One of the best tax-savings vehicles ever to come out of Washington also happens to be one of the most confusing parts of your tax return.
By itself, the concept of the Roth IRA is simple: Invest after-tax dollars into one of these retirement accounts, and once you reach age 59 1/2 (assuming the account has been open at least five years) you can withdraw those contributions and their earnings tax-free.
But by allowing investors to convert traditional IRAs to Roth IRAs -- and back again -- Congress created a host of confusing issues.
, the nation's largest tax preparation firm, asked its representatives to name the single issue causing taxpayers the most confusion, the Roth was the winner -- or should we say loser? -- hands down.
The focal point for all this confusion is the
Internal Revenue Service's
- Nondeductible IRAs
. If you created, contributed to, converted or closed a Roth IRA in 1998 you'll probably have to deal with this form.
Let's look at some of the issues you'll encounter:
You Contributed to a Roth
To be eligible to contribute, your adjusted gross income must be below $95,000 if you're single (contributions are phased out up to $110,000) or $150,000 if you're married (contributions are phased out up to $160,000). If you're married and filing separately, contributions are phased out between zero and $10,000.
If all you did in 1998 was open a new Roth IRA account and make a contribution, you don't have to file Form 8606, even though Line 19a asks for your 1998 Roth IRA contributions. (You need to fill that out if you are recharacterizing a contribution. More on recharacterizing later.)
But even if you don't need to submit Form 8606, you should fill out and file away the worksheet on page 6 of the instructions. This worksheet will help you keep track of the cost basis of your Roth IRA contributions. Hopefully, the financial institution managing your Roth account also is keeping track.
You Contributed Too Much
Your Roth IRA contributions are evaluated annually, so your year-end adjusted gross income determines your Roth contribution eligibility. It's possible that, while preparing your tax return, you could discover that your adjusted gross income exceeds the contribution limit and you're not eligible to contribute to a Roth.
If that's the case, you've got to get that money out of the Roth before your file your tax return or you'll be hit with a 6% penalty on the contributions, says Maggie Doedtman, tax research and training specialist at H&R Block. There are two ways to do it.
You can undo your contribution and get your money back. Call the financial institution holding your Roth and ask to have the entire amount returned to you. You'll most likely owe tax on any earnings that accumulated.
Or you can convert -- or recharacterize -- the amount into a new or existing traditional IRA before your tax return is due. Reporting this recharacterization on the 8606 is pretty tricky.
First, show the amount of your total contribution on line 19a. Then, report the recharacterized amount on line 19b as a negative number. If you're pocketing the entire amount, your Form 8606 reporting requirements are almost over. The only additional thing you must do is report any earnings on that amount on line 15b because you owe tax on it now.
If you decide to recharacterize your Roth contributions back to your IRA, that amount will be considered nondeductible. So you must additionally report it on line 1 as a nondeductible contribution.
Any time you do a recharacterization, you must attach a statement to your tax return, explaining the reason for the recharacterization and where the money is going now. Be sure to include any earnings that were generated.
But what if your adjusted gross income falls in the middle of the phase-out range? Page 38 of
- Individual Retirement Arrangements
will help you determine what percentage of your $2,000 you can keep in the Roth IRA without being penalized.
Converting an IRA to a Roth
You had until Dec. 31, 1998, to convert all or part of your traditional IRA into a Roth IRA for 1998. For that conversion to have been valid, your 1998 adjusted gross income couldn't exceed $100,000 for single taxpayers or for married couples filing jointly. (Spouses filing separate returns cannot convert.)
If you did convert, you should have received
- Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
from the financial institution holding your account.
Let's assume you converted a traditional IRA, currently worth $50,000, into a Roth. We'll assume this amount includes your contributions plus earnings.
Enter that $50,000 conversion amount on Line 14a of Form 8606. Assuming your contributions were all deductible -- that is, you never paid taxes on the money -- your basis in the IRA is zero. So you'd enter zero on line 15. (If you had any nondeductible contributions throughout the years, that amount would go on line 15. You don't want to pay tax twice on your money.)
Converted Too Much? Recharacterize!
What happens if you converted a traditional IRA to a Roth, in say, July 1998, and now you realize your 1998 adjusted gross income is $120,000? You are over the $100,000 limit so you have to undo the conversion and recharacterize that money back into a traditional IRA. You have until the day you file your tax return to do it and avoid a penalty.
To show the recharacterization from the Roth back to a traditional IRA, report the original withdrawal amount of $50,000 on line 14b, Recharacterizations.
In addition, remember to attach a statement to your tax return explaining why you had to recharacterize in the first place. Here you also would include any earnings the account may have generated over the last six months and note that those amounts also were moved into the traditional IRA.
But the reporting of your recharacterization is not complete yet. You now have to fill out Part I - Traditional IRAs on Form 8606.
Let's assume the original basis of your $50,000 IRA was $35,000. That must be reported on Line 2 of the 8606. The reason: Regardless of what the account is worth, you haven't paid tax on any of the contributions yet, says Doedtman. So although your withdrawal amount was higher, you never paid tax on the original money.
For those of you who recharacterized a bunch of times, you probably have a stack of 1099Rs. "Go with the latest 1099 to begin your reporting," says Doedtman. Then work backwards. But remember, after Nov. 1, you were only allowed one recharacterization. That means between Nov. 1 and Dec. 31 you were allowed one chance to convert from a Roth to a traditional IRA then back to the Roth. If you did that more than once, the IRS will just ignore it.