Free Trial: TheSiteFactory.com

The Backdoor Roth IRA Recharacterization

Key tips and advice the working tax pro can use.
#1
Wiles  
Posts:
2874
Joined:
21-Apr-2014 9:42am
Location:
Bay Area - CA
Under the TCJA, our client's are no longer able to recharacterize a Roth conversion back into an IRA after the calendar year closes.

Let me know if this can be used as a workaround:
1. Withdraw IRA monies on 12/31/18. Take possession of funds, i.e. not a direct rollover.
2. Prepare tax return before the end of February to determine effect of Roth conversion. Determine optimal amount to convert.
3. Within 60 days of IRA withdrawal, deposit the optimal amount into the Roth IRA and deposit the remaining amount back into the IRA.
Last edited by Wiles on 11-Jan-2019 11:17am, edited 1 time in total.
 

#2
makbo  
Posts:
5859
Joined:
23-Apr-2014 3:44pm
Location:
District 13
Wiles wrote: Determine optimal amount to convert.

Optimal amount to convert, and optimal amount to recharacterize, are two different things.

I always understood the point of recharacterization of Roth conversions to be the "20-20 hindsight" benefit. In other words, you had until October of the following year to see if your investments went up or down after the conversion. If you converted and invested in stock, and the stock went way down, you effectively paid current tax on money you no longer have. By recharacterizing, you could at least take some of the sting out and undo the tax bill.

Are you aware of many people who recharacterized Roth conversions so early (February) in the following year? I don't understand why anyone would do that.

I actually have a very scholarly article about this (how to optimize Roth recharacterizations, and avoid the anti-cherry-picking rules), in my archives somewhere...
 

#3
Wiles  
Posts:
2874
Joined:
21-Apr-2014 9:42am
Location:
Bay Area - CA
Are you aware of many people who recharacterized Roth conversions so early (February) in the following year?
I am aware of many people who recharacterized because they were paying too much tax on the conversion.

Example:

In 2018, taxpayer believes $50K is the optimal amount to convert and pay very little tax. However, they will not have complete information about their 2018 taxable income until mid February 2019.

They withdraw $50K on 12/31/18. In mid February 2019, they prepare their 2018 tax return and determine that $40K was the actual optimal amount to convert. There is too much tax on that last $10K.

Before the end of the 60-day rollover period, they deposit $40K into the Roth IRA (the conversion) and $10K into an IRA (a rollover).
 

#4
makbo  
Posts:
5859
Joined:
23-Apr-2014 3:44pm
Location:
District 13
OK, so you are talking about converting just enough to "top up" a tax bracket, for example, or avoid various phase-outs, or any of the other "phantom" marginal rates that pervade our newly simplified tax system.

I can't offer any good comment in that case. The part about "not having complete information about 2018 taxable income until mid February 2019" is not something I've ever run into for someone who was also a good candidate for a Roth conversion (for any taxable year). But I guess it could apply to a partner or shareholder who was not getting good, timely info from their business associates. And a few other situations I'm sure I'm overlooking right now...
 

#5
makbo  
Posts:
5859
Joined:
23-Apr-2014 3:44pm
Location:
District 13
Wiles wrote:3. Within 60 days of IRA withdrawal, deposit the optimal amount into the Roth IRA and deposit the remaining amount back into the IRA.

OK, so what is this? A Roth conversion, if so which year (obviously you want it to be the first year)? A recharacterization of a Trad IRA withdrawal back into not a withdrawal? It would be interesting to consider how this is reported on both years' tax returns, and what 1099-R/5498 forms would be issued. Just some thoughts without looking at Pubs 590A/B. :|
 

#6
Wiles  
Posts:
2874
Joined:
21-Apr-2014 9:42am
Location:
Bay Area - CA
I know you know this, but just wanted to reply...

The 2018 1099-R will show $50K.

2018 tax return -
* Report $40K as conversion to Roth IRA. Taxable
* Report $10K as rollover. Not taxable.

The 5498s issued in May 2019 will show the $40K contribution to the Roth IRA and the $10K contribution to the IRA.
 

#7
Posts:
1509
Joined:
24-Apr-2014 7:54am
Location:
Wisconsin
Wiles wrote:The 5498s issued in May 2019 will show the $40K contribution to the Roth IRA and the $10K contribution to the IRA.


If that's what the 5498s are showing you have a bit of a problem with overcontributions to a Roth IRA...

Isn't the problem with the workaround that the Roth conversion will have occured in February 2019 and is taxable in 2019, not 2018?
 

#8
Wiles  
Posts:
2874
Joined:
21-Apr-2014 9:42am
Location:
Bay Area - CA
Isn't the problem with the workaround that the Roth conversion will have occured in February 2019 and is taxable in 2019, not 2018?

Hmm... Made me research that.

Reg §1.408A-4
Q-. 7. . What are the tax consequences when an amount is converted to a Roth IRA?

A-7. (a) Any amount that is converted to a Roth IRA is includible in gross income as a distribution according to the rules of section 408(d)(1) and (2) for the taxable year in which the amount is distributed or transferred from the traditional IRA. Thus, any portion of the distribution or transfer that is treated as a return of basis under section 408(d)(1) and (2) is not includible in gross income as a result of the conversion.

(b) The 10-percent additional tax under section 72(t) generally does not apply to the taxable conversion amount. But see §1.408A-6 A-5 for circumstances under which the taxable conversion amount would be subject to the additional tax under section 72(t).

(c) Pursuant to section 408A(e), a conversion is not treated as a rollover for purposes of the one-rollover-per-year rule of section 408(d)(3)(B).

 

#9
Posts:
1509
Joined:
24-Apr-2014 7:54am
Location:
Wisconsin
That's really interesting. I guess that makes sense in some ways (taxpayer on 12/30 initiates the conversion but it settles a couple days into January).

Congratulations -- you might have just created the backdoor recharacterization!
 

#10
Wiles  
Posts:
2874
Joined:
21-Apr-2014 9:42am
Location:
Bay Area - CA
"Backdoor Recharacterization"

(Thumbs up emoji)

I like it! Changing the name of this discussion, now.
 

#11
makbo  
Posts:
5859
Joined:
23-Apr-2014 3:44pm
Location:
District 13
Wiles wrote:1. Withdraw IRA monies on 12/31/18. Take possession of funds, i.e. not a direct rollover.

You might need to bump that date back a few days. The part of the IRA distribution that you roll back into the Trad IRA is subject to once-per-year rule. I don't know if that's a year plus a day, but it could be a little tricky if you want to do this every year. [edit: I think it is a year plus a day. "Generally, if you make a tax-free rollover of any part of a distribution from a traditional IRA, you can’t, within a 1-year period, make a tax-free rollover of any later distribution from that same IRA."

The other drawback is that if invested in a long-term portfolio, you are potentially missing out on 2 months of earnings (or loss), both in the Trad IRA and the Roth. I suppose you could park the money for 60 days in something other than cash, but then you are either risking a short term loss, and paying tax on that portion of the distribution (which you don't have any longer to complete the rollover, due to the loss), or having a short term gain, subject to ordinary marginal tax rates.
 

#12
Wiles  
Posts:
2874
Joined:
21-Apr-2014 9:42am
Location:
Bay Area - CA
makbo wrote:You might need to bump that date back a few days. The part of the IRA distribution that you roll back into the Trad IRA is subject to once-per-year rule. I don't know if that's a year plus a day, but it could be a little tricky if you want to do this every year

Good point. Is it the date of the withdrawals that need to be 366 days apart or the date of the re-deposit?
 

#13
makbo  
Posts:
5859
Joined:
23-Apr-2014 3:44pm
Location:
District 13
The withdrawals.
 

#14
Doug M  
Posts:
2783
Joined:
22-Apr-2014 1:09pm
Location:
Oregon
Before the end of the 60-day rollover period, they deposit $40K into the Roth IRA (the conversion) and $10K into an IRA (a rollover).


* Report $40K as conversion to Roth IRA. Taxable


I see a lot of pitfalls. Do we know if the $40k deposited in February 2019 is taxable as a conversion in 2018?
 

#15
Wiles  
Posts:
2874
Joined:
21-Apr-2014 9:42am
Location:
Bay Area - CA
Just one pitfall - relies on taxpayer to follow directions and not be stupid. Maybe that's two pitfalls.

Yes. Taxable in 2018. See #8.
 


Return to Tax Prep: Important tips and advice



Who is online

Users browsing this forum: No registered users and 2 guests