Taxable amount for IRA distribution isn't showing correctly - standard conversion to Roth IRA and recharacterization to backdoor Roth IRA

[ab22txin]

$6000 was contributed to the Roth IRA which later ended up all being an excess contribution. The entire $6000 was recharacterized to a Traditional IRA the same year as it was contributed, 2022. The $6000 experienced a loss so only $5030.36 was actually transferred to the Traditional IRA. This amount in the Traditional IRA then had further losses to $4954.83 when it was converted back to the Roth IRA. 

Earlier in 2022 $4845.77 from the pre-existing balance in the Traditional IRA was converted to the Roth IRA. The pre-existing Traditional IRA funds originated from a rollover years prior. 

On the 1040 form, line 4b taxable amount, shows $6525.

Why is $6525 showing as taxable when only the $4845.77 conversion should have been taxable? The recharacterization with losses and subsequent conversion back to the Roth IRA should not have triggered any taxes. 

1099-R

Gross distribution:  $9800.60

2a Taxable amount:  $9800.60

2b Taxable amount not determined:  X

Total distribution ( )

3-6 are blank

7 Distribution code(s):  2

IRA/SEP/SIMPLE:  (X)

8-15 are blank

16 State distribution:  $9800.60

17-19 are blank

[fanfare]

to get a reduced taxable amount you need a prior basis allocable to your Roth conversion of $3,275.

Where did that come from?

@ab22txin 

[ab22txin]

That's what I don't know. I don't understand how that number was derived. When it asks about the total basis on 12/31/21 I entered zero because it says if you never filed a Form 8606, which I haven't, just enter zero. 

[dmertz]

The result implies that you did not have $0 in traditional IRAs at the end of 2022 but instead had $8,154 in traditional IRAs.  That would make the nontaxable amount of your $9,800 of Roth conversions be:

$9,800 * $6,000 / ($9,800 + $8,154) = $3,275

The taxable amount is then:

$9,800 - $3,275 = $6,525

and $2,725 of basis in nondeductible traditional IRA contributions remains in your traditional IRA(s) to be applied to future distributions.

[ab22txin]

You're right, there was about $8,154 in the traditional IRA at the end of 2022.

This also made me realize that I had the basis for the traditional IRA incorrect. I had a zero entered but it was actually $13,988. Now that I updated the basis my taxable amount is zero. 

What does the $6,000 represent in the formula below, Roth contribution? I presume my descriptions for the others are correct?

Total Roth Conversion * $6,000 / (Total Roth Conversion + Value at the end of 2022) = Nontaxable amount

Am I completely off base thinking that only the $4,845 should be taxable? This was the amount from the pre-existing balance in the Traditional IRA that was converted to the Roth IRA, before the recharacterization took place. It's my understanding that there shouldn't be any taxes due, since there were no gains, as result of the recharacterization and then conversion of those funds back to the Roth IRA. 

[fanfare]

@dmertz 

I think you're missing some parentheses in your formula there.

[dmertz]

@fanfare , the formula is fine (ignoring the newly mentioned $13,988 of basis).  Multiply then divide.

@ab22txin , are you saying that you had $13,988 of basis in nondeductible traditional IRA contributions carried in line 14 of your most recently filed Form 8606 which carries forward to line 2 of your 2022 Form 8606?  If so, you are correct that the taxable amount of the Roth conversion would be zero because your basis on line 3 of $19,988 exceeds the $17,954 that should be on line 9.  However, if your basis exceeded your balance in traditional IRA, it makes little sense that you did not convert everything to Roth.

[fanfare]

@dmertz 

ouch. multiply and divide are commutative.

I should know this. I got an A in algebra.

Now look at me. My brain is going.

[ab22txin]

I have never filed a Form 8606. This traditional IRA originated as a rollover from an old 401k. $13,988 was its basis at the time of the rollover in 2021, so I'm assuming that's the basis for these purposes, correct?

In 2022 I then began to convert some of it to a Roth, which ended up totaling $4845 before I paused that. Later come the recharacterization of Roth contributions and the conversion of those funds back to Roth. 

Looking at Form 8606 now I'm seeing where your numbers and logic is coming from and it would come out to zero taxable. That's assuming I'm not misunderstanding something.

Thank you very much for your help thus far!

[dmertz · Accepted solution]

Correct.  If you rolled over $13,988 of after-tax basis from the 401(k), after answering Yes that you have basis in nondeductible traditional IRA contributions, click the EasyGuide button, mark the box to indicate that you rolled over funds from an employer plan, then enter the $13,988 of basis acquired from the plan.  TurboTax will then prompt you for the required explanation statement for this adjustment to your basis in nondeductible traditional IRA contributions and will include the $13.988 on Form 8606 line 2.  Do not just directly enter the $13,988 as basis from previous years because without the required explanation statement because otherwise you will not have provided any information supporting the amount on line 2 (because it did not come from line 14 of a previously filed Form 8606).

[ab22txin]

Understood and these updates have now been made. 

Thanks so much for providing clarity and walking me through this!

[ab22txin]

@dmertz, I’ve slept on this for a few days and ran through things again and I think I must have gotten mixed up.

The $13,988 that was rolled over to a traditional IRA from an employer plan was pre-tax and would have been considered deductible. It was not after-tax, thus shouldn’t be considered nondeductible. Since it was pre-tax then when $4,845 was converted to Roth then that amount should be taxable, correct?

[ab22txin]

I think my primary issue here has been that I did not have a clear understanding of the IRA aggregation and pro-rata rules that state you cannot separate the portion that’s already been taxed from the portion that was deducted from taxes. Since there were existing balances in the Rollover IRA that were previously deducted contributions, it impacts the amount I would owe in taxes on the Roth conversion later.

I see that in my case it may have made sense to inquire about rolling over some or all of the Rollover IRA’s balance into a 401(k) so that it would not be considered in pro-rata calculations but it’s too late for that now.

I’m afraid my oversight here will end up costing me about $400 in taxes.

[dmertz]

Then my original reply on 2/9/2023 applies, assuming that $8,154 is your total 2022 year-end balance in traditional IRAs, including any amounts that remain of what was rolled over from the 401(k).

Having to include $6,250 in taxable income now means $6,250 less taxable income in the future and you still have basis in nondeductible traditional IRA contributions to reduce the taxable amount of future traditional IRA distributions and Roth conversions.

If you have a 401(k) that will accept the rollover of the pre-tax portion of your traditional IRAs, you'll be able to convert the remainder, applying all of your basis to reduce the taxable amount to zero.