Determining earnings/losses on IRA recharacterization

[twoo0]

I accidently made too much last year and am not eligible to contribute directly to a Roth IRA for 2024. I maxed out my contributions for the year beforehand so now I need to recharacterize the $7000 that I put in. I requested all the securities purchased with the contribution and the remaining cash be recharacterized, but the broker is contesting that the amount I am recharacterizing does not accurately reflect the net income according to formula of  26 CFR § 1.408-11.

The numbers here are made up, but the situation is basically that immediately prior to contributing the $7000 to the IRA the various securities in the account were worth $10,000. After contributing, I purchased 10 shares of Stock A for $600 each, leaving $1000 cash left. In the time since that purchase, the value of the assets in the account went from $17,000 to now $20,000 without any additional trading, dividends, deposits or interest (only market value increase of the held assets). The net income based on previous the formula would then be $1235.29 (but the earnings due only to the Stock A purchases are much less).

Now I have requested that the broker recharacterize by transferring the 10 shares of Stock A purchased after the contribution plus the remaining $1000 cash, since transferring the stocks purchased with the contribution captures all of the earnings attributable to the contribution. They are saying however that if I do this then they won't report the full contribution as having been recharacterized since the current market value of the shares of Stock A plus the $1000 doesn't equal $7000 + $1235.29 = $8235.29. 

Surely this can't be correct, as recharacterizing $8235.29 would mean pulling income out of the account that is attributable to earlier years' contributions and not just the 2024 contribution. So what am I to do if they aren't going to provide the correct recharacterization amount on my tax forms?

[dmertz]

The gain/loss calculation is performed over the entire account balance, not any particular subset of investments in the account.  The performance of any one investment by itself is only relevant in how it contributes to the overall performance of the account.

In your example, the account opening balance is $17,000 and the account closing balance is $20,000.  That means that the $7,000 plus the attributable gain is simply:

$7,000 * $20,000 / $17,000 = $8,235.29

So $8,235.29 of value is the amount that must be moved from the Roth IRA to the traditional IRA to accomplish a recharacterization of the $7,000 contribution.  It doesn't matter what investments in the account are moved in kind,  or sold and the cash moved, to accomplish the movement of $8,235.29 of value.  The result is a recharacterization of $7,000 of your 2024 contribution.  (You are recharacterizing $7,000, not $8,235.29; $8,235.29 is the adjusted amount transferred.)

The Form 1099-R will have $8,235.29 in box 1 and $0 in box 2a and code R in box 7.  Your explanation statement required to be included with your 2024 tax return will need to show that you recharacterized your entire $7,000 contribution and $7,000 plus an attributable gain of $1,235.29 was transferred from the Roth IRA to the traditional IRA to accomplish this.

It's usually simplest to do the transfer in cash by selling in the Roth IRA whatever shares you choose to sell, transfer the $8,235.29 in cash, then use the $8,235.29 of cash in the traditional IRA to purchase whatever you want.

[twoo0]

Thanks for your response. My issue isn't really what type of assets I'm moving, it's the value of the ones purchased with the contribution. Even though $8,235.29 is what the formula spits out, it doesn't reflect the reality of what gain is attributed to the contribution. 

For example, the $3,000 gain that the account sees over the computation period is due to a $500 appreciation of the 10 stocks purchased with the 2024 contribution and a $2,500 appreciation of the stocks purchased prior to the contribution. More simply, that means the account would have gained $2,500 even if I made no contribution in 2024 and only $500 gain is reasonably attributable to the contribution. Since $500 is less than $1,235.29, recharacterizing based on the formula would involve pulling out gains that are obviously not attributable to the 2024 contribution. I assume that the excess would then be considered an early withdrawal or a similar taxable event.

So in this case do I just recharacterize the $7,500 ($7,000 contribution + $500 attributable gain), attach the explanation to the 2024 return, and disregard how the broker chooses to report the recharacterization on my future tax forms?

[fanfare]

"$7,500"

You must use the amount of the contribution to the first IRA.

When necessary, sell a few shares to have enough cash to meet the custodian's calculation.

[fanfare]

The former penalty on early withdrawal of positive earnings is no longer.

Recharacterization:

recharacterization: the original amount to the first IRA you report as contribution to the second IRA, earnings move but that is ignored.

report this on your tax return for the year during which the contribution was made.
Treat the contribution as having been made to the second IRA on the date that it was actually made to the first IRA.

Line 4b of form 1040 is not involved

[twoo0]

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@fanfare wrote:

"$7,500"

You must use the amount of the contribution to the first IRA.

When necessary, sell a few shares to have enough cash to meet the custodian's calculation.

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Not clear what you mean. The custodian's calculation is $8,235.29 based on the formula in 1.408-11. The real contribution+gain is $7,500. Are you saying that instead of $7,500, I should be trying to take out the $8,235.29 to satisfy the custodian, even though that's an incorrect formulation of the contribution gain?

[dmertz]

The custodian's calculation is correct.  I have no idea how you are coming up with $7,500.  If you are saying that the value of the shares of Stock A purchased with the $7,000 has now risen to $7,500, that is not how you are to determine the attributable gain.

"(but the earnings due only to the Stock A purchases are much less)."

This statement is irrelevant.  The calculation is is required to be done on the value of the entire account, not on the performance of any particular investment in the account..  

[twoo0]

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@dmertz wrote:

The custodian's calculation is correct.  I have no idea how you are coming up with $7,500.  If you are saying that the value of the shares of Stock A purchased with the $7,000 has now risen to $7,500, that is not how you are to determine the attributable gain.

"(but the earnings due only to the Stock A purchases are much less)."

This statement is irrelevant.  The calculation is is required to be done on the value of the entire account, not on the performance of any particular investment in the account..  

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It's because $500 is the value that the Stock A shares increased over the computation period. The other $2500 has nothing to do with the contribution being recharacterized.

To make it simpler for you, assume that the $7000 contribution was never used to purchase any sort of security and sat as $7000 cash from the date of contribution to the date of recharacterization. There would obviously be no gain attributable to the contribution in this situation. $7000 on the date of contribution would still be worth $7000 on the date of recharacterization. The account would have still increased by $2500 as a result of the assets previously in the account, just as it would have if no money had been contributed to the account at all during 2024. In this situation, the formula would say that the net income is $1,029.41, which obviously makes no sense since there is no gain from $7000 held in cash.

[dmertz]

Your account value increased by 17.647% over the computation period.  That means that your $7,000 contribution increased by the same 17.647%.  Moving funds around inside your IRA does not change this. The amount by which Stock A changed value is not involved in the computation.

[twoo0]

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@dmertz wrote:

Your account value increased by 17.647% over the computation period.  That means that your $7,000 contribution increased by the same 17.647%.  Moving funds around inside your IRA does not change this.

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I don't understand why you say that anything has moved around in the account. 7,000 -> 7,500 is a 7.143% increase despite the overall 17,000 -> 20,000 of 17.647%. But let's stick to the all cash scenario since that should be simpler.

So with $7,000 contributed in 2024 and held in cash through the recharacterization date, the $7,000 contribution becomes $7,000 while the account overall goes from $17,000 to $19,500. And somehow this means the $7,000 which is still $7,000 cash had a gain of 14.706%? Even though making no contribution at all would result in the same $2,500 increase?

[dmertz]

"7,000 -> 7,500 is a 7.143% increase"

This is entirely irrelevant to this computation, an irrelevant detail.  The computation is required to use the overall account value, not the value of any particular investment in the IRA.

See the definition of Adjusted Opening Balance and Adjusted Closing Balance in CFR 1.408-11(b):

https://www.law.cornell.edu/cfr/text/26/1.408-11#b

[fanfare]

Because the amount of attributable earnings is ignored  on your tax return, whatever the amount the custodian comes up with does not matter when filing.  That money is still yours, but it is no longer in a Roth IRA. You have to live with that. In the scheme of things, this is not a big deal. the universe will continue on.

[twoo0]

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@fanfare wrote:

Because the amount of attributable earnings is ignored  on your tax return, whatever the amount the custodian comes up with does not matter when filing.  That money is still yours, but it is no longer in a Roth IRA. You have to live with that. In the scheme of things, this is not a big deal. the universe will continue on.

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I'm just trying to establish what the correct way to recharacterize it is and avoid any issues down the road, no need to make it dramatic. There's definitely money to lose if I'm paying penalties for handling it in an indefensible way.

I would accept "tax law doesn't rely on legitimate mathematics" as the answer and the rule is apply the formula whether it's logical or not (and seemingly despite the definition of income attributable to), but that's only a reliable answer if the situation I am describing is well-understood which hasn't been demonstrated to be the case so far in this thread.

So consider this loose facsimile of the situation:

• IRA contains securities valued at $5000 immediately prior to contribution.
• $1000 contribution is made bringing the balance to $6000.
• Nothing is purchased with the $1000, it's simply cash with no net income up to the moment it is recharacterized.
• IRA is valued at $8000 immediately before recharacterizing the $1000 contribution ($2000 gain due to the initially $5000 assets).

Then the questions are:

• Do I instruct the broker to recharacterize $1000 because there is obviously no income attributable to the contribution, or do I instruct the broker to recharacterize $1333.33 because the rule somehow still applies in this situation?
• If the latter, what's the justification for applying the rule in this situation?
• If the latter, does the $333.33 "income" that lands in the traditional IRA require any special treatment when filing for 2025 or later? Count against contribution limits, taxed as income, etc.?

[dmertz]

Regarding the new example, the amount to ask to be recharacterize is $1,000, the same as the amount of the contribution.  The amount that the law requires to be transferred to accomplish a recharacterization of the $1,000 contribution is $1,333.33 because the entire account experienced a gain of 33.33%.  The $333.33 is treated as investment gains in the receiving account.

The gain or loss on individual investments doesn't matter.  All that matters is the overall gain or loss in the account during the computation period.  You could sell all of the original shares, buy different shares, hold cash, etc., and that doesn't change the calculation of the attributable net income.  All that matters is that the account was valued at $6,000 immediately after the contribution and that the account is valued at $8,000 when the recharacterization is performed, indicating a 33.33% gain.

Consider the case where you sold all of the original investments so that you had all cash in the account, then later purchased some other investment with all of the cash.  The result would be the same if at the time of the recharacterization the account value was $8,000, a gain of 33.33% from the $6,000 value immediately following the contribution.  The performance of then individual investments in the account is irrelevant to the computation (except for how they contribute to the overall gain or loss in the account).