Contribution to Roth IRA by MISTAKE

Submitted by Florina Chuy on Mon, 2020-12-28 18:46

1. Wife usually contributes to a traditional IRA and does a backdoor Roth IRA shortly after. Husband has been contributing to a Roth IRA for about 10 years, though his income was too high to even contribute to a Roth IRA all those years. They both are in their 40s and they do Married Filing Joint. He now realizes that was a BIG mistake. What is the damage now, and what is the best way to fix this?
2. Isn’t the tax accountant’s software supposed to detect this mistake?

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Permalink Submitted by Alan - IRA critic on Mon, 2020-12-28 19:20

Yes, tax programs for which a Roth contribution is entered will flag it as excess. But was the Roth contribution communicated to the accountant? If so, and the accountant did not enter it into the program because he thought that Roth contributions did not need to be reported, would eliminate the program from flagging the contribution as excess. But then you might also ask why the IRS never flagged the excess either for ANY of these 10 years? That could have prevented this error from reoccurring.
There is no statute of limitations for excess contributions. Unless he wants to roll the audit dice he needs to withdraw all the excess contributions from the start through 2019. If he can get this done by 12/31, it will eliminate the excise taxes for the year 2020. The actual 2020 excess (if contributed) can be removed in the usual fashion with allocated earnings. Note that earnings from all the pre 2020 contributions remain in his Roth, but the excise taxes will hurt. When making the large distribution just request the actual amount be distributed, do not mention anything about excess. The combined distribution will not be taxable since it is a return of Roth basis (unless he already tapped his Roth basis).
Then he needs to file Form 5329 starting from the first excess year and pay the 6% excise tax on the excess. Perhaps their joint income was low enough in some years to avoid an excess. But the accumulated excess amount at the end of each year (all prior amounts plus the added year) will add up to some high excise taxes in the later years through 2019, eg a total excess of 300,000 for all years would result in an excise tax for all years of 18. And the IRS might bill late interest for late payment of the excise taxes as well.
All these 5329 forms can be mailed together to the IRS without a 1040X but with a brief note of explanation. If he told his tax accounting about these contributions each year, he has a bad accountant and might be able to proceed against the accountant.
The combined distribution if done by 12/31 is reported on Form 8606 as a NQ Roth distribution. As stated above, there should not be any income tax due, just the excise taxes, but any earnings returned on the 2020 distribution will be taxable on the 2020 return.

Permalink Submitted by Florina Chuy on Mon, 2020-12-28 21:48

I can always count on your advice. Many thanks!

Permalink Submitted by Anup Dulat on Tue, 2020-12-29 16:22

Permalink, helpful feedback – thank you. I did something similar this year by contributing $6k to my Roth IRA for both 2020 and 2019 (Fidelity allowed me to contribute since I hadn’t used my IRA contributions). I also now realized that my income is above the threshold. In speaking with Fidelity, they are giving me two options to correct this: 1) recharacterization and 2) return of excess. I obviously don’t want to incur any early withdrawal fees but am ok paying taxes on the gains if that’s how I can move the funds out into my individual brokerage account. Any questions I have related to taxes and penalties, they recommend I speak with a tax professional. What is the best route for me here?

Permalink Submitted by David Mertz on Tue, 2020-12-29 16:57

adulat23, assuming that you were over the MAGI limit for both 2019 and 2020, it’s too late to obtain a recharacterization or a return of contribution of your 2019 Roth IRA contribution. The only option for the 2019 excess Roth IRA contribution is to obtain a regular distribution of the $6,000 excess contribution without any adjustment for earnings and pay the 6% excess contribution for 2019. To avoid another 6% penalty on the 2019 excess contribution on your 2020 tax return this regular $6,000 distribution must be obtained before the end of 2020, which only gives you a few days. In addition to any reporting of this distribution required on 2020 Form 8606, your 2020 tax return will also include Form 5329 to show it eliminating the 2019 excess contribution carried into 2020.
You’ll need to file 2019 Form 5329 to report the excess Roth IRA contribution for 2019 and pay the 6% excess-contribution penalty.
The excess Roth IRA contribution for 2020 can be resolved by either an explicit return of contribution before the due date of your 2020 tax return or by requesting that it be recharacterized to be a traditional IRA contribution instead.

Permalink Submitted by Alan - IRA critic on Tue, 2020-12-29 17:00

You can no longer remove or recharacterize the 2019 contribution because the deadline for that was 10/15/2020. That means you will owe the 6% excise tax for the 2019 excess for 2019, but if you withdraw 6000 (the earnings remain in the Roth) by 12/31, you will avoid a second excise tax for 2020. This is just a simple distribution, and no need to even mention anything about an excess contribution when you order the 6000 distribution. Since time is critical, do this ASAP. You should not owe any income tax for the distribution since it comes from your balance of regular Roth contributions but you will have to report it on Form 8606 and 5329. The 2020 contribution can wait.
For the 2020 contribution, you still have the choice to recharacterize or withdraw with earnings. No matter which year the corrective distribution of your 2020 excess is done, the earnings will be subject to tax and penalty in the year contributed (2020). If you recharacterize it as a TIRA contribution, it will be non deductible if either you or a spouse (if filing jointly) is covered by a workplace retirement plan in 2020. Recharacterization is probably not beneficial unless you do NOT have any other TIRA balance because you could convert the recharacterized contribution and it’s earnings back to a Roth. This is referred to as a back door Roth contribution. You will owe tax on the earnings, but no penalty. If you just have the 2020 excess returned instead, you will owe both tax and penalty if under 59.5. The deadline for these actions is 10/15/2021.
There are two more options for the 2020 excess that might be better IF you have a large gain on that contribution. The first is to pay the 6% excise tax on the excess for 2020, then withdraw the excess late in 2021. The earnings stay in the Roth and you avoid tax and penalty. So you are comparing the excise tax ($360) with income tax and penalty on the amount of earnings.
The final option is a version of the above IF your income will be low enough in 2021 to qualify for a regular Roth contribution. For this, you avoid taking any distribution, but you owe the excise tax for 2020 on Form 5329, but then you use a 2021 5329 to assign the excess as a 2021 Roth contribution. Again, the earnings get to stay in the Roth. The difference with the point above is that you do not have to take a distribution or report one. You would handle this entirely on Form 5329 for 2020 and 2021.
With all of these options, to make the best decision you have to know the amount of earnings generated to date on the 2020 excess contribution.

Permalink Submitted by Anup Dulat on Tue, 2020-12-29 17:16

Thanks for the prompt feedback! Couple of follow-up questions:1) I did have strong returns in my Roth. My $12k doubled to ~$24k. Does the 2019 excise tax apply to the $12k or just the $6k contribution for 2019? 2) If I understood correctly, I can just withdraw $6000 for 2019 to limit a 6% excise tax in 2021. Do my earnings (~$6k) now grow tax-free in this account then? I was under the impression I need to withdraw contributions + earnings. 3) For 2020, can I just withdraw all of the funds (~$12k) and move to my individual brokerage? I assume here, I pay taxes on the earnings only, but no fees to do this for 2020 contributions. I say this because I can then move 2019 contributions to a traditional IRA and convert to a Roth via backdoor and stay within IRA limits.Thanks for your patience. I’m still getting the hang of this stuff…

Permalink Submitted by David Mertz on Tue, 2020-12-29 18:02

The 2019 excise tax applies just to the $6,000 contribution for 2019, a $360 excise tax. To avoid another 6% excise tax on that same 2019 excess contribution, that $6,000 must be distributed as a regular distribution by December 21, 2020, several days from now.
Since you have substantial gains, it would make sense to leave the excess 2020 contribution in the Roth IRA, pay the 6% excise tax on this contribution with your 2020 tax return, then obtain a regular distribution of just the excess after the due date of your 2020 tax return, including extensions. Since there will be no earnings distributed in this case, there will be no income tax liability on the distribution since the distribution will be from your basis in Roth IRA contributions.
If you instead did a recharacterization of your 2020 contribution, all of the roughly $6,000 in gains attributable to that contribution will accompany the movement of the excess contribution itself over to the traditional IRA, becoming pre-tax money instead of remaining tax-free money in the Roth IRA once the requirements for qualified distributions from the Roth IRA have been met. The choice is essentially between ending up with roughly $6,000 of earnings attributable to the 2020 excess contribution remaining in the Roth IRA and paying a $360 excise tax or ending up with $12,000 in a traditional IRA with the moved earnings being tax deferred.
If you obtain a return of the 2020 contribution before the due date of your tax return, you’ll pay income tax and a 10% early-distribution penalty on the roughly $6,000 of earnings. It probably doesn’t make sense to do that, so by not obtaining a return of the 2020 contribution, you’ll have already contributed the $6,000 limit for 2020.
You are not permitted to move the 2019 contribution to a traditional IRA. To eliminate the excess contribution for 2019 it must be distributed as a regular distribution. You can then use that money for whatever you want, perhaps to subsidize a 2021 traditional IRA contribution.

Permalink Submitted by Anup Dulat on Tue, 2020-12-29 18:30

@DMx, thanks for the insights. Slowly, I’m better understanding this!I have not yet done anything with my 2019 or 2020 contributions yet. What do I need to specifically do to meet the “must be a regular distribution by December 31, 2020” for my 2019 excess contributions? It sounds like based on my large gains (mostly luck), you’re suggesting I leave my 2020 excess, take the $360 hit for the excise tax, and “make regular distribution after 2020 filing”. Once again, what actions are required here? Finally, if I funded a Roth IRA but didn’t transact, can I pull that money out without any penalties / taxes? For example, I have $1500 in cash that I never put to work. Thanks!

Permalink Submitted by David Mertz on Tue, 2020-12-29 19:10

You mentioned that your account is at Fidelity. With Fidelity you can request a regular distribution online, by phone or (although the time is too short to get it done by mail) by mailing a withdrawal form.
A request for a return of contribution before the due date of the tax return is a different process than a distribution of an excess contribution after the due date of the tax return and are reported by the IRA custodian differently on Form 1099-R. If you obtain a return of contribution before the due date of the tax return, the custodian will calculate the attributable gain or loss (there would be none if the money remained uninvested) and distribute the adjusted amount. It will then be as if the contribution never happened. (If there had been an attributable gain, that money distributed would be subject to income tax and early-distribution penalty.) If you obtain a distribution of the excess after the due date of the tax return, the excess contribution is treated as having happened, subject to the 6% excise tax for each year until the excess is removed by regular distribution. So even though a $1,500 might not have any attributable gain or loss, how and when you resolve the excess will determine whether or not you have any excess contribution penalty.

Permalink Submitted by Anup Dulat on Tue, 2020-12-29 20:58

Thanks for your support today. I was able to complete a regular distribution for 2019 (and pay $360). Fidelity shared that the earnings will remain in the Roth tax-free. This really feels like another clever way to do backdoor roth, with a small fee. Fidelity also shared that leaving 2020’s balance makes sense since I have big gains this year. Once again, paying $360 there in late 2021 as an excise makes much more sense to get tax-free growth of the earnings. Starting in 2021, I can do backdoor Roth and keep things cleaner. Thanks again!

Permalink Submitted by Alan - IRA critic on Tue, 2020-12-29 23:13

Just a couple added points. The excise tax of $360 is for 2019 and the IRS may charge you a small amount of interest for late payment. Therefore, you should complete a 2019 5329 (Part IV) and sent it with a check for 360 to the IRS center that handles your area. You do not need a 1040X.
When you file your 2020 return, you will report the 1099R you will receive next month for the 6000 distribution. Use Form 8606, Part III. Since your regular contribution basis on line 22 will be more than 6000, the distribution will be tax free, but you will need to file the 8606. You will also file another 5329 for 2020 this time which shows your distribution and eliminates a second year of excise taxes for the 2019 excess, but also shows the new excess for 2020 and an excise tax of 360 for the 2020 excess.
Tag your calendar in Sept of 2021 to recheck your gain on the 2020 contribution (there is a formula to check that). If you still have a large enough gain, then take another distribution of 6000 to remove the 2020 excess just after 10/15. However, if your gain has been wiped out, you can still remove the 2020 excess by 10/15 in the usual fashion, with the much reduced earnings. The earnings will be subject to tax and penalty, but this will avoid the 360 excise tax for the 2020 excess. Again, this is a last chance to make sure that paying the excise tax is the best decision. If it should happen that your gains are erased, then you will have to amend your 2020 5329 where you paid the 360 to request a refund of that 360. Now, if you want to invest your Roth more conservatively to protect the gains you already have, that should eliminate the chance of having your large gain erased and you can proceed with the original plan of removing 6000 after 10/15.
All this can be confusing, so good idea to look at a 5329 now to see how it works.

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