Backdoor Roth "conversion" on money already contributed directly to Roth IRA

[thegoodreturn]

Earlier this year, I contributed the max amount to my Roth IRA directly, but due to a pretax to Roth 401k conversion, my taxable income will increase and I'll have to "convert" the Roth IRA contribution to a backdoor Roth to workaround the Roth IRA contribution income limit. I made the contribution several months ago, so I'm sure I will have some gains / losses.

What is the best way to go about "converting" my direct Roth IRA contribution to a backdoor Roth IRA contribution, and how would I enter it correctly in the TurboTax desktop edition?

[jtax]

You can either undo you contribution (plus earnings I think) or recharacterize your Roth contributions as Traditional IRA contributions.

For an article on this see https://www.investopedia.com/what-to-do-if-you-contribute-too-much-to-your-roth-ira-4770686

Your IRA custodian/broker should have forms or a webpage that allows you to instruct them to remove excess contributions or recharacterize contributions. This is something they do every day.

If this for the current tax year changing should be easy. It appears there are even ways to do this after filing your return (for a certain amount of time). But it should be much easier to get it taken care of before filing and why not in the same TY.

[thegoodreturn]

Thank you jtax. So it sounds like I'd recharacterize the Roth IRA to traditional. What would I do next to make it a backdoor Roth? Recharacterize it again, or is it a different process?

[jtax]

To address your question of how to do backdoor, I don't see why you couldn't convert from the Traditional IRA you use for the rechacterization.  Or if you just withdraw the excess funds make a new contribution (within the correct time for such contributions). But I could be missing something.

https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras

what you cannot do is recharacterize a Roth conversion to a traditional IRA.

[thegoodreturn]

When you say "I don't see why you couldn't convert from the Traditional IRA you use for the rechacterization" - does conversion from traditional to Roth an officially different process / term than recharacterization, which is the other way around?

I thinking about keeping the money in place to make sure this gets done by the end of the year and avoid the whole withdraw / deposit process. But maybe it's better if I do that so it's "cleaner"?

[jtax]

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@thegoodreturn wrote:

Thank you jtax. So it sounds like I'd recharacterize the Roth IRA to traditional. What would I do next to make it a backdoor Roth? Recharacterize it again, or is it a different process?

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I think you need to "convert" not "recharacterize" this Trad IRA to a Roth. Recharacterize is for just making switching a (current year?) contribution from one type to another. To do a backdoor the switch needs to be taxable.

See for example https://www.fidelity.com/retirement-ira/recharacterize , which says that you might recharacterize if (among other cases):

You originally contributed to a traditional IRA

BUT ...

you're within the income limits to get potential tax-free earnings from a Roth.

I think once the funds are in the Traditional you would convert those funds just like you would do for any Roth conversion. Usually the custodian has a form (often online these days).

Again, there could be something that prevents this, but I don't see any such exception.

[thegoodreturn]

Great, thanks! My IRA is at Vanguard so I'll have to check with them on their specific process.

[fanfare]

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 ( or Oct 15, 2025 if 1040 was timely filed or extended).
You will instruct trustee to calculate the allocable earnings.

Upon reporting a Trad IRA contribution (deductible or non-deductible)on your tax return, you can then also report a Roth conversion of the contributed amount for net tax of zero, unless your IRA already had a basis.

In that case, it can't be done tax free.

@thegoodreturn 

[thegoodreturn]

I called my custodian today. It looks like there are capital gains.

Can you help me understand why I need to pay taxes on the gains if we are taking it out of the Roth IRA just to essentially put it back in?

I'm having a hard time wrapping my mind around the concept: a direct Roth IRA contribution would not be a taxable event. A direct Roth IRA contribution recharacterization to traditional and back into Roth IRA has tax liability. In the end I'm still moving the same amount of money, but one has tax implications?

[fanfare]

positive earnings are ordinary income, not capital gains.

Besides recharacterization,

you can ask the custodian to return the contribution.

In that case, any positive earnings are returned and are taxable.

That's the end of it.

If you recharacterize, the earnings are ignored, until distributed from the Traditional IRA..

@thegoodreturn 

[Opus 17]

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@thegoodreturn wrote:

I called my custodian today. It looks like there are capital gains.

Can you help me understand why I need to pay taxes on the gains if we are taking it out of the Roth IRA just to essentially put it back in?

I'm having a hard time wrapping my mind around the concept: a direct Roth IRA contribution would not be a taxable event. A direct Roth IRA contribution recharacterization to traditional and back into Roth IRA has tax liability. In the end I'm still moving the same amount of money, but one has tax implications?

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They are both taxable, but at different times.

Recharacterization:

You recharacterize the Roth contribution as a traditional IRA contribution.   The gains are moved to the IRA without tax.  Assuming you don't take a tax deduction for the IRA contribution, you now have a basis in traditional IRAs.  You can now do a "backdoor" Roth conversion (convert the traditional IRA back to a Roth IRA).  The non-deductible contribution is not taxed but the gain is taxable, because the earnings are always taxable on such a conversion. 

For example, you contributed $7000, it is now worth $7500.  You recharacterize the contribution to a Traditional IRA, the custodian moves $7500.  The recharacterization is not taxable.  Then you do a Backdoor Roth conversion, you convert the entire $7500.  The $500 of earnings is taxable as part of the conversion.

Removal and recontribution.

You "remove" the $7000 from the Roth IRA as an excess contribution.  The custodian must also return the earnings, and they are taxable at that time.  Then, you make a new $7000 contribution to a Traditional IRA, and do a backdoor conversion that is not taxable.

For example, you contributed $7000, it is now worth $7500.  You remove the $7000 excess contribution, the custodian sends $7500 and $500 is taxable.  Then you make a new contribution of $7000 to a Traditional IRA and do an immediate Backdoor Roth conversion, you convert $7000 which is not taxable, as long as there was no growth or interest for the couple of days it sat in the account.

Either way, the earnings are taxable. 

Remember, both of these plans only work if you have no other deductible funds in any traditional IRA (even at a different bank).  If you have a pre-existing IRA with tax-deductible contributions, we have a whole different problem to work through. 

[jtax]

@Opus 17 In the case we are talking about (Roth IRA contributions recharacterized to Traditional IRA during the same tax year of the contribution) and in your first example (rechar $7000 Roth contrib + $500 NAI to Trad IRA)

am I correct in thinking that is the net effect is the same as making a $7500 contribution to the Traditional IRA?

If so then if that amount ($7500) is say, $500 over the taxpayer's traditional IRA max contribution, $500 (plus its own earnings) will have to be withdrawn as an excess contribution. Right?

[Opus 17]

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@jtax wrote:

@Opus 17 In the case we are talking about (Roth IRA contributions recharacterized to Traditional IRA during the same tax year of the contribution) and in your first example (rechar $7000 Roth contrib + $500 NAI to Trad IRA)

am I correct in thinking that is the net effect is the same as making a $7500 contribution to the Traditional IRA?

If so then if that amount ($7500) is say, $500 over the taxpayer's traditional IRA max contribution, $500 (plus its own earnings) will have to be withdrawn as an excess contribution. Right?

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A recharacterization is not a simple "contribution" because of the issue of earnings.  The contribution part that is recharacterized is subject to the usual limits, but not the movement of the earnings.   If the earnings were treated as part of the contribution, then recharactsrizations would only be practical in a declining market.  

While there ends up being $7500 of "new money" in the traditional IRA, the same thing would have happened if the taxpayer had contributed $7000 earlier in the year, which had earned $500 from market growth. 

[thegoodreturn]

@Opus 17 

Quick follow-on question: if I had originally contributed $6,000 to the Roth instead and had $500 of earnings, would the $500 of earnings still be taxed? It's not about the amount over the IRA contribution max ($7,000), but the issue of earnings, correct?

[fanfare]

the answer is in my first post above.

Please reread it.

" if I had originally contributed $6,000 to the Roth instead and had $500 of earnings,"

recharacterization gives you aTraditional IRA contribution of $6,000 on the same date as the original Roth contribution.

@thegoodreturn