Roth IRA reharacterization and taxes on gains
I converted a T IRA to a Roth in 2006 and realized that I was over the income limit, so I recharacterized it back to a T IRA, in January 2007. In the meantime, that $9,800 investment had $1,300 in gains (up to $12,100). I recharacterized the $12,100 and figured that I was done. The IRS has come back to me on my 2006 return and said that I must file a Form 8606, Part II and will be taxed on the $1,300 in gains (and also charged interest back to April 2007). They say that the reason is that I have not had that ROTH IRA for 5 years and therefore I am subject to the “5-Year rule”. Can someone advise me on the following:
(1) What is the five year rule?
(2) I have had other Roth IRAs for more than 5 years. Does that mean that I am still subject to the five year rule?
(3) Assuming I am still subject to this rule and must file the Form 8606 and pay taxes on $1,300, what is the recordkeeping for this? I am told by the IRS that I won’t be taxed on that $1,300 when I take it out at age 59 1/2, but that each withdrawal after 59 1/2 must have part of that $1,300 in it (as a percentage of my total). Is this true? This sounds insane..to have a recordkeeping burden like that.
(4) Assuming (3) is true, can’t I just convert all of my T IRAs to Roth IRAs in 2010 (when the income limits are removed), and circumvent this ongoing recordkeeping burden?
Sorry for the multiple questions, but this is tough stuff.
Sincerely, jfry
Permalink Submitted by Alan Spross on Mon, 2008-08-25 20:04
Yes, it’s tough because this makes no sense whatsoever. Apparently, either the IRS employee does not understand recharacterizations or something went wrong with the reporting.
I would start by checking the 1099R and Form 5498 that reported the recharacterization to you and the IRS. In addition, you should have attached an explanatory statement with your 2006 return explaining the conversion and recharacterization, since the IRS was not due to receive the 1099 and 5498 forms until January, 2008.
The 5 year rule has absolutely nothing to do with your situation, since a recharacterization is not a taxable Roth distribution.
Also, note that 9800 plus 1300 = 11,100 not 12,100.
After checking out what your 2007 1099R and 5498 forms indicate, feel free to re post any questions.
Permalink Submitted by John Fry on Tue, 2008-08-26 01:34
Let me try again, because I want to be clear. Let me start by saying that I was originally unaware that I needed an explanatory statement, which is probably what encouraged the IRS to focus on this. There was no intent on my part to deceive the Service, but this is irrelevant. I will explain in detail when I reply to them in writing. Below are the corrected facts based on the 1099-R and 5498.
I converted a T IRA to a Roth in 2006 and realized that I was over the income limit, so I recharacterized it back to a T IRA, in January 2007. In the meantime, that $9,807.65 investment had risen to 10,773.43, for a “gain” of $965.78. I recharacterized the $10,773.43 and figured that I was done. The IRS has come back to me on my 2006 return and said that I must file a Form 8606, Part II and will be taxed on the $965.78 gain in 2006 (and also charged interest back to April 2007). The agent said that the reason is that I have not had that ROTH IRA for 5 years and therefore I am subject to the “5-Year rule”.
Based on your initial reply, it sounds as if a recharacterization back to a T IRA, even one with a “gain” such as mine, would not be subject to tax in 2006, even for the gain amount only. It that correct?.
I will provide them copies of the 1099-R and 5498, and explain the transaction, but can you direct me to a section of the code or provide the proper wording/explanation to the IRS agenct to help resolve this?
I apologize for the initial confusion based on my erroneous facts. Sincerely, jfry
Permalink Submitted by Alan Spross on Tue, 2008-08-26 01:56
The format for the explanatory statement is in the Inst for Form 8606, p 3. In your case it would read:
“On xx/xx/2006 I converted $x of my traditional IRA to a Roth IRA. Because my modified AGI exceeded the limit, I recharacterized the entire conversion, which was then valued at $10,773, back to the traditional IRA on 01/yy/2007.”
You do not need to attach an 8606 to your return. This should eliminate the problem unless the 1099R and 5498 do NOT agree with what you indicate occurred. That might happen if the IRA custodian did not process the forms correctly or processed the recharacterization as a distribution. The traditional IRA custodian that received the recharaterization should issue a 5498 with the recharacterized amount received shown in Box #4. If you do not have correct 1099R and 5498 forms, getting this resolved will be much more difficult.
Permalink Submitted by John Fry on Tue, 2008-08-26 03:53
The Form 1099-R shows the box 7 distribution code as an “R” for recharacterization. That appears to be correct. The Form 5498 shows Box 3 as $9,807.65 and Box 5 as $10,773.43 Box 4 on the 5498 is empty. You seem to indicate that this is an error on the part of T. Rowe Price, and that this will be a much bigger problem to correct. Can you point me in the right direction about what I should do to correct it for the IRS? Thanks for the help.
Sincerely, jfry
Permalink Submitted by John Fry on Tue, 2008-08-26 04:05
Oops. I was looking at the wrong 5498. The correct 5498 shows the recharacterized contributions in box 4. So, I will proceed with your advice in the prior email.
Points of clarification: (1) Are you saying that I don’t need to file the 8606 and can just use the draft language you provided in a letter to them that I will fax? (2) It is your understanding that (based on what I have said) no tax is owed on the “gain”? (I won’t quote you or anything, I just want to be clear.)
Question: What else do I need to file with the IRS to clarify my position? They already have the Form 5498 with the correct amount in box 4. What I mean to ask is: “Is there anything I can do to get them to stop pursuing this? Is there a IRS code reference or anything?”
Thanks. jfry
Permalink Submitted by Alan Spross on Tue, 2008-08-26 04:49
1) Yes – no 8606 needed, just the explanatory statement.
2) There should be no tax or penalty since you totally and properly reversed the conversion. Since the custodian issued forms appear to be correct, hopefully your response will get to a more knowledgeable IRS agent.
3) You might send copies of the 1099R forms and 5498 forms, of which there are two sets – a 2006 set to report the conversion and a 2007 set to report the recharacterization. These should match up with the recommended statement you are making.
The above should suffice. However, if you need further references, the attached link is to the appropriate IRS Reg:
http://www.taxalmanac.org/index.php/Treasury_Regulations%2C_Subchapter_A…
Permalink Submitted by John Fry on Wed, 2008-08-27 14:24
I’ll send this information off to the IRS and see if it yields the correct result. Thanks for your help.
jfry