I have a problem with a Roth IRA I opened in 2006.
I opened a Roth IRA at a local bank on July 1, 2006 that I shouldn’t have. I didn’t have any job/income for that year, so I’ve obviously broken the requirement of earning at least as much income as you contribute to a Roth IRA.
I was originally planning on merging this Roth with my Vanguard Roth at the end of the year (which I contributed to in 2007 and 2008). I don’t think I can do that now since it shouldn’t have even been opened in the first place though.
I’ve been trying to figure out how to remedy the situation (and minimize penalties), but I’m feeling kind of stuck. This past weekend I went to the bank where I opened the Roth up originally to ask what I should do, and the guy said I should talk to a “tax person” instead.
I posted my question on another forum, and someone gave this response:
[quote]Since you opened it for 2006 and passed the tax deadline of 4/15/2006 You then had until i believe it is October of so of of that year to remove it. If you didn’t you get the penalty of 6% for each year, and then they come back at you with a tax due and fine on the 6% because it isn’t considered a penalty by the IRS it is money that you didn’t pay tax on. So what you have to do is call the custodian of the account and have them back it out with all the interest. The you have to file a form 5329 and a 1040x amended return. The custodian will tell you the amount of the funds removed you fill out the form and send it to the IRS with the 1040x for that tax year and the 6%, it is easy if you use turbo tax. I had to do it for the previous year. The IRS will get back to you with the penalty and the interest owed. On 4k it cost $240 upfront and then they came back at me with $126 more in fines and interest. Thing is don’t wait as the deadline is I believe somewhere in the August to October range. If you go past that it is another year. The way it figures now it is i believe one year for you. It also doesn’t go away, so take care of it.[/quote]
I don’t know that this is accurate though since I contributed on July 1, 2006 (so wouldn’t 4/15/2007, rather than 2006, be the date that passed?).
I was also referenced to this page: http://www.fairmark.com/rothira/excess.htm
I’m still a bit confused about how to go forward though. Can I just download those forms (it looks like 5329 and 1040x) from an IRS website or something? Do I mail them somewhere once they’re filled out, with all the information on there of what I did? Should I liquidate the Roth entirely (that’s like a 10% “early withdrawal” penalty as well, right?)?
I really messed up in opening this up, and it just seems to be getting more and more complex. This is a very tough lesson learned on my part. Any help/advice would be greatly appreciated!
Permalink Submitted by Alan Spross on Tue, 2008-07-08 20:28
Your copied “advice” contained about an equal amount of correct and incorrect information.
At this point you have incurred two years worth of 6% excise taxes for an uncorrected excess Roth contribution. Those taxes were incurred as of 12/31/06 because you did not correct the excess by 10/15/07 and a second 6% charge as of 12/31/07. The positive in all this is that any earnings on your contribution can stay in the Roth because earnings only come out if you corrected the excess on time (by 10/15/07).
To fix this, simply tell the IRA custodian that you want to take a distribution equal to the amount of your contribution. No earnings calculation applies, so do not even mention that you are correcting a prior year excess contribution. You will report the distribution on your 2008 return using Form 8606, and since this is a return of a Roth contribution that you did not deduct, there is no ordinary income tax due for the actual distribution.
However, you must also deal with the excise tax. Download a 2006 Form 5329 and report the 6% tax in Part IV and do the same for 2007. Obviously, these amounts will be the same (6% of your 2006 contribution). Send them to the IRS ASAP as interest on those amounts continues to accrue. The IRS will more than likely bill you for the interest. You will also need to file a 5329 for 2008 just to show that you have corrected the excess amount. There will be no tax or penalty for this. These forms can be filed stand along without the need for a 1040X.
If you want to, you can transfer this account to Vanguard before doing the distribution, and then order
the corrective distribution from Vanguard. The amount you need to distribute will not change, and it does not matter who you order it from.
I am assuming from your comment that you made your maximum Roth contributions for 2007 and 2008. If you made less than your max, please advise, as that will change the above instructions, and reduce your penalty somewhat by applying your excess to 2007 and/or 2008.
Permalink Submitted by Adam Hoefler on Tue, 2008-07-08 20:45
Thank you very much for this response!
I did contribute the maximum Roth amounts for 2007/2008.
Should I go ahead and send a check for the sum of the 6% penalties along with the 5329 forms for 2006/2007? It should be $480, and then they will bill me for the interest on those amounts, correct?
Permalink Submitted by Alan Spross on Tue, 2008-07-08 21:03
Right. There is always a chance they will not bill you as the IRS is not exactly consistent when it comes to IRA administration. But at least by paying the $480 now, you will stop the clock from running further on interest, so the sooner you complete this part, the better.
With respect to the distribution, there is no further penalty or interest as long as you take the distribution prior to year end. In fact, if you wait the $4,000 will have another few months to generate tax free earnings. Just be sure not to forget to order the distribution because if it is not out by 12/31, another 6% penalty is incurred.