form 8606 missing or incorrect".
Done this way, you sign 1040-X, not 8606.
Do not include your old 1040 nor your revised 1040 because the Form 1040-X reflects any changes there and becomes your new tax return. In this case there is no revised 1040.

@Bbrun200587 

[Opus 17]

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@Bbrun200587 wrote:

Thanks for your help. The original story is long but I assure you, it was an oversight. The account started with a zero balance, no money was every transferred, only deposits from her checking account. Last question, would it be taxed as ordinary income or at a capital gains rate? 

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What you are asking is to do a conversion from a traditional to a Roth IRA account.  By default, the conversion is always taxable.  If you can prove you made non-deductible contributions, that part of the conversion will be non-taxable, but the gains (which have been growing tax-free) will be taxable.

You prove that your contributions were tax-deductible by filing form 8606 each year that you made non-deductible contributions.  So at a minimum, you need to go back 5 years and file amended tax returns to report the non-deductible contributions and generate a form 8606 for each year.  Each form will build off the previous one, if you opened the account in 2019, you need a form 8606 for 2019.  Then if you contributed in 2020, you will take the info from the 2019 form 8606 plus the new contribution info to generate a new form 8606 for 2020, and so on.

(For your 2021, 2022 and 2023 tax returns, it would be possible to amend your returns to take the tax deduction and get a refund.  But then, much more of the conversion will be taxable and you will just have to pay that refund back as taxes when you do the conversion.)

File all the amended returns separately.  You will need to prepare 2019 and 2020 by hand or seek another tax preparer, because turbotax is not supported that far back.  Keep copies of the form 8606s with your other important tax papers for 7 years after the Roth conversion, in case of audit.  

For the 2024 contribution specifically, you can leave it in the account, or remove it.  But it won't really hurt to leave it in, since there won't be very much earnings from a recent contribution and if you don't take the deduction, it won't be taxable.

Then, you will be prepared to do the conversion.  The simplest thing is to convert the entire account to a Roth.  Suppose that over the years, you made $38,000 of non-deductible contributions and the account balance is $60,000 due to gains.  The $38,000 conversion is tax-free and the other $22,000 will be taxable.  However, you are not allowed to only convert the contributions.  All conversions are pro-rated, so if you did try to convert a smaller amount, it would still be 63% tax-free and 37% taxable.   The conversion, the non-deductible portion and the taxable portion will be reported and calculated on your 2024 tax return, assuming the conversion is done during 2024.