Q: I contributed to my Roth IRA in 2011, but discovered when preparing my 2011 federal tax return that I wasn't qualified to make a Roth IRA contribution because of my income level. So I recharacterized my 2011 Roth contribution to a traditional IRA in March 2012. In August 2012, I converted this money back to my Roth IRA. My understanding was this series of transactions are considered legal and correct. I received a 2012 1099-R from my mutual fund, and it says this money I pulled out of my traditional IRA is taxable. I don't understand this, because I didn't deduct the recharacterized contribution to the traditional IRA on my 2011 tax return.
A: As you will see, there is nothing simple about IRA recharacterizations and conversions.
IRA custodians are required by law to file information returns with the IRS reporting contributions to and distributions from IRA accounts. Contributions are reported on IRS Form 5498. Distributions are reported on IRS Form 1099-R. Without knowing exactly what information is reported on the 1099-R that you received, or how you reported the recharacterized IRA contribution on your 2011 income tax return, I can only give you a general answer.
Since there was a distribution from your regular IRA to your Roth IRA to effect the conversion to the Roth IRA, the IRA custodian was required to issue the Form 1099-R. They don't know whether you deducted the contribution or not, so they may have reported the distribution as taxable. There should be numeric and or alphabetic codes in Box 7. These codes provide specific information about the type of IRA distribution that is reported on the 1099-R.
You will need to enter the information contained on the 1099-R on your 2012 individual income tax return, Form 1040. Report the gross distribution on line 15a and enter zero on line 15b, "Taxable amount," if you are sure that none of the distribution is taxable. This will allow the IRS to match the gross distirbution reported on the 1099-R to your return, yet you will not be increasing your taxable income.
Whether the distribution from your traditional IRA is taxable or not depends on a number of factors. If you designated the recharacterized contribution as a nondeductible IRA contribution on Form 8606 in your 2011 tax return, had no other traditional IRA accounts, and the IRA account into which you deposited the recharacterized 2011 Roth IRA contribution had no earnings between March and August 2012, then the 2012 distribution should not be taxable.
If you did not designate the recharacterized Roth IRA contribution as nondeductible in your 2011 tax return then it is treated as a deductible contribution whether you actually deducted it or not. All distributions from traditional IRA accounts will be taxed unless you can show, with satisfactory evidence, that nondeductible contributions were made. That means having a properly filed Form 8606 on hand.
You can file a new Form 8606 with an amended return, Form 1040X, for 2011 to designate the recharacterized contribution as a nondeductible contribution. The other option is to file an amended return claiming an IRA deduction on yuour 2011 return for the recharacterized contribution. In that case the 2012 distribution would be taxable.
If you had funds in traditional IRA accounts from previous years' deductible contributions or those accounts had earnings, some or all of the 2012 conversion distribution may be taxable. The basic rule is that a distribution from a traditional IRA is taxable to the extent that it exceeds the pro-rated portion of the taxapayer's basis in his or her IRA accounts, if any. A taxpayer typically has basis to the extent that he or she has made nondeductible IRA contributions. The basis portion of an IRA distribution is calculated as follows: Total non-deductible contributions divided by total IRA account balance as of the end of the year plus the distribution amount times the distribution amount. If you have more than one traditional IRA account, all of your traditional IRA accounts are added together and all of your non-deductible contributions to those accounts are totaled for this calculation.
The earnings on funds in traditional IRA accounts will be taxable upon conversion regardless of whether the contributions were deductible or nondeductible.
Although you think that the conversion distribution is not taxable since you did not deduct it on your 2011 return, that may not be the case. If you did not designate the recharacterized 2011 IRA contribution as a nondeductible contribution in your original return, you can avoid paying tax on the distribution by filing a Form 8608 with an amended return for 2011. If you neither deducted the recharacterization contribution on your original return nor designated it a nondeductible contribution on Form 8606, then the 2012 distribution is taxable.