IRA Accident - how to handle/tax implications?

[GiannaLuna]

Last week, in order to make my 2021 IRA contribution, I transferred the $7K from my external bank account to my Vanguard account. I intended for it to be deposited into my Roth account, but somehow it ended up in my zero balance T-IRA account at Vanguard.

As I plan to transfer the funds over to my Roth - what are the tax implications (if any?) I have left the funds untouched in the settlement account....so maybe at most, they have earned a penny in this past week.

Thanks

[sycamore]

You could just do a recharacterization. I've not done this myself but hopefully there's a simple form online at Vanguard to accomplish this.

[David Jay]

As I plan to transfer the funds over to my Roth - what are the tax implications (if any?) I have left the funds untouched in the settlement account....so maybe at most, they have earned a penny in this past week.

First, let’s get the language right. You will do a Roth Conversion, not a transfer. Convert the entire amount, including any pennies.

You will theoretically owe taxes on the pennies for your 2021 taxes. But the IRS let’s you round down, so after you calculate the tax on the pennies you will likely pay nothing. At the very worst, it could round up to an extra $1 in taxes. If you do your own taxes, be sure to fill out form 8606 to document the after-tax contribution to the tIRA.

What you have done, in effect, is a “Backdoor Roth”. It is more paperwork than a simple Roth contribution but you end up in the same place.

[sycamore]

As I plan to transfer the funds over to my Roth - what are the tax implications (if any?) I have left the funds untouched in the settlement account....so maybe at most, they have earned a penny in this past week.

First, let’s get the language right. You will do a Roth Conversion, not a transfer. Convert the entire amount, including any pennies.

You will theoretically owe taxes on the pennies for your 2021 taxes. But the IRS let’s you round down, so after you calculate the tax on the pennies you will likely pay nothing. At the very worst, it could round up to an extra $1 in taxes. If you do your own taxes, be sure to fill out form 8606 to document the after-tax contribution to the tIRA.

What you have done, in effect, is a “Backdoor Roth”. It is more paperwork than a simple Roth contribution but you end up in the same place.

OP, one follow-on question for the Roth conversion approach -- do you have any Traditional IRA balances (either at Vanguard or other custodians), other than the one you accidentally contributed to? If no, then a Roth conversion would be straightforward. If yes, that complicates matters...

[newacct]

A recharacterization makes sense here, since it treats it as having been a Roth IRA contribution all along, which is what the OP wanted anyway.

With a conversion, they would have to deal with the pro-rata rule if there was any money in Traditional/SIMPLE/SEP IRAs. Furthermore, they would either have to treat the Traditional IRA contribution as non-deductible (in which case they would have to report a non-deductible contribution on Form 8606, and then a conversion on Form 8606) or deductible (in which case they would have to report an IRA deduction on Schedule 1, and then a conversion on Form 8606, where the taxable income from the conversion cancels out the deduction), both of which require more forms to file. Also, any earnings between contribution and conversion would be taxable, which would not be the case if it were recharacterized to be a Roth IRA contribution to begin with.

[ofckrupke]

Both of these methods are possible. Neither is reversible (in this case; if the contribution had established a new TIRA then I believe double recharacterization, timely done, would be a possibility).

Conversion will have an undesired tax consequence if on Dec 31 2021 any TIRA in the OP's name has a substantial balance, whether present at the end of 2020 or by rollover between now and EOY2021.

Recharacterization of a TIRA contribution as a Roth contribution can be done at any point between now and the tax return due date in 2022, without tax liability associated with intervening growth. [Obviously if some part of the TIRA contribution would be deductible then recharacterizing all of it as Roth would increase tax liability.]

But early TIRA->RIRA recharacterization will leave the OP in a pickle if their 2021 MAGI eventually turns out to limit or disallow Roth contribution; whereas if they are going to convert it's arguably better to do it ASAP, before the account balance grows much, since tax will be owed on growth without regard to whether the contribution itself is deductible.

Basically, the sooner one or the other of the corner scenarios described above can be ruled out, the sooner the choice of solution can safely be made.

[GiannaLuna]

OP, one follow-on question for the Roth conversion approach -- do you have any Traditional IRA balances (either at Vanguard or other custodians), other than the one you accidentally contributed to? If no, then a Roth conversion would be straightforward. If yes, that complicates matters...

I do not have any other T-IRA accounts or balances anywhere else. This account had a zero balance before the current transfer deposit of $7K.

I am retiring this year, end of the first quarter, so my income for this year and next will decrease dramatically. I will be living off withdrawals and a pension until Soc Sec somewhere down the line.

Appreciate the helpful comments, thank you.

[David Jay]

I do not have any other T-IRA accounts or balances anywhere else. This account had a zero balance before the current transfer deposit of $7K.

My original post gives you exactly the steps to follow.