Should I take 6% penalty for excess Roth IRA contribution since I had significant earnings?

Submitted by Steven Chan on Thu, 2017-04-13 22:26

I overcontributed by $5500 for tax year 2016 and have until the tax deadline which is in a few days to remove the proceeds. The problem is my earnings on the excess comes out to be $15000 out of a total account value of $50000 after I contributed and when I do the math I would have to pay taxes on $2000 or so if I withdraw. I was wondering should I:

1) Leave the amount in and pay the 6% penalty

2) Withdraw the full amount before the deadline and pay 30% taxes plus 10% for early withdrawal

3) Withdraw excess and apply the earnings for next year’s contribution

My tax bracket for the year is 30% by the way.

Also, I am currently unemployed and studying so I am not sure whether I will have any earned income for the year 2017 to contribute again to a Roth IRA for 2017.

Also, if I withdraw the whole excess amount next year, would you categorize it as a excess removal or a regular distribution if I do not apply the excess to 2017 contribution? And would I pay taxes on the earnings if I wait a year?



Submitted by Alan - IRA critic on Thu, 2017-04-13 23:25

  • Option 3 is not possible, but if your earnings are large enough you can pay the 6% excise tax for 2016 on Form 5329 and then remove the 5500 this year without earnings to stop the excise taxes at just 2016. That said, you are probably not calculating your earnings correctly as your Roth would have to quadruple to have 15k of earnings on a 5500 contribution. This is the formula to use:  http://retirementdictionary.com/definitions/netincomeattributablenia
  • Once you get the earnings figure correct, compare 40% of it (taxable at 2016 rates if the contribution was made in 2016) to 6% of the excess contribution. Go with the lower figure.
  • I take it that your 2016 MAGI was too high for any Roth contribution?
  • The excise tax and the withdrawal of earnings are mutually exclusive. So if you pay the excise tax for 2016, then the earnings get to remain in the Roth.
  • You lose one year of contribution space either way when you either remove the contribution (with or without earnings) or are able to assign it to a later year on Form 5329.

Submitted by Steven Chan on Fri, 2017-04-14 00:55

I would have to pay taxes on $2000 with the formula.  

  • Option 3 is not possible, but if your earnings are large enough you can pay the 6% excise tax for 2016 on Form 5329 and then remove the 5500 this year without earnings to stop the excise taxes at just 2016. That said, you are probably not calculating your earnings correctly as your Roth would have to quadruple to have 15k of earnings on a 5500 contribution. This is the formula to use:  http://retirementdictionary.com/definitions/netincomeattributablenia
  •  So I would be able to pay the penalty right now and not have to worry about it come 2017 tax year? It is still before the deadline however
  • Once you get the earnings figure correct, compare 40% of it (taxable at 2016 rates if the contribution was made in 2016) to 6% of the excess contribution. Go with the lower figure.
  • 5500 {(50,000- 35,000)/35,000} is the formula I used to find out the penalty. Does this look right?  Penalty of about 2300 times tax bracket of .3 and .1
  • I take it that your 2016 MAGI was too high for any Roth contribution?
  • Yep
  • The excise tax and the withdrawal of earnings are mutually exclusive. So if you pay the excise tax for 2016, then the earnings get to remain in the Roth.
  • Do I pay the tax before December 2017, or before April 18 2018? Thanks!
  • You lose one year of contribution space either way when you either remove the contribution (with or without earnings) or are able to assign it to a later year on Form 5329.
  • I cannot really carryover it because I won’t have earned income right?

Submitted by Steven Chan on Fri, 2017-04-14 00:57

Another user said this, but I wanted to hear your take on it because this response from the other user got me confused.  You need to remove the $5,500 and the earnings on the $5,500 since it was contributed. I don’t know how you got your other numbers and it is irrelevant how much was in the account before that. You need to call up the custodian and ask for an “Excess Contribution” to be removed. (Use that term since it means you weren’t eligible to contribute as much as you did. You apparently were only eligible to contribute $0.) They will calculate the earnings that go with it, but I suspect you only have earnings of no more than 10% (or $550). The withdrawal will go back to taxable as if the contribution never occurred. Only the gains will be taxed.  

mask107 wrote:1) Leave the amount in and pay the 6% penalty. Then withdraw the excess after a yearWhy pay a penalty for being late? You’ll have to remove it anyway if you didn’t have earned income last year. The gains will most likely increase. 2) Withdraw the full amount before the deadline and pay 30% taxes plus 10% for early withdrawalThis is not a “withdrawal”. It is un-doing a transaction.  3) Withdraw excess and apply the earnings for next year’s contributionYou can do anything you want with it after it returns to taxable.My tax bracket for the year is 30% by the way.Also, I am currently unemployed and studying so I am not sure whether I will have any earned income for the year 2017 to contribute again to a Roth IRA for 2017.I guess you can either take a chance and make an “Excess Contribution” again and be prepared to un-do it next year, else earn some money by working. To make it simpler to understand, if you make a new contribution, why not put it in a new IRA so the money is kept separate from your older IRA. Then if you don’t have any earned income this year, when you remove the “Excess Contribution”, the account will return to 0.Also, if I withdraw the whole excess amount next year, would you categorize it as a excess removal or a regular distribution if I do not apply the excess to 2017 contribution? And would I pay taxes on the earnings if I wait a year?Since you are going to ask for a removal of an “Excess Contribution” (use THOSE WORDS), the tax forms will be coded as to what kind of transaction this is. You will pay taxes for the year the gains were removed. 

Alan S. wrote:In round numbers if you had 30k in the account, then made a new contribution of 5.5k, your opening balance is 35.5k. Your closing balance is 50k and this is a 41% gain.

This is true ONLY if all the contributions were Excess Contributions. If only $5,500 is Excess Contributions (only done for one year), think of it as if it had been put into a separate account. You only have to pay taxes on the part of the gain that goes with the $5,500. You don’t have to pay taxes on the gains on the other $30K if they were contributed in earlier years when you worked and were eligible to contribute. Those gains can remain with the $30K.

Submitted by William Tuttle on Fri, 2017-04-14 01:29

You posted here, it confuses the issue. Alan here is also the Alan who replied there. He is probably the most knowlegeable and helpful person you will find on this topic. Follow his advice. The other indiviual means well, but… is not as knowledgeable and mesured with the experience on these issues.

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