Roth IRA – Taxable?
If a couple, with no taxable income on line 43 of their Form 1040 because of the combination of itemized deductions and personal exemptions exceeding their AGI, both fund Roth IRAs in an appropriate amount it is possible for them to owe tax on line 60 of their Form 1040 attaching the Form 5329?
Please explain the rationale of the tax if you would.
Permalink Submitted by Al Fry on Sun, 2008-04-13 00:48
The original question was confusing. If one has earned income at least equal to their Roth IRA contribution, there would not be an excess contribution, even if their taxable income is zero (assuming their MAGI was not so high as to disallow a Roth contribution).
Permalink Submitted by Alan Spross on Sun, 2008-04-13 04:09
Tom,
Like any excess contribution, there is a choice in dealing with it. For this particular situation, in which I will assume that they made Roth contributions for a greater amount than their taxable compensation, the choices are:
1) Correct the excess contribution prior to filing so that the 2007 return can be final. It is very possible to have only the excise tax on line 60 due, which will be 10% of the earnings on the corrective distribution. However, in this case, the taxpayers are probably over 59.5 and therefore there is no early withdrawal penalty. The earnings may be covered by the deductions and exemptions.
2) If not yet corrected, but taxpayer files and does not want to amend later, he can leave the excess in the Roths, and pay the 6% excise tax on Form 5329 (one for each spouse). They can then correct the excess after October 15th to avoid another 6% for 2008. The 6% is likely the reason you mentioned a line 60 entry. This is usually not a good way to go if the excess contributions are more than an incidental amount.
3) At this late date, taxpayer does not have time to correct the excess prior to filing if it has not already been corrected and should therefore extend the return, correct the excess contributions and then file prior to October showing the earnings income and the 10% penalty on the earnings. Again, no penalty for those over 59.5 as of the date of distribution of any excess contributions.
There may be other factors that enter into the decision such as whether taxpayers expect to be eligible for Roth contributions in 2008. In that case, they could use #2 above and file Form 5329 with their 2008 return which will apply the 2007 excess to their unused 2008 contributions. In that case, they would not have to notify the IRA custodian to make any corrective distributions, since this is all done on Form 5329 of the tax return. The amount of any earnings on the excess may affect the decision also, eg if there are excellent earnings it comparatively makes more sense to pay the excise tax on the excess in order to keep the earnings in the Roth instead of distributing them as current taxable income.
Unfortunately, making a logical decision on a situation like this is difficult at this point in the tax season, since most taxpayers do not know how the current year is going to play out with respect to all the variables mentioned.
Permalink Submitted by Janine Janine on Sun, 2008-04-13 14:05
A question, indeed, a rhetorical question:
In order to contribute to a Roth IRA you must have an equal amount in “earned” income. If CD interest, pension and Social Security benefits are not “earned” income, why do we pay taxes on these? In fact, these “unearned” funds along with RMD’s can increase the MAGI so that one is not eligible for the Economic Stimulas Package, decrease the amount of contributions that are deductible, increase the amount of Social Security benefits that are taxable, etc….all this without the MAGI really putting one among the well-to-do.