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Hi there,

I'd really appreciate some advice - I rushed what I now realize was a big decision, took totally unqualified advice and now want to figure out a) if I did mess up and b) how do I fix this and c) either way, what on earth do I put on my tax form?

Here's the story: In mid-January, for the first time since having moved to the US I was in the happy position of having maxed out my 401K ($16,500) and having a bit more to save, and wanted to take advantage of an IRA. As I understood it you could either save $5000 before tax in a Traditional IRA and deduct it (which I probably couldn't do being over the earnings limit) or just save $5000 of your after-tax dollars into a Roth IRA.

So, I opened a Roth IRA with ING, who hold my few shares and emergency fund and have always been great to work with. I then (note the wrong-way-round timing here) looked a little more into the IRA rules and found out that I was also over the income limit to contribute to a Roth IRA (I earned >$150K in 2011 with bonuses).
I called ING and they guy (who kept reminding me he wasn't a qualified tax professional) said that I could recharacterize my Roth IRA to a Traditional one, and then convert it back to a Roth IRA, as there is now no cap on converting Traditional to Roth except you pay taxes on the Traditional gains when you do. I had heard this second part before, and asked another friend who is a CPA and quite smart about tax planning, and he said that he did that (and he earns more than me). Being in a bit of a rush, wanting to get this all done before my tax time was up, I went and did just that.

Was this a bad idea? What would have happened if I had contributed to a Roth IRA and was over the limit, do they just tax that part of the capital gains when you take it at the end, so it's just like a regular savings account?
Is my Roth now "real" in that by changing it to a traditional IRA and converting back I put the money into it in an "eligible" way? Will this mean I will not be taxed on it if I only take the gains as per the rules when I am retired etc? What happens if I take money out before then?
As luck would have it, I technically lost about $200 from when I bought the shares in the original Roth to when I recharacterized it, and then gained back about $200 from when I recharacterized the shares into the Traditional IRA and before I converted it to back to the Roth. What, if anything, do I declare as gains and losses for tax?
Is there anything else I missed? How can I avoid this next year (apart from not rushing, getting better advice and coming to this board sooner)?

Thanks to everyone in advance for your help.

Ali
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For the sake of clarity I'm going to rewrite the story. If I get anything wrong stop reading and correct me.

Before Tax Year 2011 you had no IRA account, traditional or Roth, anywhere.

In January 2012 you made a $5,000 Roth IRS contribution for Tax Year (TY) 2011. Later in 2012 you recharacterized that contribution to a traditional IRA contribution, which will be nondeductible because your income is too high for a deduction. Later in 2012 you converted your traditional IRA to Roth.

You did nothing wrong (exept acting before you came here for advice).

Here's how it affects your returns:

TY 2011: You will not receive a 1099-R. Sometime around June 1, 2012 you will receive Form 5498 showing I'm not quite sure what for TY 2011. We'll burn that bridge when we come to it.

On your 1040 you enter the amount recharacterized at line 15a and zero at line 15b. On Form 8606, Part I, you report the $5,000 nondeductible traditional IRA contribution. You attach an explanation of the recharacterization, including the amount originally contributed and the value at the time of the recharacterization. References: instructions for 1040, line 15 and Form 8606.

You report nothing about the conversion. That is a TY 2012 transaction.

TY 2012
On your 2012 1040 you'll report the conversion on Form 8606, Part II. It should result in little if any taxable income.

You can repeat the process for TY 2012, assuming you again do not qualify for a Roth contribution. Just skip steps one and two and make a traditional IRA contribution, immediately converting it to Roth. You can do this for TY 2012 any time between now and 4/15/2013.

Phil
Rule Your Retirement Home Fool
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An amendment to my earlier response.

On your 2011 1040 show nothing at line 15 a or b. Report the recharacterization information on only the attached statement.

I came to this conclusion while dropping a note to the IRS about an apparent conflict between the 1040 and 8606 instructions.

Phil
Rule Your Retirement Home Fool
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Thank you so much Phil, I really appreciate the help! Everything is exactly as you said, and I'm relieved to hear I didn't do anything illegal or irreparable.

Just out of curiosity, what does happen to a Roth IRA if you contribute but are ineligible due to earning over the limit? Do you pay tax on it eventually when to take the payout, or over time on the capital gains each year?

Thanks again.
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Just out of curiosity, what does happen to a Roth IRA if you contribute but are ineligible due to earning over the limit?

You would owe a penalty tax for excess IRA contributions. Off the top of my head, that tax is 6% of the excess contribution for each year the excess contribution exists.

To correct the excess contribution, you have to withdraw the excess contribution plus any earnings on the contribution. Those earnings are taxed as ordinary income and are subject to the 10% early withdrawal penalty.

--Peter
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