Roth IRA Question

[focals]

Hi there,
I didn't realize it until I started doing my taxes but after adding all my income sources, I'm over the $208k limit of being able to contribute to a Roth IRA (for Tax Year 2021).

I've already contributed $3600 (each) to both my and my wife's (non-working) Roth IRA.

I would not like to pay a penalty so want to ask what options I have now (and their implications).

Also, I would like to be able to make contribution to a Roth through back-door Roth option.

Thank you so much for your time,
AH

[terran]

If you're a good candidate for making backdoor Roth contributions (no previously deducted IRAs including rollovers and SEP IRAs) then you can recharacterize your Roth contributions to traditional and then proceed with the backdoor Roth contribution as normal.

[secondcor521]

Most people would probably consider the recharacterize than Roth conversion approach as their first choice.

The other option to (mostly) avoid penalties is to withdraw the contributions plus attributable earnings before the tax filing deadline without extensions (i.e., April 18, 2022).  You'll owe ordinary income taxes and probably a 10% penalty on the earnings, but those should be relatively small.

[focals]

Thank you @secondcor521 and @terran
I think it makes sense to recharacterize my Roth IRA to a Traditional IRA (and then proceed with Backdoor Roth Conversion).

I have 2 follow-up questions (I did some research but am still confused):
1. Do I need to report something on my 2021 year taxes? (I'm using Turbo Tax). My understanding is that I report the Backdoor Roth Conversion when I get 1099-R (in 2023 Jan). For Tax Year 2021, I just need to report that I made an IRA contribution. Is that correct?
2. Do I need to keep something in mind when I do the recharacterization (Roth IRA to Traditional IRA)? (calculating loss or gain on my contributions is something I'm thinking of letting Vanguard handle, if they normally do it).

Thank you again for your time and advice,
AH

[secondcor521]

Thank you @secondcor521 and @terran
I think it makes sense to recharacterize my Roth IRA to a Traditional IRA (and then proceed with Backdoor Roth Conversion).

I have 2 follow-up questions (I did some research but am still confused):
1. Do I need to report something on my 2021 year taxes? (I'm using Turbo Tax). My understanding is that I report the Backdoor Roth Conversion when I get 1099-R (in 2023 Jan). For Tax Year 2021, I just need to report that I made an IRA contribution. Is that correct?
2. Do I need to keep something in mind when I do the recharacterization (Roth IRA to Traditional IRA)? (calculating loss or gain on my contributions is something I'm thinking of letting Vanguard handle, if they normally do it).

Thank you again for your time and advice,
AH

1.  Recharacterizations (the first half of the backdoor Roth in your case) are not reported on tax returns at all.  It is treated as though you made the initial contribution on the initial date to the IRA to which the recharacterization was done (the traditional IRA in your case).

The non-deductible traditional IRA contribution would be reported on Part I of Form 8606 with your 2021 Form 1040.  You might also want to report it on line 1 of Form 8880 if you and your wife are in the income range to qualify for the retirement savings contribution credit.

You are correct that you will report the Roth conversion (the second half of the backdoor Roth in your case) on your 2022 tax return after receiving the 1099-R in January 2023.  This will be reported in Part II of Form 8606.

There is some sort of handling that has to happen because of the fact that your contribution amount will not equal your conversion amount.  I can never remember if this has to be taken care of on your 2021 return or your 2022 return.

There is also a pro-rata calculation that would need to take place if you or your wife had a non-zero balance in your traditional, SEP, or SIMPLE IRAs at the end of the year in which you do the Roth conversion (presumably 2022).

2.  Nope.  As noted above, it's treated as though you made the contribution to the traditional IRA originally (even though in actual fact you made it to the Roth IRA).  Any gains or losses on your contribution are treated as though they happened in the traditional IRA (even though in actual fact they happened in the Roth IRA).(*)  A recharacterization is like a time-machine do-over.

(*) And honestly, except for recharacterizations and withdrawals of excess contributions, gains and losses inside either type of IRA are pretty much irrelevant from a tax point of view.

[terran]

Recharacterizations (the first half of the backdoor Roth in your case) are not reported on tax returns at all.  It is treated as though you made the initial contribution on the initial date to the IRA to which the recharacterization was done (the traditional IRA in your case).

This isn't entirely true. According to the instructions for form 8606, when you recharacterize an IRA you should attach a statement explaining what you did. Despite this direction being explained in the instructions for form 8606, you wouldn't complete form 8606 for a recharactization except, as secondcor521 explains, non-deductible traditional IRA contributions are reported there.

[secondcor521]

Recharacterizations (the first half of the backdoor Roth in your case) are not reported on tax returns at all.  It is treated as though you made the initial contribution on the initial date to the IRA to which the recharacterization was done (the traditional IRA in your case).

This isn't entirely true. According to the instructions for form 8606, when you recharacterize an IRA you should attach a statement explaining what you did. Despite this direction being explained in the instructions for form 8606, you wouldn't complete form 8606 for a recharactization except, as secondcor521 explains, non-deductible traditional IRA contributions are reported there.

Right...thank you for the correction.

[focals]

Gotcha. Thank you for clarifying it for me @secondcor521 and @terran. I really appreciate you responding and sharing your knowledge.

[focals]

Hi there,
I'm back with a follow-up question :)

I 'recharacterized' exactly $6000 (Roth -> Traditional).
My IRA showed $6693 so I called Vanguard, and was told that the rest ($693) were earnings.
I converted the entire $6693 from Traditional to Roth.

What taxes should I expect in 2022?
My understanding is that I'll need to pay regular income tax on the earnings ($693).



Thank you so much in advance,
AH

[terran]

My understanding is that I'll need to pay regular income tax on the earnings ($693).

Correct.

[secondcor521]

My understanding is that I'll need to pay regular income tax on the earnings ($693).

Correct.

I agree.

I think you may also need to complete Form 8606 Part I with your 2021 tax return in order to reflect the 2021 nondeductible traditional IRA contribution.

Then you'll complete Form 8606 Parts I and II with your 2022 tax return.  Part II is where that $693 will get taxed (via line 18).

I think, anyway.  @terran?

[MDM]

My understanding is that I'll need to pay regular income tax on the earnings ($693).

Correct.

I agree.

I think you may also need to complete Form 8606 Part I with your 2021 tax return in order to reflect the 2021 nondeductible traditional IRA contribution.

Then you'll complete Form 8606 Parts I and II with your 2022 tax return.  Part II is where that $693 will get taxed (via line 18).

I think, anyway.  @terran?

Yes.

The Form8606 tab in the case study spreadsheet might be worth using.  Ease of use is in the eye of the beholder, but commercial tax software is notorious for having unclear Q&A in this area.  Knowing how 8606 should look is useful.

[focals]

Thank you @terran , @secondcor521 , and @MDM . I cannot thank you enough :)
That spreadsheet is scary :) (to me at least).

[MDM]

That spreadsheet is scary :) (to me at least).

Changes based on feedback from people seeing it for the first time can be useful for those who come later.  Feel free to ask/suggest things here, or in the Case Study Spreadsheet updates thread, or by PM.  Good luck!