Excess Roth IRA contribution

Submitted by Dan Cahill on Tue, 2020-12-15 19:12

Hi,

I have a client who made a 2020 Roth IRA contribution of $6,000 early this year, but is going to be well over the AGI limitation for 2020. He earned substantial investment income from the contribution, so taking the distribution on the $6K plus earnings and paying the early distribution tax/penalty is not an option. He also will likely earn more than the AGI limitation going forward.

It seems like the best course of action is to file a 5329 for 2020 and pay the 6% penalty of $360 for 2020, and withdraw the $6,000 as an ordinary distribution (i.e. return of original contribution) in late 2021. Then he could start doing backdoor contributions in 2022 if he chooses. He is also well under the 59 1/2 age, if that matters as well.

Does this approach sound correct, or could there be any other strategy that may help him? I assume it won’t affect the future taxability of his Roth IRA distributions (i.e. none of his Roth contributions were deductible).

Thanks much in advance for any help.

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Permalink Submitted by Alan - IRA critic on Tue, 2020-12-15 19:22

Yes, when the excise tax is lower than the income tax and penalty on the withdrawal of earnings with an excess contribution, doing as you suggest is wise. He will have to file the 5329 to pay the 2020 excise tax, then in 2021 file an 8606 to report the non taxable Roth distribution, and also a 5329 to report the elimination of the excess through the distribution. Only cost will be the $360 with 2020 5329. If the gains on the contribution implode before the extended due date (10/15/2021), he could still have the corrective distribution done for the reduced gains and amend the 2020 return to delete the 5329 excise tax and report any gains on the excess removal as income, plus penalty.
Using back door Roth in the future assumes he has no pre tax TIRA balances.

Permalink Submitted by Dan Cahill on Tue, 2020-12-15 20:06

Excellent, thank you much for the helpful and quick feedback. He’d be looking at around $60K of earnings at this point on just the 2020 contribution, so only paying the $360 in penalty sounds like a win! Yes, no previous traditional IRA balance, he only has Roth IRA contributions from prior years, so the backdoor sounds like it would be an option going forward. Thank you again!

Permalink Submitted by Alan - IRA critic on Tue, 2020-12-15 20:34

His entire Roth account appreciated by 1000% in less than a year? Is that correct?

Permalink Submitted by Dan Cahill on Tue, 2020-12-15 21:28

Yes, stock market has been kind to him I guess!