Withdrawing ROTH Contributions within the year

[Guest archimedes_pie]

My wife created a ROTH IRA account at Ameritrade for 2005, and deposited the maximum amount $4,000, In the meantime it has grown to $6,500. However, for tax purposes, I would like to have that contribution go towards a Traditional IRA in 2005 so that we may deduct the contribution from our gross income. This is the last year we can use the Traditional to qualify for a deduction for her since 2006 is the first year she will have a retirement plan available to her at work and from now on we will simply send the maximum to her ROTH. So, the question is: can we withdraw just the contribution without any tax consequences, and then use the funds to max out a Traditional for 2005? This will leave the 2500 in earnings in the ROTH, which if we wait till her retirement age will never be taxed. Is this correct?

[John G]

Wow, now that is a complicated scenario. Since you were not eligible for a Roth, I am not sure you can withdraw the contribution and leave the gain. The gain might have to follow the contribution to the regular IRA. Has your custodian commented on this?

Perhaps our accountants can weigh in on that point.

It seems like a lot of hoops to jump through to get a tax deduction. OK, you want to reduce current taxes, and perhaps we are talking about more than $1,000. But is your current tax rate much higher than when you would make future withdrawals? Remember that seeking a deduction will mean that the 4K in a regular IRA will exit at some future date as a much larger amount as ordinary income. You would have to make some guesses about future tax rates to determine if there is a benefit. Keeping it all in a Roth is simpler - no future tax obligation, plus no required withdrawal schedule.

[Guest llaplount]

It sounds like what your referring to is Recharacterizing the original 2005 Roth Contribution.

To Recharacterize the contribution, you must recharacterize not only the contribution itself but the earnings as well. The deadline for a 2005 recharacterization is October 15th provided you file your taxes by April 15th.

[Appleby]

It sounds like what your referring to is Recharacterizing the original 2005 Roth Contribution.

To Recharacterize the contribution, you must recharacterize not only the contribution itself but the earnings as well. The deadline for a 2005 recharacterization is October 15th provided you file your taxes by April 15th.

I agree. This is a recharacterization.

It sounds like the only contribution that was made to the Roth IRA is the 2005 contribution. If so, it will be an easy fix, as all your wife needs to do is recharacterize the entire balance to her traditional IRA. The recharacterization must include the earnings, as technically, she would be treating the contribution as if it was made to the Traditional IRA initially- therefore, all associated earnings/losses must be moved to the Traditional IRA.

The IRA custodian should have a special form that is used for that purpose…or a simple letter of authorization, stating that she wants to recharacterize her entire Roth IRA balance to her traditional IRA may suffice. She should check with the custodian to determine their documentation requirements.

She would then reflect the contribution on her Tax return as a Traditional IRA contribution.

If she made other contributions or conversions to the Roth IRA ( which does not appear to be the case), then a special calculation formula must be used to determine applicable earnings/losses. The formula is provided in TD 9056 at available http://www.irs.gov/pub/irs-regs/td9056.pdf

[Guest archimedes_pie]

Our account is with Ameritrade. It appears we could take the nonqualifed distribtion, and leave the earnings in the ROTH, but since we have already made a 4000 deposit to the ROTH for 2005, we cannot make another 4000 contribution to a Traditional IRA for the same year. So, I'm stuck with recharacterizing the entire account. This will save us about 1,000 in taxes this year(25% tax bracket), and cost us the taxes on 6500 when we retire, (probably about .15*6500=975). So it saves us 1,000 today and overall saves us 25, but when the money is saved is almost more important than how much. My only regret is I sold out of a great stock in order to have the cash in the account ready to transfer, but now it's not going to matter.

Thanks for you help.

[John G]

Your math is off.

The tax deduction value for this year can be predicted better than the future tax obligation on the IRA. You probably know you marginal tax rate for 2005.

If you are successful in life and accumulate substantial assets, your future 15% rate could be way low. Some of the recent folks who have become seniors are suprised at their tax rates when the pensions and distributions kick in and all those exemptions have moved out and are married and the homestead mortage was "burned" years ago.

Keep in mind that you will NOT be paying taxes on $6,500 but paying taxes on the future amount which is likely to be much greater. The younger you are, the bigger that $6,500 will grow. Hopefully, the immediate deduction is invested and grows sufficiently to offset the future tax obligation.

There are lots of scenarios where the $1,000 in hand might not be the best choice.

Also, you did not have to sell the assets in your Roth to recharacterize the assets to an IRA. If you had only one investment in a Roth with only one contribution, the recharacterization would have been easy... everything would just get flipped over to the contributory IRA.