IRA Recharacterization after losses

[JeuneCracoucas]

Hi there,

Due to an increase in my wife's salary, the $6k Roth IRA contribution for 2022 that I made last year is not valid any more. I'm not 100% sure but it seems like I have 2 ways:

1) I could recharacterize to a TIRA, and then do a Roth conversion. I suspect I had losses because I had invested these $6k in VTSAX - I think Vanguard can calculate that. Say the amount is $5k. If I do a Roth conversion right after recharacterizing my 2022 Roth IRA contribution, I will end up with $5k in 2022 Roth IRA contribution. And a bunch of tax forms to file.

2) Apparently, I could also request the contribution be returned as an excess contribution rather than recharacterizing, and pay a 6% fee on the excess, which I think is $6k. The fee is therefore $360. And I get back around $4600. I then make a non-deductible TIRA contribution for 2022 of $6k and convert it right away. I end up with $6k in 2022 Roth IRA but I lost $360 in the process. And I'm sure there's also a bunch of tax forms to file.

Questions:
- 2) is obviously a better long-term solution (although we're just talking about $1k growing in Roth vs $360 growing in taxable). But is 2) easier to execute before April 15?

- In 1), when doing the conversion, I don't pay taxes since I had a loss. There's no deduction possible?

Thanks for the help!

[toddthebod]

If you recharacterize an IRA contribution, it's as if the first contribution never happened, i.e., it's treated as if the gains/losses happened in the new account. In your case, it will be as if you made a $6,000 non-deductible contribution to a traditional IRA, then lost $1,000, then did a Roth conversion. The interesting consequence of doing this is that you will always have $1,000 of basis in your traditional IRA to carryforward year after year that will never go away. But that doesn't really matter.

[HomeStretch]

If this was a Roth IRA contribution made in 2022 for 2022, you have until your tax filing deadline in 2023 to avoid the 6% tax by having the excess contribution and any income returned to you (edit - sounds like $6k + $0 in your case). You then have the option of making a 2022 non-deductible TIRA contribution and converting it to Roth IRA (aka a backdoor Roth, works best if you have no pretax IRA balance).

See this IRS page:
https://www.irs.gov/retirement-plans/pl ... tax%20year.

[little_star]

Hi there,

Due to an increase in my wife's salary, the $6k Roth IRA contribution for 2022 that I made last year is not valid any more. I'm not 100% sure but it seems like I have 2 ways:

1) I could recharacterize to a TIRA, and then do a Roth conversion. I suspect I had losses because I had invested these $6k in VTSAX - I think Vanguard can calculate that. Say the amount is $5k. If I do a Roth conversion right after recharacterizing my 2022 Roth IRA contribution, I will end up with $5k in 2022 Roth IRA contribution. And a bunch of tax forms to file.

2) Apparently, I could also request the contribution be returned as an excess contribution rather than recharacterizing, and pay a 6% fee on the excess, which I think is $6k. The fee is therefore $360. And I get back around $4600. I then make a non-deductible TIRA contribution for 2022 of $6k and convert it right away. I end up with $6k in 2022 Roth IRA but I lost $360 in the process. And I'm sure there's also a bunch of tax forms to file.

Questions:
- 2) is obviously a better long-term solution (although we're just talking about $1k growing in Roth vs $360 growing in taxable). But is 2) easier to execute before April 15?

- In 1), when doing the conversion, I don't pay taxes since I had a loss. There's no deduction possible?

Thanks for the help!

Your analysis for option 2 is incorrect. If this is a contribution for 2022, you have until tax day (April 2023) to fix your excess contribution. Thus, you can choose to have your contribution returned without the 6% fee if you act in a timely manner. You should then be able to make a new contribution directly to a traditional IRA, as the first step in the backdoor Roth process. However, if you already have substantial pre-tax $$ in a traditional IRA (SEP, SIMPLE, rollover, etc) then you should probably not proceed with the backdoor Roth process, due to the pro-rata rule.

If you have no pre-tax $$ in a traditional IRA, either option 1) or option 2) [with a new contribution to tIRA after the return of contribution] provide the starting point for a backdoor Roth process. Because you are making the contribution for tax year 2022 in the calendar year 2023, your 2022 tax forms include IRS Form 8606 documenting the non-deductible contribution and a statement regarding recharacterization (option 1) or return of contributions (option 2). Your non-deductible contributions reported on IRS Form 8606 are $6k (option 1) or $amount contributed after the return of contributions (possibly also $6k).

If you choose to convert to Roth (step 2 of the backdoor Roth process), you will report the conversion on IRS Form 8606 of the year in which you do the conversion. It is recommended that you do the conversion shortly after you make the non-deductible contribution, so you will likely need to file IRS Form 8606 for 2023 reporting the conversion (and, possibly, the 2023 non-deductible contribution). The pro-rata rule is based on the value of your traditional IRA(s) on December 31 of the year in which you do the Roth conversion. So, if you plan to do the backdoor Roth process in this and subsequent years, you should remember NOT to roll your 401k $$ into an IRA at any time, as that will complicate the process.

If you choose to recharacterize and then convert while you have a loss on the original contribution (option 1), you will be in a situation where you have basis in the traditional IRA even though it has $0 balance. This is an oddity that may or may not bother you. It does not impact your taxes at this time. If you remember it, it does mean that you could have some gain in the traditional IRA without subsequent taxes, but you should not have much gain in the traditional IRA if you are timely about the Roth conversion step. To avoid this oddity, and to get as much into your Roth as you can, I recommend the strategy of option 2: return of contributions and a subsequent new contribution to the traditional IRA. Just make certain that it is a return of contribution, not a Roth withdrawal.

Finally, it is recommended to fill out IRS Form 8606 by hand before making a Roth conversion to have a better understanding of potential tax consequences. Roth conversions can no longer be undone.

[JeuneCracoucas]

Thank you for the responses! I have no TIRA money so I think I'm going to take Option 2.

[Remster]

Just to piggyback on this thread - I did my taxes and due to unexpected capital gains I ended up over contributing to my Roth IRA by $770. I created a new nondeductible traditional IRA (tIRA) yesterday that currently has a zero balance (I have no other tIRA's). I made $500 purchases on 01/03/22 of Growth, Small Cap, 500 index, and REIT. I was thinking of recharacterizing $385 in the 500 index (purchased at $442.63, currently at $366.65) and Growth (purchased at $166.28, currently at $122.98) into the tIRA. Would I just put those funds in the Money Market Fund for the tIRA?

Do I have taxes taken out as suggested by Vanguard (10%) or decline as I am choosing funds that (should) have lost money? Right now I have a warning that my settlement vehicle doesn't have funds to cover any taxes due but I also read that withholding on earnings will be paid from the mutual funds I select.

Once the money is in the tIRA do I add money to cover the losses (to bring back up to $770) and then convert the $770 back into the Roth? Would there be taxes due for my 2023 tax return?

Also - do I use the trade date or the settlement date for the date in question?

Is this the cleanest way to do this and avoid the 6% penalty and keep money in the market?

Thanks!

[toddthebod]

Just to piggyback on this thread - I did my taxes and due to unexpected capital gains I ended up over contributing to my Roth IRA by $770. I created a new nondeductible traditional IRA (tIRA) yesterday that currently has a zero balance (I have no other tIRA's). I made $500 purchases on 01/03/22 of Growth, Small Cap, 500 index, and REIT. I was thinking of recharacterizing $385 in the 500 index (purchased at $442.63, currently at $366.65) and Growth (purchased at $166.28, currently at $122.98) into the tIRA. Would I just put those funds in the Money Market Fund for the tIRA?

Do I have taxes taken out as suggested by Vanguard (10%) or decline as I am choosing funds that (should) have lost money? Right now I have a warning that my settlement vehicle doesn't have funds to cover any taxes due but I also read that withholding on earnings will be paid from the mutual funds I select.

Once the money is in the tIRA do I add money to cover the losses (to bring back up to $770) and then convert the $770 back into the Roth? Would there be taxes due for my 2023 tax return?

Also - do I use the trade date or the settlement date for the date in question?

Is this the cleanest way to do this and avoid the 6% penalty and keep money in the market?

Thanks!

You have two options: option 1 is to request a recharacterization of some Roth contributions to Traditional, then to do a Roth conversion. If you go that route, you cannot top it up to replace the losses. Option 2 is to request a return of excess contributions. In that case, if they remove less than $770 due to losses, you can top it up when you make a new contribution to your Traditional IRA.

Whether or not you have earnings or losses is based on the change in the value of the entire account, not a specific investment. For example, if you contributed $6,000 in 2021 and invested in X, then contributed $6,000 in 2022 and invested in Y, and between the date of the 2022 contribution and now, X went up 200% while Y went down 50%, then you request a recharacterization or return of just the 2022 contribution, you will still have earnings because the entire account is used for the calculation.

So what you need to do is look at the value of your account on the day you made your last contribution (which hopefully was more than the $770 or this gets messy). If the value of your entire account has gone up, you want to recharacterize. If it's gone down, you want to return excess contributions.

[Remster]

toddthebod,

I contributed $7000 to the Roth IRA in 2022 with the last contribution for 2022 on 01/21/22 and $6230 was allowed per Turbotax (I seem to have run out of deductions and had a surprise $2000 in capital gains). My last contribution to the Roth was 2/23/23 for 2023 and I am currently at $3750 of $7500 allowed (I waited in case I needed space in 2023 to roll the excess contribution of 2022 into 2023). The account as a whole is down roughly $40,000 from 2022 but up 3% since January of this year.

The form on Vanguard for recharacterization says I can choose the date of the contribution and which funds I want to withdraw the excess from so that's why I was looking at those two funds. Turbotax mentioned to recharacterize so I was looking that way. If I recharacterize into a tIRA it is what it is, a $770 contribution to a retirement account with either gains/losses. Taxes due, of course, on the gains.

Or I could remove the excess contribution with gains/losses to a taxable account. If I have gains above the $770 then I pay taxes and can then contribute up to $770 into a traditional IRA for 2022 to meet the $7000 limit. If I have losses (say I get $550 back) then I can add $220 of new money to get to $770 to meet the $7000 limit. In either case I can then backdoor the $770 into my Roth for 2022?

Are my thoughts correct on this? I tried to run the form as either excess contribution or recharacterization but it won't show me the results until I commit to a course of action. All accounts have more than $7000 in them so the $770 won't cause an insufficient balance.

[toddthebod]

toddthebod,

I contributed $7000 to the Roth IRA in 2022 with the last contribution for 2022 on 01/21/22 and $6230 was allowed per Turbotax (I seem to have run out of deductions and had a surprise $2000 in capital gains). My last contribution to the Roth was 2/23/23 for 2023 and I am currently at $3750 of $7500 allowed (I waited in case I needed space in 2023 to roll the excess contribution of 2022 into 2023). The account as a whole is down roughly $40,000 from 2022 but up 3% since January of this year.

The form on Vanguard for recharacterization says I can choose the date of the contribution and which funds I want to withdraw the excess from so that's why I was looking at those two funds. Turbotax mentioned to recharacterize so I was looking that way. If I recharacterize into a tIRA it is what it is, a $770 contribution to a retirement account with either gains/losses. Taxes due, of course, on the gains.

Or I could remove the excess contribution with gains/losses to a taxable account. If I have gains above the $770 then I pay taxes and can then contribute up to $770 into a traditional IRA for 2022 to meet the $7000 limit. If I have losses (say I get $550 back) then I can add $220 of new money to get to $770 to meet the $7000 limit. In either case I can then backdoor the $770 into my Roth for 2022?

Are my thoughts correct on this? I tried to run the form as either excess contribution or recharacterization but it won't show me the results until I commit to a course of action. All accounts have more than $7000 in them so the $770 won't cause an insufficient balance.

Yes you can pick which funds to get the money from. But the calculation on how much money will be recharacterized or removed as excess when adding in the earnings will be based on the change in the value of the entire account between 1/21/22 and the day they process the form. It's probably down, in which case a removal of excess will allow you to make a new 2022 contribution to a Traditional IRA of $770, even if after the calculation they only remove $600 or whatever from the Roth account because of losses in the market. If the entire account is up, they will remove or recharacterize >$770, in which case a recharacterization will move the earnings to the new IRA. You can then convert everything back to Roth, and you will owe a small amount of tax on the earnings.

So just look at your approximate account balance as of 1/22/2022 after the contribution (at the very least you should be able to find yourbalance on your 1/31/2022 statement), and if it's up since then, do a recharacterization, and if it's down, do a removal of excess contributions. Let them calculate the earnings attributable. Then if it's a removal, once the money hits your new account, you can make a new $770 2022 contribution to your Traditional IRA.

[Remster]

Thanks so much for the help!