Excess Roth Contribution
We have a client who needs to remove their 2020 Roth contribution. Client will be removing 7k contribution + 2k earnings. I’m assuming the client will need to pay income taxes on the 2k earnings? The 10% penalty wouldn’t apply as we will have the funds removed by tax deadline of May 17,2021.
Permalink Submitted by Alan - IRA critic on Mon, 2021-05-03 16:58
Removing the excess by the due date eliminates the 6% excise tax, but not the penalty if under 59.5. With a 30% gain on the excess contribution, client may find that paying the excise tax ($420) is actually lower than the ordinary tax and penalty on the gains. If so, client should NOT request a return of the contribution, report the excise tax on Form 5329 for 2020, then simply request a distribution of 7000 by year end. The 2000 of gain can then remain in the Roth, and the 7000 distribution will be non taxable.
There are also other solutions. If client expects 2021 income to allow a Roth contribution for 2021, they could proceed as above, except that the 7000 distribution later in the year could be avoided as the excess amount could then be applied as a 2021 Roth contribution on Form 5329.
Finally, if client has NO TIRA account, they could do the back door Roth by recharacterizing the excess contribution and earnings as a TIRA contribution, then converting back to Roth. They would owe tax on the 2k of gains, but no penalty and the excise tax is avoided. This gets 9k into the Roth with only 2k taxed.
There is usually multiple solutions to excess contributions once the amount of the gain is determined and is substantial, and that is the case here. All 3 options are roughly the same amount of reporting work, but end up with different tax costs and different amounts preserved in the Roth IRA.