IRA Tax Issue [Did IRA recharacterization instead of Roth conversion]

[mahoosuc]

Hi everyone, long-time occasional lurker but figured this forum would have the best advice for my situation.

The quick summary is that I messed up in Merrill Edge last year and filled out an IRA recharacterization form rather than a conversion form when intending to do a traditional to Roth conversion (my error completely but annoying for sure). I didn't figure this out until doing my taxes for 2023 and need to address this since I was ineligible to contribute to a Roth for 2023 and 2022 (unfortunately the recharacterization executed in 2023 was for both tax years 2022 and 2023).

I contacted Merrill and they did not offer any simple fix (e.g. retroactively changing the recharacterization to a conversion). My hunch is that what I need to do is re-recharacterize back to traditional, but curious if anyone here has run into this issue before or has advice.

Thank you!

[Alan S.]

Hi everyone, long-time occasional lurker but figured this forum would have the best advice for my situation.

The quick summary is that I messed up in Merrill Edge last year and filled out an IRA recharacterization form rather than a conversion form when intending to do a traditional to Roth conversion (my error completely but annoying for sure). I didn't figure this out until doing my taxes for 2023 and need to address this since I was ineligible to contribute to a Roth for 2023 and 2022 (unfortunately the recharacterization executed in 2023 was for both tax years 2022 and 2023).

I contacted Merrill and they did not offer any simple fix (e.g. retroactively changing the recharacterization to a conversion). My hunch is that what I need to do is re-recharacterize back to traditional, but curious if anyone here has run into this issue before or has advice.

Thank you!

If you recharacterized TIRA contributions as Roth contributions for 2022 and 2023, you should have received 2 1099R forms in January, one coded "N" and the other "R". Unfortunately, recharacterized contributions cannot be recharacterized back per IRS rules, so you are stuck with these regular Roth contributions, with the following result:

1) For 2022 you have an excess Roth contribution for which you owe the 6% excise tax on 2022 Form 5329. This excess was still in your Roth IRA at year end 2023, so you also owe another 6% excise tax on the excess amount on a 2023 5329. You should remove this excess amount (no gain/loss adjustment) before year end 2024.

2) The 2023 Roth excess can still be removed prior to 10/15/2024, but only if you either filed your 2023 return on time or filed a timely extension for your 2023 return. ME will return your 2023 Roth excess adjusted for gain or loss. If there is a gain it will be taxable in 2023 because you made the original contribution in 2023. The gain would have to be reported on a 2023 1040X if you have filed your 2023 return.
There is another option if your gain on the 2023 contribution is substantial (around 25% or more). You could let the 10/15 deadline pass and just remove the excess amount as a normal distribution (the gain stays in the Roth) before year end. Although you will owe the 2023 excise tax of 6% for 2023 on the 2023 excess, the gain stays in the Roth and taxable income on the gain is avoided, and your 2023 taxable income is not increased. You would then remove the excess amount only before year end to eliminate any 2024 excise tax.

3) The distribution of the 2022 excess (and 2023 excess if done without gain/loss after 10/15) will be reported on a 1099R for 2024. You will report these distributions on Form 8606, but since they come from your balance of regular Roth contributions, the distribution will not be taxable. If you remove the 2023 excess before 10/15, you will get a 1099R for that removal. This would NOT be reported on an 8606.

4) Another option, but only if you know you will be under the Roth contribution MAGI limit for 2024: You could apply the 2023 excess amount to 2024, also on Form 5329, instead of removing it.

5) You would then have to file a 2024 5329 showing that all prior excess contributions have been removed and there would be no excise tax due for 2024.

Confusing, but as you can see there are various options at your disposal depending on the amount of gain on the 2023 excess, and whether your income will be low enough in 2024 to apply the 2023 excess to 2024.

[mahoosuc]

Thank you so much, returning to this after some travel around Labor Day.

I just submitted the distribution of excess contribution form to Merrill for 2023. Appreciate your advice on potentially letting it sit and then taking the 6% hit, but I'm inclined to just fix this now rather than filing my taxes before the October deadline and then amending, etc.

Once that goes through I'll submit one to withdraw the 2022 contribution.

Anything special I will need to do to make sure not to trigger the 10% early withdrawal penalty since I am under 59.5?

[Alan S.]

Thank you so much, returning to this after some travel around Labor Day.

I just submitted the distribution of excess contribution form to Merrill for 2023. Appreciate your advice on potentially letting it sit and then taking the 6% hit, but I'm inclined to just fix this now rather than filing my taxes before the October deadline and then amending, etc.

Once that goes through I'll submit one to withdraw the 2022 contribution.

Anything special I will need to do to make sure not to trigger the 10% early withdrawal penalty since I am under 59.5?

There should not be any penalty on the earnings returned for the 2023 contribution, as Secure 2.0 eliminated that penalty. But the gains will be taxable on your 2023 return. If you already filed your 2023 return and the corrective distribution includes gains, you will have to amend your 2023 return to report the gains. If you will be filing under extension by 10/15 you should include an explanatory statement regarding the removal of your excess Roth contribution for 2023.

As for the return of the excess contribution amounts, since they are coming from your regular Roth contribution balance, those distributions are tax free (except for the gain on the 2023 contribution).

[mahoosuc]

Finally was able to get Merrill to return the excess contribution (I'm not sure what was the cause for the delay on their end, but it took nearly two weeks.

I filed for the extension in April so I have a couple of weeks to finalize my taxes (had put in all other info before the extension, so it should be ready to go other than this IRA issue). Do I need to wait for them to post/send some adjusted tax forms, or just delete the 2023 contribution and file like it never happened, then add the gains to my income?