Ineligible ROTH CONTRIBUTIONS

Submitted by David J Chapman, CFP on Thu, 2008-05-29 02:30

I have a client who made contributions to her Roth account in 2006 and 2007. She was unaware of the income limitations and exceeded them – I know she can recharacterize the 2007 contribution up until Oct 15 of this year – how should seh proceed on the 2006 ineligible contribution?



Submitted by Alan Spross on Thu, 2008-05-29 03:58

Right, she can recharacterize or withdraw 2007 providing she timely filed or extended 2007 by 4/15.

With respect to 2006, she owes the 6% excise tax for both 2006 and 2007, which can be reported on Form 5329 on a stand alone basis. The IRA will probably bill an interest amount. To correct the 2006 excess she has two choices:
1) If she will be eligible for a 2008 contribution, Form 5329 for 2008 will apply the excess amount to 2008 and there will be no further penalty or tax.
2) If she will not be eligible for 2008 either, she needs to order a regular Roth distribution for the amount of the 2006 excess contribution. No earnings are distributed as they can stay in the Roth IRA. For that reason, she might want to wait until December to allow more earnings to be generated on the contribution. There is no advantage to correcting this now as there is no reduction of penalty since new penalties are incurred as of each year end. The distribution will be reported on both Forms 8606 and 5329 and will be tax free since it will come from contributions.

This gets more complex if she was in the income phaseout range instead completely exceeding the range.



Submitted by David J Chapman, CFP on Thu, 2008-05-29 13:16

Alan,

Why will she owe the penalty for 2007 – I thought if you recharacterized the contribution + earnings to a traditional non deductible IRA that there would be no penalty – I thought it would be as if the Roth contribution had never happened. I also don’t understand the following:

The IRA will probably bill an interest amount.

Thanks for your input.



Submitted by Alan Spross on Thu, 2008-05-29 21:03

The penalty for tax year 2007 is not due to the 2007 excess contribution, which will be properly recharacterized as you indicated. Rather, the penalty is for failing to correct the 2006 excess contribution until 2008. That contribution was there as of both 12/31/06 and 12/31/07, therefore there are two 6% penalties for the amount of that 2006 excess contribution.

The first 2006 penalty was incurred when the excess was not corrected by the extended due date of 10/15/07. The second penalty was added because the excess was still not corrected by 12/31/07 either.

The interest the IRS may (or may not) bill is based on late payment of the both of these penalties, particularly the first penalty for 2006 which was due 4/15/07. The second one was due 4/15/08.



Submitted by David J Chapman, CFP on Fri, 2008-05-30 13:07

Thanks Alan – that clears it up for me.



Submitted by David J Chapman, CFP on Fri, 2008-05-30 13:47

Alan – can you site the booklet and or code that says you do not have to remove the earnings along with the excess contribution – I was under the assumption that you had to remove both if there was an excess contribution.

Thanks



Submitted by Alan Spross on Fri, 2008-05-30 23:05

You do have to remove both if you timely correct the excess contribution per Pub 590, p 51, but not if you correct it later than the extended due date. The publication does not clearly distinguish the different handling of earnings in the second situation, but a copy of the appropriate code section follows.

On p 51, the first section deals with corrections done by the due date and specifies that earnings must also be withdrawn. The next section deals with withdrawals after the due date, and there is no mention of earnings being withdrawn.

The 6% excise tax and the withdrawal of earnings are mutually exclusive. That is, if you owe the 6%, then the earnings stay in the IRA, but if you correct it on time and avoid the 6% excise tax, then you must move the earnings by either recharacterization or distribution.

IRA custodians code the withdrawals after the due date as early or normal distributions rather than using the code P or 8 which requires that earnings also be distributed.

The following is a copy of Sec 408(d)4 of the tax code showing both types of excess contribution correction procedures:

>>>>>>> >>>>>>>>>>
(4) Contributions returned before due date of return
Paragraph (1) does not apply to the distribution of any contribution paid during a taxable year to an individual retirement account or for an individual retirement annuity if –
(A) such distribution is received on or before the day prescribed by law (including extensions of time) for filing such individual’s return for such taxable year,
(B) no deduction is allowed under section 219 with respect to such contribution, and
(C) such distribution is accompanied by the amount of net income attributable to such contribution. In the case of such a distribution, for purposes of section 61, any net income described in subparagraph (C) shall be deemed to have been earned and receivable in the taxable year in which such contribution is made.
(5) Distributions of excess contributions after due date for
taxable year and certain excess rollover contributions
(A) In general
In the case of any individual, if the aggregate contributions (other than rollover contributions) paid for any taxable year to an individual retirement account or for an individual retirement annuity do not exceed the dollar amount in effect under section 219(b)(1)(A), paragraph (1) shall not apply to the distribution of any such contribution to the extent that such contribution exceeds the amount allowable as a deduction under section 219 for the taxable year for which the contribution was paid –
(i) if such distribution is received after the date described in paragraph (4),
(ii) but only to the extent that no deduction has been allowed under section 219 with respect to such excess contribution. If employer contributions on behalf of the individual are paid for the taxable year to a simplified employee pension, the dollar limitation of the preceding sentence shall be increased by the lesser of the amount of such contributions or the dollar limitation in effect under section 415(c)(1)(A) for such taxable year.
(B) Excess rollover contributions attributable to erroneous
information
If –
(i) the taxpayer reasonably relies on information supplied pursuant to subtitle F for determining the amount of a rollover contribution, but
(ii) the information was erroneous, subparagraph (A) shall be applied by increasing the dollar limit set forth therein by that portion of the excess contribution which was attributable to such information. For purposes of this paragraph, the amount allowable as a deduction under section 219 shall be computed without regard to section 219(g).
>>>>>>> >>>>>>>>>>>>>



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