How to compute backdoor Roth IRA capital gains?

[MJ2404]

I contacted Fidelity because I wanted to return the distribution of my traditional IRA back to my non-retirement account and they told me that I will pay taxes plus 10% penalty on the gains from the contributions that I have made from last month.  They suggested that why not do a backdoor contribution to my ROTH IRA and that way I will only pay taxes on the capital gains.  

My question is how do you compute the capital gains from the contributions that I made last month  if you do a backdoor ROTH?  I contributed $6k and they said it has a capital gain of more than $400 even though the cash was just sitting in my IRA account.  They said the IRS taxes me on the whole capital gains of my IRA account.

[dmertz]

CFR 1.408-11 describes the entire calculation:  https://www.law.cornell.edu/cfr/text/26/1.408-11

The calculation is performed over the investment performance of the entire IRA, not just the particular investment in which the contribution being returned was originally invested.  In the simplest case, if the entire IRA gained, say, 7% in value while the contribution being returned was in the account, the gains attributable to the contribution being returned is equal to 7% of the amount being returned.  For example, if you contributed $6,000 and the value of the entire IRA went up 7%, a return of the $6,000 is required to be accompanied by $420 of earnings for a total distribution of $6,420 from the IRA.  That $6,420 can come from any of the investments in this IRA account.

Fidelity will do the earnings calculation for you based on the IRA value on the date of the distribution of the return of contribution and earnings.  You'll just need to tell Fidelity from which investments to make the distribution.

The earnings distributed ($420 in the example above) will be subject to income tax and, if you are under age 59½, to a 10% early-distribution penalty.

[MJ2404]

Thanks for replying.  If I do the Backdoor Roth, should I transfer the $6000 contribution plus the capital gains from the traditional IRA or just the $6000?  Is there a article at Turbotax on how to do this on my Turbotax software?

[dmertz]

In my previous reply I should have said that a return of your traditional IRA contribution or recharacterization of your traditional IRA contribution to be a Roth IRA contribution instead has nothing to do with a backdoor Roth.  Recharacterization simply makes it as if the original contribution had been made to a Roth IRA, meaning that you must be eligible to have made the Roth IRA contribution based on your filing status and modified AGI for the purpose of a Roth IRA contribution.

You didn't say why you were considering a recharacterization.  

If you were ineligible to contribute to a Roth IRA because your MAGI is too high, you can get money into a Roth IRA by doing a Roth conversion from your traditional IRA.  The original traditional IRA contribution, would remain a traditional IRA contribution and the Roth conversion would be a separate transaction.  The taxable amount of the Roth conversion would be calculated on Form 8606.

If you are eligible to have made a Roth IRA contribution for 2020, it would be more beneficial to do a recharacterization than to do either a Roth conversion or a return of contribution.

[MJ2404]

Im not eligible for Roth IRA because my MAGI is too high.  My original plan was to request a “return of contribution” from Fidelity because I don’t want to contribute to my traditional IRA if there’s no tax benefits but they said that I will pay taxes on the capital gains if I do that so I was thinking why not do a backdoor Roth IRA and pay taxes on the capital gains now from the traditional IRA account then pay no tax once I convert my traditional IRA to Roth IRA. 

Does it make sense?

[dmertz]

The "backdoor" provides the maximum benefit only if you have no other funds in traditional IRAs at the end of 2021.  If you have other funds in traditional IRAs your Roth conversion would be largely taxable and some of your basis in nondeductible traditional IRA contributions will remain with your traditional IRAs to be applied to future distributions or Roth conversions.  Your 2020 tax return will include Form 8606 to report only the nondeductible traditional IRA contribution.  The Roth conversion will be taxable in on your 2021 tax return with the taxable amount calculated on the 2021 Form 8606.  Line 14 of your 2020 Form 8606 will carry forward to line 2 of your 2021 Form 8606 to be used in that calculation.

[MJ2404]

I found article online and it shows how to do a backdoor Roth in Turbotax:

https://thefinancebuff.com/how-to-report-backdoor-roth-in-turbotax.html

It mentions about 1099-R form.  I don't have this form from my 2019 tax returns.  Can I skip this section?  I opened my traditional IRA last year 2019.  If I want to convert everything to Roth IRA, where or what steps should I start in Turbotax?

[dmertz]

If you do a Roth conversion in 2021, you'll receive a code 2 2021 From 1099-R near the end of January 2022 that you'll report on your 2021 tax return.  Is you convert all of your traditional IRA(s) to Roth, which would seem to make sense in your case, all of your basis in nondeductible traditional IRA contributions made for 2020 would be applied to your 2021 Roth conversion as I described in my previous reply.

I wish that people would stop referring to a "backdoor" Roth.  It's nothing more than a Roth conversion after having made a traditional IRA contribution.  Roth conversions are reportable on the tax return for the year in which the Roth conversion is performed.

If you choose not to obtain a return of the traditional IRA contribution that you made for 2020, simply enter the traditional IRA contribution into 2020 TurboTax and let TurboTax automatically generate Form 8606 with the result being contribution being included on line 14 to be carried forward to line 2 of your 2021 Form 8606.

[MJ2404]

Okay got it.  Thanks for all the help.  I really appreciate it.