Roth IRA Excess Contribution Withdrawals and Penalties
Client made two contributions to Roth IRA for minor child of $1000 each in tax years 2008 and 2009. Contributions were subsequently deemed to be invalid/excess because minor child had no earned income in either year, and client requested removal of excess contributions in February 2010 accordingly.
Parent/custodian requested removal of all excess contributions (constituting 100% of account) of Trustee (Vanguard). Trustee removed from Roth IRA and returned (1) 2009 contribution along with earnings attributable to 2009 contribution along with (2) 2008 contribution. Earnings attributed to the 2008 contribution (approximately $1000) were left in the Roth IRA account.
I believe that the 2009 contribution and attributable earnings come out penalty free since they were withdrawn before the 2009 tax year filing deadline. As for the 2008 contribution, I do expect that this will require a 2010 tax return to be completed for the minor child along with a Form 8606, and the withdrawal will be subject to penalties, correct? Also, can the attributable earnings stay in the account penalty free, or must they be taken as a withdrawal now else be subject to additional penalties?
Many thanks in advance for the help…
Permalink Submitted by Alan Spross on Wed, 2010-04-21 00:25
Sounds strange, but the earnings generated on the 2008 contribution can stay in the Roth IRA. The trade off is that a 6% excise tax is owed for 2008 and also for 2009 since the excess contribution was not withdrawn until this year.
The 2009 excess contribution, unlike the 2008 contribution, was still corrected before the extended due date and therefore there is no excise tax for it. However, the earnings will be taxable and subject to the 10% penalty.
Reporting: A 2008 5329 to pay the 6% excise tax for the 2008 contribution. This can be filed stand alone. The IRS may bill interest on the penalty amount due to late pay.
The 2009 contribution earnings will be taxable in the year the contribution was actually made. If that was in 2009, that return needs to be amended if filed. Do not know if minor had to even file, but will have to file to pay the 10% penalty on the earnings even if income is otherwise too low to have to file.
Since the distributions took place in 2010, an 8606 for 2010 will be needed to report the distribution. It will be tax and penalty free since it is composed of regular Roth contribution amounts. A 2010 5329 will also be needed to report the correction of the prior year excess amount, but again no penalty applies.
A technical note here. Since none of the regular contributions were allowable, the 5 year clock has not started to run yet even though there is an earnings balance in the account. There will be no balance of regular contributions left in the Roth, just earnings. Therefore, further withdrawals in the near future of those earnings will be taxed and subject to the early withdrawal penalty.
Final comment: Are you sure the child has NO earned income? Household work can qualify, eg mowing loans etc. There does not have to be a W-2 or SS taxes paid to have taxable compensation in this situation………….but the income must be reasonable for the work performed.
Permalink Submitted by EJ Monterinho on Wed, 2010-04-21 00:49
Alan – thanks for the thorough response. The situation is indeed strange.
My impression is that the best bet is just to leave the earnings in the Roth at this point, though an eligible contribution will need to be made in order to start the 5-year clock to prevent early contribution penalties, yes? Then, beyond the two consecutive 6% excise taxes, the earnings will be tax- and penalty-free.
Since child filed no return for 2009, a return will now need to be filed to pay the 10% penalty on the earnings (despite fact that earnings amounted to $40 since contribution was only made in late December 2009) on the 2009 contribution.
Child in question was born in November 2008. First contribution was made at 2 months old and second at a little over 1 year of age, hence the plausibility of having some reasonable explanation for earned income is slim :-). The parents, though well-intentioned in wanting to establish an IRA for the child early on, were apparently unaware of earned income restrictions and probably should have guided this to an UTMA or other non-qualified account.
Permalink Submitted by Alan Spross on Wed, 2010-04-21 02:15
Yes, quite a bit too young for earned income.
No need to file a return for 2009 just to report taxes on the earnings. The 10% penalty can be filed on a stand alone 5329 for 2009. Same form but a different section than the 6% excise tax.
With respect to the remaining earnings, the account can stay open if it is worth it considering small account expenses. Later on, regular contributions can be made, but those earnings will not be tax and penalty free until age 59.5. That requirement also applies along with the 5 year holding period from the year of the first eligible Roth contribution.
Permalink Submitted by mk foss on Thu, 2010-04-22 16:50
I always get color advertisements at home from local dentists with pictures of smiling children. I believe they pay the children a “modeling fee” as earned income. I’d think you’d need a full set of teeth to earn income that way.
Permalink Submitted by Alan Spross on Thu, 2010-04-22 21:23
Or perhaps an Octomom with a TV reality show including all the infants 🙂