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The way I see it, a Roth IRA has 3 implicit buckets of money withdrawn in this order (with the big "conversions" bucket actually being a large number of smaller buckets):

  • Contributions
  • Conversions (FIFO)
    • Taxable portion
    • Non-taxable portion
  • Earnings

If I:

  1. Contributed X to a Roth IRA, then
  2. Recharacterized X + α to a traditional IRA, where α is the net gain or loss while in the Roth IRA, then
  3. Converted X + α + β to the Roth IRA, where β is the net gain or loss while in the traditional IRA

What is the net change in each of these buckets?

My current understanding would be:

  • Contributions (0) - Not subject to tax or penalty, ever.
  • Conversions (FIFO)
    • Taxable portion (+α + β) - Not subject to tax; subject to penalty if withdrawn within 5 tax years of conversion
    • Non-taxable portion (+X) - Not subject to tax or penalty, ever.
  • Earnings (0) - Subject to tax and penalty unless qualified

So...

  • Is this correct?
  • Does it matter if α and β are any combination of positive or negative?
    • If α + β < 0, then the converted amount would be < X resulting in leftover basis in the traditional IRA that could be used to offset any gains prior to conversion at a future date?
  • Does the 5 year rule for conversions apply?
  • What taxable events (if any) and/or tax forms would become relevant? (Form 8606?) Assume current tax year and that nothing has been filed yet.
2

The original contribution of X to Roth IRA in your reasoning is a red herring. It doesn't exist, never happened. You recharacterized it, so what you did in reality is contribute X to Traditional IRA.

  • Ok, so X would be the non-taxable portion of the conversion and α + β would be the taxable portion? (as if all the net gain/loss occurred in the traditional)? – arcyqwerty Jan 30 '16 at 5:54
  • @arcyqwerty that depends on the calculations on your form 8606. – littleadv Jan 30 '16 at 6:05
  • Assume I am not taking the IRA deduction (which wouldn't make any sense since I'd end up paying those taxes right back for the contribution), it should end up as specified? – arcyqwerty Jan 30 '16 at 6:10
  • @arcyqwerty assuming also you don't have any other IRA balance - yes. – littleadv Jan 30 '16 at 6:16
  • Great! If there was a net loss while "in" the traditional IRA (α + β < 0), then does that basis stay in the traditional IRA, available to offset future earnings on conversions? For example, say α + β = -$100. If I later contribute $1000 to the traditional IRA, it gains $200 while it's in there, and I convert it to Roth, is only $100 of that conversion then taxable? – arcyqwerty Jan 30 '16 at 6:20
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Your 1&2 are the end of that chapter. You can't convert for that year again, and must wait 30 days to convert in the new tax year.

For example, each year for over a decade, I've helped my mother in law with this. In May, we convert a chunk of money/stock to Roth. In April, I'll recharacterize just enough so she tops off her 15% bracket but doesn't hit 25%. 30 days later, the new conversion happens. All the Roth money is money now taxed at 15%, which, in an emergency, a need for a lot of cash, will avoid the potential of 25% or higher, tax.

You see, your 3 never really happens.

  • You are misunderstanding the situation. There is no "converting again". There was just one conversion, in #3. – user102008 Jan 31 '16 at 4:41
  • "α is the net gain or loss while in the Roth" yet, α appears in the math for scenario 3. How does this happen, exactly? – JoeTaxpayer Jan 31 '16 at 13:12
  • As I understand it, the limit on converting again is if I originally had a tIRA->Roth rechar or conversion and then recharacterized it back to the tIRA. At this point I couldn't convert to the roth until 30 days / next year, whichever is later. – arcyqwerty Jan 31 '16 at 15:56
  • @JoeTaxpayer: Say I put X=2000 in the Roth, it gains to 2500 (α=+500). It gets recharacterized to tIRA. It loses β=300 while in the tIRA so the total conversion is 2200 (X + α + β). I didn't intend 1,2,3 to be different scenarios. They're chronological steps of the same single case. – arcyqwerty Jan 31 '16 at 15:58
  • @JoeTaxpayer: X is the contribution amount. α is the gain after contribution and before the recharacterization; after recharacterization of X to a Traditional IRA contribution, α becomes the gain in the Traditional IRA after contribution. β is the gain after in the Traditional IRA after recharacterization. Actually there is no distinction between α and β (they are both considered gains in the Traditional IRA after contribution). – user102008 Jan 31 '16 at 17:17

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