The C-Word(s)

The C-Word(s)

If you really want to upset someone, use the C-Word. Or the other C-Word. If you want to really get them spinning, use the other, other C-Word.  Of course, we’re talking about Contribution, Conversion, and (Re-)Characterization and how they apply to your IRA. This is a personal finance article, not edgy British banter but these C-Words cause untold confusion, consternation, and conundrums for IRA investors. Wouldn’t be great to finally comprehend the C-words?

IRAs and the C-Words

The C-Words crop up for IRA investors because each C-Word has considerable IRS-driven rules and limits that affect what you can and can’t do with your IRA. Let’s break down each C-Word.

C-Word #1–Contribution

Contribution: A Contribution to an IRA is new cash conveyed into the IRA. You transfer money from say, your checking account, to your IRA each year if you meet certain criteria:

  1. Calendar Year: Contributions are limited to the calendar year, plus the time to the personal income tax filing deadline, usually April 15th. I.e., you get 15 ½ months from January 1, 2023 to April 15, 2024 to Contribute cash to the coffer. 
  2. Ceiling: No matter how much you earn, you can’t Contribute more than the annual Contribution limit. In 2023, that’s $6,500 or $7,500 if you’re over age 50 (including the year you turn 50). 
  3. Compensation: Depending on how much you earn, your Contributions can be limited. Common compensation limits (for 2023) include:
    1. $218K—above this, you need to bring Backdoor Roth IRA into your crosscheck ($138K for single tax filers). 
    2. $116K—above this, you can’t deduct the whole Contribution… if you have an employer plan too such as the TSP or 401(k). ($73K for single tax filers). 
    3. $6,500—below this level of earnings, you can’t Contribute the full amount to your IRA. Except for a non-working spouse, you must have earned income to Contribute to your IRA. For two spouses, $13K is the number and over age 50, add $1K-$2K for single and married.
    4. There are many other limits, but these are the most common.
  4. Company: If you work for an employer that offers a plan such as a pension, 401(k), TSP, etc., then the existence of their plan affects whether you can Contribute to, and DEDUCT from income, any amount to an IRA. Most larger employers offer some sort of plan, but not all. 
  5. Combo: While you can Contribute to both a Traditional IRA and Roth IRA in the same year, it’s uncommon do so. You have the same overall cap: $6,500 or $7,500 in 2023, so you would be splitting it between both types of accounts.  In some novel cases, this could make sense. 

Contributing is the main C-Word most of us do each year. We earn cash, cogitate about Contributing, then convey the dollars from our checking to our IRA account. It’s quite possible you’ll never have a merge with the other C-Words, but let’s check them out anyway!

C-Word #2–Conversion

Conversion: A Conversion in IRA parlance is the act of transferring money from a pre-tax (Traditional) account such as an IRA, TSP, or 401(k) into a Roth account, usually an IRA. The logic of a Conversion is that you decide it’s better to pay taxes on the Converted amount today rather than some future date, e.g., retirement. Considerations for Conversions cover the spectrum:

  1. Cost: Converting costs money in the form of additional tax dollars paid that year. If you Convert $100K from a pre-tax account to a Roth account and you’re in the low portion of the 24% federal bracket, you know the Conversion will cost at least $24K.
  2. Customs: Most of the rules for Contributions come from Aunt IRS. Many of the Conversion rules do as well. But employer plans can have their own Conversion rules. E.g., many airline 401(k) plans allow “Mega Backdoor Roth IRA” Conversions inside the plan. The main rules that apply to Conversions include:
    1. One 60-day rollover per year. It’s possible to have your Traditional IRA/401(k) custodian cut you a check for the Conversion amount. You then have 60 days from receipt to deposit the entire amount into the Roth IRA. In the intervening 60 days, you can buy whatever vapor investment your troops are telling you about and hope it goes to the moon… but you still must come up with the whole rollover amount by day 60 or you’ll not only pay tax on the Conversion but an additional 10% if you’re under age 59 ½. 
    2. No limit on amount Converted. One of the main sources of C-word confusion is that IRAs have Contribution limits, e.g., $6,500 per person in 2023 but you can theoretically Convert infinity dollars per year.  
    3. No interplay between Contributions and Conversions. Just as there is no interplay between the amount you Contribute to your IRA and the amount you Contribute your TSP/401(k)/403(b), there is no governing limit between the amount you Contribute to your IRA and the amount you Convert to your Roth IRA in a year.  You might self-impose a limit based on the amount of tax you want to pay, but Tax Uncle won’t cap your Conversions
    4. Unlimited trustee-to-trustee Conversions. While you can only take personal possession of your Traditional dollars as part of a rollover once per year, you can have your brokerage (e.g., Vanguard, Fidelity, Schwab, etc.) perform Conversions as often as you like (to pay taxes…). 
  3. Cinco Year Rule: There are many five-year rules in the IRA world, and for younger investors, they’re generally irrelevant. Nonetheless, Converted dollars must stay in the IRA five years before being pulled out or they incur a 10% penalty tax.  The reason why this rarely matters is that IRS rules for ordering the dollars coming out of an IRA stipulate that Contributions precede Conversions which precede earnings on exit from a Roth IRA. As long as you’ve been Contributing for a few decades by the time you start pulling money from your Roth IRA, you’ll have a low pK of transgressing the 5-year rule.
  4. Counting: Tax professionals often caution against Roth Conversions because they increase your tax bill in a single year. The core reason for the Conversion is to lower the lifetime tax bill by boosting the current year tax bill. If you don’t count the expected cost of your taxes over your lifetime, you can’t really assess whether the Conversion makes mathematical sense. 
  5. Common: Once you join Backdoor Roth Club, you’ll be doing both a Contribution and Conversion each year. This will be your normal practice.

Conversion is the second most common C-Word. Younger savers that have had access to Roth IRA and TSP/401(k) their whole working lives may never have to Convert. The rest of us old codgers need to understand Conversions to max-perform them.

C-Word #3—(Re)Characterization

Characterize is the third C-Word. It’s most often found in its “re-“ format in IRA world, so we’re going to count “Recharacterize” as a C-Word. Recharacterize is the C-Word that trips many a tax return self-preparer up because it’s both similar to Conversion with its “C-ness” and with its definition. 

Recharacterizing an IRA Contribution is the act of Contributing to a Roth IRA or Traditional IRA, then deciding to switch to the other type in the same tax year before filing your tax return. When contemplating Recharacterization, consider the following:

  1. Contributions only:  Congress cancelled the ability to Recharacterize Conversions some years ago. You can only Recharacterize amounts that you Contributed in the current year.  This prevents a strategy of continuously flopping money from one tax status to another based on market conditions and other tax events.
  2. Common Cause: The most common reason for Recharacterization is that you Contributed to a Roth IRA but were over the income limit for that year and needed to charge your dollars into Backdoor Roth Club. When you originally Contribute to a Roth IRA but change those dollars back to a Traditional IRA in the same year, that’s not a Conversion, it’s a Recharacterization.  The same is true if you Contribute to a Traditional IRA thinking you’ll receive a deduction, but after realizing that you’re over the income limit to deduct a Traditional IRA, you decide to Recharacterize the Contribution to a Roth IRA before the tax deadline (April 15th most years). 
  3. Complications: When Recharacterizing, you must account for not just the Contribution, but losses and gains as well.  
    1. Losses are easier to handle (mathematically, not emotionally). If your $6,500 Contribution to a Roth IRA becomes $6,000 because of market conditions, you can not only Recharacterize the $6,000 to your Traditional IRA (probably as part of a Backdoor Roth IRA maneuver) but you can top off the $6,000 back to $6,500 so that your ultimate Contribution amount for the year is at the annual limit (2023). 
    2. Gains have complexity. If you Contribute $6,500 to your Roth IRA and the market goes up before you realize the need to Recharacterize, then you’ll have to remove the $6,500 Contribution (to Recharacterize it) and the earnings associated with the Contribution. There’s a specific formula for determining which gains are caused by your recent Contribution versus gains associated with the prior balance of the account, so it’s often best to consult a professional for help. 
      1. You’ll likely pay income tax on the gains plus 10% penalty tax on the gains when you remove them from the Roth IRA if you’re under 59 ½. You won’t pay any additional tax on the principal amount (e.g., $6,500) if you remove it prior to the tax filing deadline (plus extensions, so usually October 15th) since you should have already included that amount in your income. 
  4. Chance: You get one chance to Recharacterize without a truly unholy mess. Let’s say you Contributed to a Roth IRA in 2022 but upon consideration, you earned over the income limit. You can Recharacterize before October 15th (really the 16th due to holidays) without starting to pay a 6% tax on the Contribution… per year until you remove it. At least you can still Recharacterize last year’s Contribution and still get it inside an IRA wrapper for preferential tax treatment.  Often, high income families realize, “Fiddlesticks… we weren’t just over the Roth IRA limit last year… we’ve been Contributing while earning over the income limit for several years!” 

Unfortunately, you can’t Recharacterize Contributions from a year prior to the prior tax year. I.e., you can’t Recharacterize 2021 and prior year excess Roth IRA Contributions (Excess Contributions is the IRS term for a Contribution you weren’t allowed to make.) You must withdraw those Contributions and pay the 6% excise tax plus interest.  While you do get to leave the earnings in the Roth IRA, you’ve forever lost the opportunity to maintain Roth treatment for the Contributions

Imagine a dual-military couple that first earned over the Roth IRA limit in 2013. Ten years of excess Roth IRA Contributions could be at least $57K each that is now nakedly hanging around exposed to the (tax) elements each year. 

Recharacterization trips up many a taxpayer. It’s easily confused with Conversion but is considerably and consequentially contrasted. Recharacterization commonly chases Contributions caused by confusion over compensation ceilings.  If your cranium is currently circling concentrically about this… call for help!

Cleared to Rejoin

Congratulations on conquering the C-Words. Clearly, Contribution, Conversion, and Recharacterization confusion has been corrected now, right? Okay, so consternation could continue, but let’s recap the crucial considerations:

  • Contributions have several limits. Measure twice before Contributing.
  • Conversions have tax consequences, but they can be good ones.  Consult help before Converting.
  • Recharacterization often happens after a (series of) mistake(s). This can be bad news that ages poorly.  If you were told there would be no math, you may be disappointed as you navigate Recharacterization

It’s a catastrophe that the collector of taxes creates conditions such that you’re culpable for comprehension of colossal chunks of tax-related C-Words, but such is the condition of which we must constantly and cautiously conscious!

Fight’s On!

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