Better to pay excise tax on excess ROTH contribution?
I am a mid-20s grad student, paid by the university (~$31,000/yr) to do research. After saving up for many years, I thought I was doing a good thing when I opened a Roth IRA account with a $5000 contribution in 2010. However, I have discovered that because of the way that the university pays us, none of my income is considered compensation by the IRS, and therefore, in 2010 I was eligible to contribute $0 to the Roth IRA (or any IRA for that matter– confirmed with IRS over the phone). I will be in the same situation for at least the next couple of years, and possibly until my late 30s, since post-docs at many universities are paid the same way.
I believe that I have until Oct 15, 2011 to withdraw my entire $5000 contribution from my Roth IRA + any earnings the IRA has made (currently approx $900). If I were to do this, I believe that I would pay no extra tax or penalty on the $5000 contribution, but a 10% penalty on the $900 in earnings, plus the extra tax from that earnings being added to my income. I calculate this would raise my taxes by $214.
However, if I pay the excise tax instead, I would pay 6% of $5000 ($300). I could then (assuming the IRA does not require >$900 balance to stay open) take the $5000 out of the Roth as an early distribution (which should not be penalized, since it was my contribution), and leave the $900 in earnings in the IRA to grow tax free until I retire.
I am leaning toward option #2, since at least that leaves some money in to grow in a retirement account for later, and the difference in cost to me is $86.
My questions are:
(1) Is my understanding of the situation correct, and are there any downsides that I am missing?
(2) Would the second option be allowed since I was technically not eligible to contribute any money to the IRA?
(3) Would the $900 in earnings I would be leaving in the IRA be considered a contribution for 2011 and would I run into a similar problem next year.
(4) Can I pay the excise tax when I file my 2010 taxes for this year, or do I have to wait until after Oct 15, when the deadline for option #1 runs out?
(5) Assuming I can do option #2, would I have to take the early distribution before I file my 2010 taxes this year to avoid paying another $300 excise tax for next year?
Thank you for any guidance!
Permalink Submitted by Alan Spross on Thu, 2011-03-24 04:38
You have done your homework well and understand the situation correctly.
1) The choice is a toss up. The obvious downside is that the present cost is known, but the future value of the $900 is not. If you have to pay any service charge for a low value Roth balance, that would probably swing the best choice over to a corrective distribution and save the $86.
2) The option is allowed, but one effect is that your Roth holding period cannot start with an excess contribution even given the earnings. This is not a large problem since you will eventually qualify to make either a regular or conversion contribution to start the clock running. The holding period is immaterial until you reach 59.5 when it is needed for Roth qualification.
3) No, it is not a contribution for 2011, it is just earnings. You would be in the odd situation of having a Roth consisting solely of earnings for awhile. For 2011 you would have to report the distribution of the 5,000 on an 8606 and also need a 5329 to show removal of the excess amount so that your only excise tax will be for 2010.
4) You could pay the excise tax with your 2010 return with Form 5329, and that avoids an interest charge for late payment of a tax due by April 18th. But no sense in removing the 5,000 until 12/2011 since it does not incur another penalty until 12/31/2011. If you leave it in the Roth it has another several months to generate more income (although if you are in the stock market, you could also lose money). Just don’t forget to take it out or you get another 6% hit for 2011.
5) No, see above. You can leave it in the Roth until December.
If your investment tanks by September, you could still change your mind and do a corrective distribution, but would have to amend your return on an 1040 X. You would get a refund of the excise tax and the amount of earnings and the tax and penalty for 2010 would be less.
Note: If your pay can be restructed to W-2 pay in 2011, you can also apply the excess toward your eligible contribution for 2011. If you earned 5,000 you would not have to remove the contribution at all, but would still owe the excise tax for 2010.