Tax and penalties applicable when doing Roth IRA -> Traditional IRA -> Roth IRA

[Guavalord54]

Hi, here's a quick timeline of events and the questions I have:

1. In 2022, I contributed $6000 (the max) for my 2022 Roth IRA account and invested the cash into various mutual funds.
2. In 2023, I recharacterized all the 2022 Roth IRA "in kind" into a Traditional IRA due to income limits. As I had $100 of earnings, a total of $6100 ($6000 original contribution + $100 earnings) was put into Traditional IRA.
3. A few days after the recharacterization, I converted the Traditional IRA back to Roth IRA. As I had an additional $50 of earnings, a total of $6150 ($6100 + $50) was put into my Roth IRA account. 
4. All of the above has been done before tax deadline plus extentions 

Based off this sequence of operations, I want to know what tax and penalites I can expect.

1. Will I incur any 10% early distribution penalty given the above has been done before tax deadline plus extentions?
2. My understanding is that any applicable taxes here will be at ordinary income tax rates. How do taxes work on earnings in this senario? Is it the case that taxes will calulated as the delta between the original contribution ($6000) and the value that is taken out after each conversion/recharacterization? E.g. recharacterzation event earnings yeild ($6100 - $6000) = $100  and the conversion event yeild ($6150 - $6000) = $150 so taxes would be ($100 * taxes) + ($150 * taxes). Or would it be the case that the taxes are calculated as the delta between the value I put in and the value that is taken out after each conversion/recharacterization? E.g.  recharacterzation event earnings yeild ($6100 - $6000) = $100 and the conversion event yeild ($6150 - $6100) = $50 so taxes would be ($100 * taxes) + ($50 * taxes). Or is neither the case? 
3. My brokerage says I will get the tax docs related to theese events in Feb 2024 given I executed the above operations in 2023. Would all taxes and penalites be only applicable for tax year 2022 and I need to report as such on my 2022 tax return, meaning I should expect no taxes of penalites related to the above operations for tax year 2023?

[fanfare]

recharacterization: the original amount to the first IRA you report as contribution to the second IRA, earnings move but are ignored.
report this on your tax return for the year during which the contribution was made.

"Will I incur any 10% early distribution penalty given the above has been done before tax deadline plus extentions?"

This is my understanding based on my research.

[positive earnings removed are no longer penalized 10% if you are under age 59 1/2. (eliminated in 2023)
You must have a) filed by tax day, or b) requested an extension of time to file by tax day.]

I'm not sure the two sentences in brackets are correct so I'll ask @dmertz to confirm or clarify.

@dmertz 

@Guavalord54 

[dmertz]

I'm not sure what you mean by "2022" Roth IRA.  The attributable gain or loss is determined over the entire account, not just the investment that you made with the excess contribution unless the account contains nothing but the excess contribution.  I'll assume that you mean that you contributed $6,000 to a previously empty Roth IRA account.

You then apparently did a recharacterization of your Roth IRA contribution to be a traditional IRA contribution instead by moving the entire contents of the Roth IRA to a traditional IRA.  There is never a penalty on a recharacterization.  Your $6,000 Roth IRA contribution became a $6,000 traditional IRA contribution and the $100 of earnings in the Roth IRA became $100 of earnings in the traditional IRA.

If your traditional IRA contribution was nondeductible (resulting in $6,000 on line 14 of your 2022 Form 8606) and you have no other funds in traditional IRAs, the $6,000 of basis in nondeductible traditional IRA contributions reduces the taxable amount of your $6,150 Roth conversion in 2023 to $150 on your 2023 Form 8606.

[Guavalord54]

Thanks for the prompt reply. 

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@dmertz wrote:

I'm not sure what you mean by "2022" Roth IRA... I'll assume that you mean that you contributed $6,000 to a previously empty Roth IRA account.

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To be clear, I contributed $6000 to my Roth IRA for the 2022 tax year. That same Roth IRA account previously had $20,000 inside from previous tax years. 

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The attributable gain or loss is determined over the entire account, not just the investment that you made with the excess contribution unless the account contains nothing but the excess contribution. 

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As for this,  I was attempting to just isolate the $6000 I contributed for tax year 2022 in my Roth IRA account and not for any previous years. The following is an explaination of how my brokerage calulcates the attributable gain or loss from the $6000: "The
earnings or loss applicable to the recharacterization were calculated based on the method outlined in IRS
Notice 2000-39 and IRS Final Regulation 1.408-11. The calculation is based on the total earnings in
your IRA during the period the IRA held the contribution or conversion-specifically from the business day
immediately prior to the contribution or conversion deposit date to the business day immediately prior to
the date you recharacterize, known as the computation period. " 

Would any of the info I provided change the taxable amount you helpfully suggested? 

[fanfare]

the allocable amount of earnings is to be calculated by the custodian of the account.

It will be on your 1099-R. You can rely on that, as will the IRS.

If you want the amount ahead of time, call the custodian or consult your monthly statement.

@Guavalord54 

[dmertz · Accepted solution]

Because the attributable earnings must be calculated over the investment performance of the entire account, unless all of the money in the Roth IRA was invested in the same investment, an in-kind movement to the traditional IRA of exactly the same shares as were purchased with the $6,000 excess contribution would likely not meet the requirements of a recharacterization that would correct the excess Roth IRA contribution.  However, if the brokerage calculated the attributable earnings over the investment performance of the entire account and then did an in-kind transfer of a number of shares having a total value on the date of the transfer equal to $6,000 plus the calculated gain (or loss), that would satisfy the requirements of CFR 1.408-11.

In your case, the $100 gain would need to have been determined based on the overall investment performance in the Roth IRA, not just the performance of the shares that were moved in the in-kind transfer to the traditional IRA.  Done as an in-kind transfer, the transfer would then have to consist of any shares from the Roth IRA having a value of $6,100 on the date of the transfer.

[fanfare]

@dmertz 

I've seen elsewhere the conditions  a) and b) I quoted in [brackets] above.

but I'm  confused. 

can you carify under what situations, a) and b) apply?

I think fhis is for taking an excess out after tax day, but before extension day.

Otherwise the rule for removal after tax filing date applies.

[Guavalord54]

if the brokerage calculated the attributable earnings over the investment performance of the entire account and then did an in-kind transfer of a number of shares having a total value on the date of the transfer equal to $6,000 plus the calculated gain (or loss), that would satisfy the requirements of CFR 1.408-11.

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I beleive this is what the brokerage recharacterization tool was doing as described by their process I quoted in my previous reply. 

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In your case, the $100 gain would need to have been determined based on the overall investment performance in the Roth IRA, not just the performance of the shares that were moved in the in-kind transfer to the traditional IRA.  Done as an in-kind transfer, the transfer would then have to consist of any shares from the Roth IRA having a value of $6,100 on the date of the transfer.

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The in-kind transfer here meant I had to provde my brokerage an ordering of the shares in my Roth IRA to transfer over to the traditional IRA. The shares woiuld be transfer in-kind following the provided order until all of the calculated contribution plus or minus earnings and loss were covered. E.g. First transfer all of money market position, then transfer all of mutual fund position, lastly transfer stock position. 

[Guavalord54]

@fanfare 

Seems like your brackets sentence is correct; this is what I found online: "Section 333 of the SECURE 2.0 Act (SECURE 2.0) exempts the excess contribution and earnings allocable to the excess contribution from the 10% additional tax on early distributions, and is effective for any determination of, or affecting, liability for taxes, interest, or penalties which is made on or after December 29, 2022, without regard to whether the act (or failure to act) upon which the determination is based occurred before such date." 

[dmertz]

@fanfare , section 408(d)(4) allows a return of contribution to be made by the due date of the tax return, including extensions.  Section 301.9100-2 provides an automatic extension to make a statutory election if the tax return was filed by the regular filing deadline.

[fanfare]

Therefor, if you did not file by April 15, and you did not request an extension,

you must use Form 5329 to carry forward your excess and pay 6% penalty.

@dmertz  

[dmertz]

@fanfare , that's correct.

[Guavalord54]

I did not file by April 15, but I am in an area which received an automatic extention to Oct 16, so I don't believe any penalties or carry forward is needed. 

Thanks for the help!