Excess Roth IRA Contribution Remedy ?
Happy New Year All. I’m happy to have stumbled upon this informative forum.
In this economy, it’s probably not a unique case – but it’s new to me.
It looks TY 2010 wage income might turn out somewhat less than the amount contributed to a (Roth) IRA early in 2010 (in anticipation of greater annual salary).
i.e. excess 2010 contribution.
From poking around IRS publications, there appear to be two relevant remedies:
1) Somehow apply the excess 2010 Roth contribution to TY 2011 (paying a 6%(?) penalty on the excess contribution amount, on the income tax form for TY 2010)
or
2) Withdraw the excess contribution and earnings on it (paying both a 10%(?) early withdrawal penalty and income tax on (only?) the earnings, on the 1040 for TY 2010).
I’m not sure what procedures to follow with my IRA custodian (a large discount brokerage), or of rules for calculating earnings if remedy #2 above (I’d estimate that the Roth IRA appreciated ~ 17% in 2010), etc. It looks like there might be a similar net “penalty” in either #1 or #2. I would certainly appreciate any direction in this situation.
Permalink Submitted by Alan Spross on Sun, 2011-01-02 18:43
You are correct about your options, and the tax cost would be about the same either way if you are in the 25% bracket, but considerably less with the return of excess contribution if you are in a lower bracket for 2010. With your wage income so small, do you have other income that would result in your being in a higher bracket? Are you able to use the Savers Credit on your return, since that may also impact the best solution?
If you elect a return of the excess contribution, most custodians will calculate the earnings for you but you must tell them the amount of your excess. The earnings calculation uses the entire change in value of the Roth account you contributed to including the changes on pre existing balances. The amount returned to you includes the earnings and the excess contribution with the earnings being the excess over the excess amount you are correcting. That earnings amount is taxable in 2010 and subject to the 10% penalty unless you are 59.5.
Of course, if you need the money the best choice is more obvious.
If you decided to leave the excess in, it would be applied to 2011 to the extent you are eligible for a 2011 contribution of that amount. If not, then there is another 6% excise tax for 2011. If you go this route, do not even contact the custodian since Form 5329 on your 2011 tax return will apply the excess from 2010 to 2011.
Without knowing your total present tax situation and prospects for 2011, I cannot make a recommendation between the two, but you do correctly understand the basic situation.
Permalink Submitted by Steve Griffin on Sun, 2011-01-02 23:55
Thank you so much for your clear and expert reply.
I’m certain to be eligible to contribute the $5,000 maximum in TY 2011, but will not be eligible for 2010 Savers Credit as no taxes owed.
You are certainly correct that, in my low bracket, return of the $2000 excess would generate a much lower tax cost in relative terms (I estimate 3 X smaller), but the absolute difference between the two options seems to be less than $85.
It makes me want to choose whichever option will be easier and invite less potential for errors.
The return of excess appears a bit more complicated. As there is not enough free cash in the Roth, I suppose assets would be sold, although perhaps I could first make a 2011 contribution to “cover” it. At least one more form (a 1099-R, box 7 code P ?) would likely be generated, as well.
I’ll think over this a while more, but am leaning towards the “apply to 2011” option, as it seems to be the simpler one – particularly as you pointed out the custodian does not have to be involved.
Since starting an IRA I’ve always maximized contributions, and am disappointed I didn’t keep my eye on things this past year.
Once again, I sincerely appreciate the assistance.
Permalink Submitted by Alan Spross on Mon, 2011-01-03 01:01
Probably not much difference in ease of handling, but the return of excess contributions is much more common than applying the excess to a later year on Form 5329.
You are correct that if you decide to have the excess plus earnings returned to you, it would work better to sell some investments to generate the amount of cash to avoid the hassle of an in kind distribution of shares to cover the excess amount plus earnings. Your figures on the current cost of the correction appear correct, ie $34 for the removal and $120 for the 6% excise tax for 2010. And incidentally, the Savers Credit could not be applied against either of these costs since they are both Form 5329 taxes.
Note that paying the 6% excise results in your earnings staying in the Roth IRA and as such, your Roth balance would be higher by the amount of earnings ($340) after including your 2011 contribution limit:
If you carry the excess over to 2011, the $340 stays in the Roth, and your 2011 additional contribution capacity is reduced to 3,000. Net total 3,000 additional in the Roth.
If you remove the excess, the earnings and the excess come out, but then you can contribute 5,000 for 2011. 5,000 less 2,340 = 2,660 net total additional in the Roth.
That provides an incremental boost to the carryover, resulting solely from the positive earnings.
I assume that if you made this contribution to an existing Roth IRA, you used the entire account result to come up with the 17% earnings gain. You cannot isolate the earnings calculation to what happened only with the contributed funds, as would be the case if you contributed to a new Roth account.
Permalink Submitted by Steve Griffin on Mon, 2011-01-03 08:41
Wow.
I think I might indeed like to keep a bit more money inside of the Roth.
Yes it is an existing IRA, and I calculated the gain/net income attributable using a formula at a link from this very website:
Net Income = Contribution x [(Adjusted Closing Balance – Adjusted Opening Balance) / Adjusted Opening Balance]
Since you point out that a withdrawal is most common, I suspect the custodian probably has such computations set up on autopilot.
I wasn’t exactly sure how close to the initial contribution date the computation period is required to start. Perhaps the custodian could supply the IRA balance the night before the first (of two) contributions, but I used the prior month’s ending statement balance. For this exercise, the period ended with the 12-31-2010 balance, as opposed to a real date in 2011 when the excess would be returned.
Of course, applying the excess to 2011 avoids all but a single (six) percentage calculation, and enables a “boost” to the carryover, as you put it.
I must thank you once again for your insight and clarity. As a consequence, I am much more confident in dealing with the mechanics of either remedy. (Don’t think I’ve often experienced that with the tax code…)