Scenario for intentionally not fixing an excess Roth contribution?
I have a scenario where after researching at length at my options for dealing with a excess ROTH contribution, I’m starting to think that it is possible the best course of action would be the intentionally not fix the excess and pay the 6% penalty yearly until the contribution eventually can be allowed.
I opened a ROTH IRA in 2020 and made a small contribution, say $500 in 2020 before I realized i would hit income limits that would designate this $500 as excess contributions. Let say then i experience a sizable gain to my original investment and the balance of the roth ballons to $50k. At first i considering trying to do a backdoor ROTH conversion by re-characterizing the contribution and then converting back into a ROTH, but then I found out about the IRA aggregation rule which would apply in that case due to me having other IRAs containing pre-tax funds.
This leads me to believe that rather than recharacterizing the contributions into a traditional IRA any pay taxes on the larger gains made in the account, it seems better just to continually pay the 6% excess tax on the contribution ($500, i plan on not making any more ineligable contributions) until I have a year where my income does not prevent me from contributing to an ROTH. (e.g. paying 6% on $500 is better than pay income tax on a larger future balance)
Am I missing something here?
Permalink Submitted by Alan - IRA critic on Mon, 2021-02-15 18:39
Even with a gain of only 30% or so, you are usually better off to pay the excise tax instead of removing the distribution with earnings and paying tax and penalty on the earnings. But you do not have to incur the 6% tax for more than one year to protect the gains. Just wait until after 10/15 and take a typical distribution of the $500 and your gain stays in the Roth. You only owe the 6% for 2020, and the distribution will be non taxable.
However, if you know that you will be eligible for at least a 500 contribution for 2021, you do not have to take any distribution. Just make a 2021 contribution of 500 less than you will be eligible for. Form 5329 will then automatically (if completed correctly) apply your 2020 excess to 2021. This is known as curing an excess by “absorption” and does not even require contact with the custodian. Withdrawing the 500 would be curing the excess by “distribution” and of course would require requesting the distribution.