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Converting traditional IRA contribution to Roth

Forum|Forum|2 years ago
October 20, 2023
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I have only recently learned about Roth IRA's and would like to re-characterize my 2023 traditional IRA contribution of $7500 as a Roth IRA contribution instead. The $7500 was contributed into a Schwab traditional IRA in January 2023 and has made minimal gains since then. I checked with Schwab regarding a same-trustee transfer from traditional to Roth and they said they can process the transaction as an IRA recharacterization. I understand that 2023 federal and state income tax will be owed on the $7500 once it's recharacterized as a Roth. I know that we will have enough deductions and tax credits so that the additional $7500 won't make a significant difference, if any (perhaps a slightly smaller refund). However, I am concerned about unnecessarily complicating our 2023 taxes because of any possible gains (though with recent volatility I think those gains were minimal). Will we just need to file the Form 8606: Nondeductible IRAs when we file our taxes or is there something additional that will need to be completed due to the conversion? Can the regular Turbotax product handle this conversion or will I need additional help? I just want to make sure I'm not missing any crucial detail prior to completing this conversion. If it becomes too complicated, I will likely just wait until 2024 to open a Roth IRA rather than converting this year's contribution.

Best answer by dmertz

You mention possibly performing one of two entirely different types of transactions: conversion and recharacterization. You seem to be proposing a recharacterization and are misusing the word "conversion" to mean recharacterization.

A recharacterization from traditional to Roth makes it as though your original contribution was deposited into a Roth IRA instead of to the traditional IRA, subject to the normal MAGI limitations on making a Roth IRA contribution. A Roth conversion retains the traditional IRA contribution and involves a taxable distribution and rollover to a Roth IRA. The difference is in how any investment gain or loss on the earnings is treated and the type of basis created in the Roth IRA. With a recharacterization the investment gain or loss while in the traditional IRA simply becomes investment gain or loss in the Roth IRA. With a conversion any investment gain while in the traditional IRA is taxed and becomes conversion basis in the Roth IRA.

Since you'll be doing either of these transactions in 2023 with regard to your 2023 traditional IRA contribution, neither is difficult to enter into TurboTax. There is no significant difference in the complexity in reporting these two types of transactions except that with a recharacterization TurboTax will prompt you to provide a simple explanation statement describing the recharacterization.

With investment gains while in the traditional IRA, it probably makes more sent to do a recharacterization instead of a conversion to get the advantage of having Roth IRA contribution basis instead of conversion basis in the Roth IRA. If there was a substantial loss while in the traditional IRA it might make sense to do a Roth conversion instead, saving some in taxes but creating conversion basis instead of regular contribution basis. Conversion basis would have to remain in the Roth IRA until 2028 before it could be taken out penalty-free before age 59½.

If your MAGI relative to your filing status does not permit a Roth IRA contribution for 2023, conversion is your only option.

Regarding Form 8606, a recharacterization to a Roth IRA does not involve Form 8606. On the other hand, a Roth conversion must be reported on Form 8606. TurboTax automatically prepares Form 8606 when your contribution and Form 1099-R entries indicate that it is required.

D

dmertzAnswer

Employee

You mention possibly performing one of two entirely different types of transactions: conversion and recharacterization. You seem to be proposing a recharacterization and are misusing the word "conversion" to mean recharacterization.

A recharacterization from traditional to Roth makes it as though your original contribution was deposited into a Roth IRA instead of to the traditional IRA, subject to the normal MAGI limitations on making a Roth IRA contribution. A Roth conversion retains the traditional IRA contribution and involves a taxable distribution and rollover to a Roth IRA. The difference is in how any investment gain or loss on the earnings is treated and the type of basis created in the Roth IRA. With a recharacterization the investment gain or loss while in the traditional IRA simply becomes investment gain or loss in the Roth IRA. With a conversion any investment gain while in the traditional IRA is taxed and becomes conversion basis in the Roth IRA.

Since you'll be doing either of these transactions in 2023 with regard to your 2023 traditional IRA contribution, neither is difficult to enter into TurboTax. There is no significant difference in the complexity in reporting these two types of transactions except that with a recharacterization TurboTax will prompt you to provide a simple explanation statement describing the recharacterization.

With investment gains while in the traditional IRA, it probably makes more sent to do a recharacterization instead of a conversion to get the advantage of having Roth IRA contribution basis instead of conversion basis in the Roth IRA. If there was a substantial loss while in the traditional IRA it might make sense to do a Roth conversion instead, saving some in taxes but creating conversion basis instead of regular contribution basis. Conversion basis would have to remain in the Roth IRA until 2028 before it could be taken out penalty-free before age 59½.

If your MAGI relative to your filing status does not permit a Roth IRA contribution for 2023, conversion is your only option.

Regarding Form 8606, a recharacterization to a Roth IRA does not involve Form 8606. On the other hand, a Roth conversion must be reported on Form 8606. TurboTax automatically prepares Form 8606 when your contribution and Form 1099-R entries indicate that it is required.

K

kbdaAuthor

Thank you for clarifying. Yes, I'm wanting to recharacterize the 2023 contribution as Roth rather than traditional, so this would be a recharacterization, not a conversion. I actually don't know if the $7500 I contributed in January has gained or lost overall, since it's part of a larger traditional IRA. However, from a tax perspective, our MAGI is well below the Roth limits, so it's not likely to make a difference in our tax bill either way.
One follow up question: if I perform a recharacterization of the 2023 contribution from traditional to Roth, will this amount be subject to the 5-year requirement prior to taking a penalty-free withdrawal? Or does the IRS essentially consider this contribution as having been a Roth contribution from day one?

Thank you so much for your assistance.

D

dmertz

Employee

If you recharacterize, the original contribution becomes a Roth contribution instead of a traditional IRA contribution. You obtain a distribution of your regular Roth IRA contribution basis anytime, free of any penalty. Contribution basis comes out of your Roth IRAs first.