ROTH IRA MESS!
I have a BIG Roth IRA problem. I have been contributing the maximum amount to a Roth on an after “tax basis” since 2000. I have a 401k at my place of employment.
Starting in 2004, my AGI disqualified me from contributing. Now I need to clean up the mess! (I’m disgusted that my investment company didn’t even ask me about my AGI each year and now is deflecting any responsibility, but that’s beside the point.)
I’m getting help from my tax preparer but it seems that there are different answers to the same question.
Here’s what I’m clear about:
1) I need to with draw the excess contributions from each year where my AGI exceeded the limit.
2) I’ll need to pay a 6% penalty for each year each contribution was in the account.
Here are my questions:
3) What about the interest gained on the contributions? Do I need to withdraw that as well? If so, do I need to pay tax on the interest gained? Is there another option?
4) If I pull out all excess contributions from previous years before Oct 15, will I owe the 6% for each contribution for the 2007 tax year?
5) Are there any other penalties for pulling it out before age 591/2 (even though it wasn’t supposed to be there in the first place?)
6) Can I leave the interest
Any advice and thoughts would be greatly appreciated!
Permalink Submitted by Alan Spross on Sat, 2008-08-30 20:36
3) You have to separate the years of excess contributions into those that can be corrected by the extended due date of your return, and those that are too late for that. 2007 and 2008 can still be corrected on a timely basis, but the deadline for 2007 is 10/15/08. You would advise your IRA custodian that you want both years (if applicable) contributions along with allocated earnings to be distributed to you. Most custodians will do the earnings calculation, but are not required to. The earnings amount distributed would be taxable for the year of contribution and would be subject to a 10% early withdrawal penalty unless you are over 59.5 or meet another exception to the penalty.
The interest comes out ONLY on your 2007 and 2008 contributions. Note that you can still correct 2007 as above ONLY if you filed your return on time or filed for an extension by 4/15/08. Otherwise it would be too late to handle 2007 in the above manner.
You asked about alternatives. Yes, there are choices. You do NOT have to withdraw as above if you are willing to incur the 6% excise tax every year you do not correct, but if you do incur the tax, the earnings STAY in the Roth. This works if you have great earnings, perhaps 35% or more, which is not likely in this market. Also, if you do NOT correct an excess contribution, it is automatically applied to the first year you become eligible to contribute and do not. For example, if your earnings allowed you to contribute for 2008 and if you did NOT contribute, the oldest uncorrected excess amount would be applied as a 2008 contribution.
The situation is totally different for 2004, 05 and 06 which you can no longer correct on a timely basis. For those years, the earnings do NOT come out, but you incur the 6% excise tax for each year the contribution remained. You correct these by asking for a normal distribution of the contribution only (no earnings) and do not even tell the custodian why, because they need to code this as a normal distribution.
4) You will only owe the 6% for the 04, 05 and 06 year contributions that remained in the account as of 12/31/07.
5) The penalties are mutually exclusive. You owe 6% for 04 through 06, but for those years you leave the interest in the account. For 07 and 08 you do not owe the 6%, but you will owe 10% on the interest that you must withdraw for those years.
6) You MUST leave the interest for years that you owe the 6% excise tax. For the later years, you cannot leave the interest unless you want to incur more 6% taxes by not correcting by 10/15 of the following year.
Here is an example, assuming you contributed 4,000 each year from 04 through 07 and your earnings for the 07 contribution only were $150:
1) Have the custodian correct your 07 excess by 10/15 by returning 4,150. You will owe ordinary tax on the 150 on your 2007 return (you will have to amend it if you already filed) and 10% penalty or $15 on the earnings.
2) Separately and no later than year end 2008, request a distribution of 12,000, which is the total for 04 through 06. You will owe 6% of 4,000 or $240 on a Form 5329 for 04; 6% of 8,000 or $480 for 05; 6% of 12,000 or $720 for 06 and another 6% of 12,000 for those former year contributions that were still in on 12/31/07. That would be a total of 2,160 for those years and the IRS could also bill your for interest on that amount for paying the earlier years late. I indicated you must correct these by year end because there is no benefit to doing it now, because you do not incur another 6% excise tax until 12/31/08. So you might as well let the interest build up till year end since you will be leaving the interest in the Roth.
You can file the old 5329 forms on a stand along basis without an amended return, but if you have to amend 2007, but the 2007 5329 in with the 1040X.
Obviously, before you proceed be absolutely sure your modified AGI for your marital status was too high for all these years. If you were eligible for just one of them, your penalties would be reduced accordingly. Note that the income limit was increased every year for inflation.
Finally, note that if you had your taxes done professionally, these excess contributions should have been caught by the tax software when you filed. This is true because you should be asked if you made a Roth contribution even though a Roth contribution does not get reported on your return.
Permalink Submitted by Alan Spross on Sat, 2008-08-30 20:43
Forgot to include that you have another option for the 2007 and 2008 contributions. You could have them recharacterized to a non deductible traditional IRA contribution if you wish. This would avoid pulling out the earnings and being taxed and penalized on the earnings.
You ask to have those contributions recharacterized to a traditional IRA contribution to an existing or new TIRA account. Since you will not be able to deduct them, you will have to file an 8606 to report the non deductible contributions. You can file the 8606 on a stand alone basis for 2007. You could then convert part or all of your TIRA to a Roth IRA in 2010 when the income limits disappear if you wish.
Again, this is only for 2007 and 2008 excess amounts. The earlier excess amount cannot be recharacterized as the deadline has passed. But it does provide an option for 2007 and 2008 amounts if you do not mind dealing with a Form 8606 into the future. The 8606 is what prevents you from being double taxed.
Permalink Submitted by Diana Davia on Sat, 2008-08-30 21:46
This is so helpful. Let me repeat to ensure I get this straight:
2007 CONTRIBUTION:
I did not make a contribution in 2008, so I’ll only need to clean up 2007. OPTION 1: I’ll ask my custodian to withdraw both the contribution and the interest for that year. The earnings amount distributed will be taxable for the year of 2007 and are subject to a 10% early withdrawal penalty (I’m less than 59.5 and meet no other exceptions to the penalty). I’ll file an amended 2007 return.
OPTION 2: I could have my $4000 from 2007 recharacterized to a non deductible traditional IRA contribution thereby avoiding pulling out the earnings and being taxed and penalized.
QUESTION: If I recharacterize, would I still need to file an amended return?
2004, 2005 and 2006 CONTRIBUTIONS:
For these years, the earnings do NOT come out, but I will incur the 6% excise tax for each year the contribution remained. I will correct this by asking for a normal distribution of the contribution only (no earnings). I’ll pay the 6% penalties as you noted. I’ll use the 5329 form.
QUESTION: Do I complete one 5329 for each year?
Could you clarify this statement?
You can file the old 5329 forms on a stand along basis without an amended return, but if you have to amend 2007, but the 2007 5329 in with the 1040X.
Finally – I’ve had my taxes professionally done for the past 10 years. It was my fault for not noting to my preparer that I had this account. Mia copa! Hard for the software to catch what it didn’t know. And I’ll be using the same preparer to help fix this mess!
Permalink Submitted by Alan Spross on Sat, 2008-08-30 23:28
1) If you recharacterize the 2007 contribution to a traditional IRA, it is best to file an amended return just to provide a place for a recommended explanatory statement of what you did and also you can attach the 8606 to it. But since the numbers of the return do NOT change, you can avoid the more confusing columns showing prior and current income amounts. Your explanatory statement should be similar to this:
“On xx/xx/2007 I contributed $y to a Roth IRA, however because my modified AGI was too high for that contribution, on xx/xx/2008 I recharacterized the entire contribution with earnings, which was then valued at $z to a traditional IRA.”
2) You should use each year’s version of Form 5329 and you can download them off the IRS website. Start with the oldest year first, and then send them to your IRS office together. Do not mention interest on the late payments. They may or may not bill you for interest on the amount of the excise taxes. You will also need a 2008 5329 when you file 2008, but it will just show that you have corrected the old excess contributions and have a -0- balance of excess contributions as of 12/31/08. Order the distribution no later than 12/15/08 to make sure it gets done prior to year end, or if you just want it off your mind you could do it earlier. You will also need an 8606 with your 2008 return that will report the distributions taken. Since they will come from your balance of regular contributions, they will be tax and penalty free.
Request to clarify a statement:
There was a typo: the statement should show “stand alone” not stand along. You do not need an amended return for 2004, 05 or 06, just the respective 5329 forms, Part IV only. For 2007, an amended return is best, so you would add the 2007 5329 to that amended return along with the 8606 showing your non deductible contribution. It should have read “put” the 5329 in with the 1040x.
Note: If you ever made prior non deductible contributions to a traditional IRA you should have filed an 8606 for those years. Since these forms add up your non deductible contributions, check back to see if you already have a balance of those contributions from the past. If so, your recharacterized 2007 contribution would be added to the prior total.
Finally, to further explain why the preparer should have known about this, most preparers send you a pre meeting “organizer questionnaire to fill out, and most of these ask if you made a Roth contribution. When you answer, they enter the amount into their software and it captures that information. If your contributions are “excess”, it will spit out a warning message that you must correct it. Capturing the contributions also allows any early distributions you might take to be reported correctly. So you may not have been asked, but you should have been asked and it would have saved any of these from getting old enough to result in the 6% excise tax.
Permalink Submitted by Diana Davia on Sun, 2008-08-31 01:00
Thank you so much.
This error is pretty much on me….my preparer did have the questionnaire you speak of and I simply didn’t include the information for him.