Mike Bauer's Return: How to Report a Roth Conversion and Mortgage Refinancing

Editor's note: TSC is doing reader Mike Bauer's tax return to illustrate how tax laws apply to real people. On Wednesday, we introduced Bauer and his family and spotlighted his Form 1040. Today, we'll show you how Bauer handled the conversion of his IRA into a Roth IRA and a refinancing of his mortgage. Friday, we'll take a close look at how he reports his trading activities on Schedule D.

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Mike Bauer did two things with his Individual Retirement Account in 1998. He moved it from one account to another and then converted it to a Roth IRA. Let's look at both events.

In January, Bauer transferred his $25,000 IRA from T. Rowe Price to Prudential to consolidate his retirement and trading accounts with the same broker. But here's the rub. Bauer didn't get a Form 1099R - Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. noting this rollover from T. Rowe Price. Is this a problem?

Not in this case. The rollover was a trustee-to-trustee transfer, which means the money was wired from one broker to another. So there's no need for a Form 1099R, and Bauer does not need to report this rollover on his 1998 tax return, says Tom Ochsenschlager of Grant Thorton in Washington, D.C.

If T. Rowe Price had sent a check for the rollover amount to Bauer, he would've had 60 days to put the money into a new account to avoid paying taxes and penalties. In that case, he would have received a Form 1099R and would have been required to report the rollover amount on Line 15a of his Form 1040.

By December, Bauer's $25,000 Prudential IRA had declined in value to $17,329, so he decided to convert it to a mighty Roth IRA. "I figured I would see the cloud's silver lining and convert while I was down," he says.

Great move. In exchange for paying a little more in taxes over the next four years, he'll be able to withdraw all his retirement money from this account tax-free after age 59 1/2. He received a Form 1099R noting this conversion, and, of course, he has to report it.

Enter Form 8606 - Nondeductible IRAs. Bauer must enter the exact amount being rolled on line 14a of Form 8606.

If any of his IRA contributions over the years had been nondeductible -- that is, he paid tax on the money before putting it in his IRA -- there would be no need to pay tax again when the money is moved to a Roth, notes Ochsenschlager. The nondeductible portion of the IRA would go on line 15. The balance, on line 16, would be the amount on which he would owe taxes.

All of the Bauers' contributions were deductible, so the whole $17,329 is reported on line 16. That amount can be spread over the next four years, and that's what the Bauers did. This year, they'll include an additional $4,332 in income, one-fourth of the $17,329 that was converted.

Bauer did not contribute to the Roth for 1998, so technically he's done with Form 8606. But if he'd like to contribute, he has until April 15 to do so.

Rollovers and Conversions A note for users of TurboTax or TaxCut software: Don't let the words rollover and conversion confuse you. We tend to use those words interchangeably. But when it comes to these software programs, a rollover usually refers to movement from one IRA to another. If conversion is mentioned, you're in Roth territory.

Here's a big heads-up: Form 8606 requires a separate signature on page 2, reminds Ochsenschlager. So be sure to sign it along with the second page of your Form 1040.

Mortgage Refinancing

Thanks to the big dip in interest rates, the Bauers refinanced their mortgage this year. But they are not strangers to the refinancing world. This is the second time they're doing it.

Originally, Bauer had a fixed rate of 9 1/2% on his 30-year mortgage. He refinanced in 1993 to get a 4.3% adjustable-rate mortgage. "You do NOT take an ARM when rates are at their lowest in a generation," laments Bauer. So last year, he traded in the ARM for a 30-year, fixed rate of 6.75%.

The first time he refinanced, he paid points. Points (a.k.a. loan origination fees, maximum loan charges, loan discount or discount points) are charges paid to obtain a home mortgage, according to the Ernst & Young Tax Guide. There are a few different rules surrounding the taxation of points.

Rule No. 1. The points must be paid for a mortgage to buy your primary home, and the mortgage must be secured by that home. You can deduct the points in the year you paid them, but only if you pay them upfront at the closing and there are no hidden fees buried in the amount.

To get a full deduction, they points must have been paid directly by you. If the seller pays the points, you can't deduct them.

Rule No. 2. You cannot fully deduct points paid for refinancing a loan (or for home improvements, a vacation home or a home equity loan). Any points paid to refinance are deducted in equal portions during each year of the loan. In accountant-speak, you're amortizing the points over the life of the loan.

The Bauers paid points on their first refinancing, so only a portion of those points was deductible each year. Then they decided to refinance their mortgage again. Now two things will happen. Let's call the initial refinancing Mortgage A and the second refinancing Mortgage B.

The Bauers basically have ended the life of Mortgage A because they refinanced, says Bill Fleming of PricewaterhouseCoopers in Hartford, Conn. So the balance of points on that mortgage is fully deductible in 1998. That gives Bauer a deduction of $1,096. The amount goes on line 12 of Schedule A - Itemized Deductions.

Bauer did not receive a Form 1098 - Mortgage Interest Statement reporting this amount. But that's okay. He just needs to retain all his records as backup so he can prove this number if he ever has to.

Bauer did not pay points on the second refinancing. If he had, he would divide the dollar amount of the points by 30, the number of years in the new mortgage, and deduct 1/30th each year.

It would not hurt to attach a statement to your tax return showing the calculation behind your amortization of those points, says Fleming, although it is not necessary. But again, you need to keep the calculation on file for your own records in case you are ever asked to prove your deduction. This also will help you determine your points deduction in future years.

But be sure to check out the Internal Revenue Service's Publication 936 - Home Mortgage Interest Deduction for more details.

And if you have any questions on any of the above, send them to [e-mail]. I'll try to answer as many as I can in Saturday's Tax Forum.