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Tax-Free Roth IRA Conversions?

We received many questions this past tax season about Roth IRA conversions that were supposed to be tax-free, but were not.

Here is the scenario.

Pam is eligible to make an IRA contribution but is not eligible to deduct it. She also is not eligible to make a Roth IRA contribution. Pam is advised to make an after-tax IRA contribution to her “after-tax” IRA and then to convert the contribution to a Roth IRA. She is advised that this will be a tax-free Roth IRA conversion. Pam follows this advice.

When it comes time to do her income tax return, Pam finds out that her conversion is not tax-free. There is one small detail that her advisor overlooked.

Pam has an existing IRA with pre-tax funds in it.

When an individual has both pre- and after-tax funds in their IRA accounts, then they must use the pro-rata rule when they do a Roth IRA conversion.

The pro-rata rule says that you must include all IRA balances, including SEP and SIMPLE IRA balances. It determines the percentage of after-tax amounts in the IRA accounts and applies this percentage to distributions taken that year from the IRA. Each distribution will consist of a percentage of pre-tax amounts.

Example:  Pam has $195,000 in an existing IRA which is all pre-tax funds. She opens a separate IRA and makes a $5,000 after-tax contribution to this IRA. Pam then converts the new IRA to a Roth IRA (we will assume there are no earnings for this example). Pam’s total IRA balances are $200,000. The percentage of after-tax assets is 2.5% ($5,000/$200,000). Pam’s converted amount is $5,000. Only 2.5%, or $125 ($5,000 X 2.5%), will be after-tax funds. The remaining amount of $4,875 will be included in Pam’s income for the year.

Can Pam undo all of this and return to where she was before she made the after-tax contribution. Yes, but there will be a lot of paperwork and there is a deadline to meet. Pam can recharacterize her Roth IRA conversion. She will have to do a net income calculation on the $5,000 she converted and do a direct transfer of the net amount to her IRA account. Then she will have to do a return of an excess contribution. She will have to do another net income calculation on her $5,000 after-tax contribution and have the net amount distributed to her. She will owe income tax on any earnings attributable to her contribution and, if she is under age 59 ½, she could owe the 10% early distribution penalty on the earnings as well.

Both the Roth recharacterization and the return of excess contribution have a deadline of October 15thof the year after the year of the contribution and conversion. But, if the contribution was made this year for last year, and the conversion was done this year, the October 15th dates for the two transactions will be in different years. Pam only has until October 15th of the current year to have the contribution returned as an excess contribution. She will have until October 15th of next year to do the recharacterization.