Roth IRA recharacterization, earnings, and conversions

Question

The way I see it, a Roth IRA has 3 implicit buckets of money withdrawn in this order (with the big "conversions" bucket actually being a large number of smaller buckets):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  • Taxable portion (+α + β) - Not subject to tax; subject to penalty if withdrawn within 5 tax years of conversion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.

Answer 1

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.

Answer 2

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.