Roth IRA Excess Contribution to tax-free Recharacterization then Backdoor Roth Conversion

Full Transcript

In this video, I'm going to talk about a Roth excess contribution being recharacterized back to the traditional side as a nondeductible contribution and then back to the Roth with a backdoor Roth conversion.

What's going on, guys? Welcome back to the channel or if this is your first time at our channel welcome to the channel. My name is Travis Sickle.

And here is where this question is coming from today. It is a question from Drone and Video A-Z.

"Maybe you can help me... I contributed to a Roth IRA and I have a workplace 401k I made with the selling of stocks over what is allowed to put money into a Roth but I did contribute to one during the year. Can I move this to a traditional IRA and then take it as a tax deduction? Subscribed Thanks for any help."

So here is what you need to consider. There's actually a handful of things.

First, can you do the recharacterization? The answer is yes.

You have an excess contribution to the Roth IRA, but you want to do it as a recharacterization to the traditional side so you don't have any taxes or penalties.

Now, pulling the money from the Roth over to the traditional side as a nondeductible contribution, you're also going to have some gains in there.

Or maybe you'll have some gains, that have to go with your contribution. So let's say that you put in $6,000 into the Roth IRA, you realized you couldn't do it. It's an excess contribution. You had to pull the money out. But let's say in this example that it grew by $1,000. So you have $7,000 inside of your Roth IRA that needs to be converted over to the traditional side.

Now, the $6,000 is going to get converted, but it would be as a nondeductible contribution. Now you have a workplace plan, so it's likely you're earning too much to make a traditional contribution. And if you just look here at the limit for single covered by a workplace plan, $66,000 to $76,000. So if you're making over $66,000, you can make the full contribution in 2021 and for 2022 that's going up to $68,000 to 78,000.

This is the phaseout to make a contribution to your traditional IRA. If again you have a workplace plan, so it cannot be a pretax contribution, so it will be nondeductible. Now the earnings on that is going to be taxable, but now it's sitting in the traditional IRA. So when you do the conversion you're going to get hit with the pro-rata rule unless you pull those earnings out.

Now you have a couple of options. You can pull the earnings out and put them into your workplace plan. If your plan allows it, that is separating the money from your traditional IRA, leaving you with only nondeductible contributions unless you also have other contributions or an old IRA because they all get aggregated. You have to add them all up.

But if you don't have any of the traditional IRA money, it's only the nondeductible money and you do the conversion not going to be taxable. So really, you're just pulling the money from the Roth, assuming there's no growth or losses and you're putting it over as a nondeductible contribution and then you're going right back to the Roth. So there's a couple of things that you need to know here is when you're doing the right characterization, there's going to be no taxable events, no penalties, because you're doing the right characterization within a timely manner, meaning you're doing it before the tax filing deadlines including extensions.

Then you can put it over to the traditional side. The original contribution will be as a nondeductible contribution and there will be earnings, but when we go back over to the Roth in a backdoor Roth conversion is taxable in the year that you're doing that conversion. So if you're doing it in 2022 even though it was a 2021 contribution, when you're doing the conversion, the conversion will be on your 2022 taxes.

So just something to note, you're going to get a whole bunch of tax forms, including 1099-R for all of the distributions and the characterizations and of course the contributions that have the form 5498. So just be aware of these transactions as you're doing your taxes, work with your account and your CPA while you're going through this just to make sure it's reported correctly but it's not well, it is a headache, it's not that big of a deal.

It can be fixed. It is a headache though, and you need to make sure that you're doing it correctly. Because like I said, going from the Roth side to the traditional IRA and then back, you're going to get hit with stuff like the pro-rata rule or additional taxes on the conversions because that conversion is going to have the pro-rata rule.

And even if you just have the original contribution and the growth portion, then you're going to want to convert all of it at the same time in order to get all of the nondeductible, all the nondeductible contributions back to the Roth side. So a bit of a headache, but get through it to make sure that you can fix it because the last thing you want to do is just do the characterization.

Leave it because you don't want to deal with the pro-rata rule or you don't want to deal with having to take money out of the IRA into your workplace plan or solar for a one K or what have you. Go through those motions because it will only make the problem significantly worse the longer that you wait for that non-deductible contribution to convert over to the Roth side.

So hopefully this is helped. They know it's a complicated situation and it really dried out in this video. But if you have any questions about it, let me know in the comments down below. And if you've enjoyed this video, be sure to subscribe and see you're coming down the bottom.