Treatment of Earnings on Excess Roth contributions moved to next year

Submitted by Kathleen Sonnabend on Wed, 2021-02-17 14:32

First, thank you in advance for your response. It is amazing how complicated these topics can be and you are providing a great service.

It is my understanding that an excess Roth contribution for 2020 can be corrected without the 6% excise tax if completed prior to the 2020 tax filing deadline. And further, that one option is to move the excess contribution to 2021 to the extent that the account holder has not already reached the contribution limit for 2021. The American Funds Distribution Request for Excess Contributions form says that earnings associated with the requested excess amount will also be moved to 2021, and if the total of excess and earnings exceed the eligible contribution amount for 2021, the amount of that new 2021 excess will be distributed as earnings first (not moved to 2021). And those earnings will be subject to income tax and 10% early withdrawal for an account holder under the age of 59 1/2. Am I understanding this correctly and that any associated earnings that do not exceed the 2021 limit are not taxed or penalized in any way?



Submitted by Alan - IRA critic on Wed, 2021-02-17 15:29

No. If you want to avoid the 6% excise tax, you will owe tax (and penalty if under 59.5) on the earnings. If you made the contribution in 2020, the earnings will have to be added to your 2020 tax return. The rest of the explanation involving 2021 assumes that instead of returning the excess and earnings to you, they will make a new 2021 Roth contribution with that amount, but not more than the contribution limit. Either way, you will owe tax and penalty on the amount of earnings, and will get a 1099R next January reporting a corrective distribution which by that time should have been included on your 2020 return.
Some people have generated substantial gains on their 2020 excess contributions and actually save money by paying the excise tax to avoid tax and penalty on the earnings. A gain of 25% and up may be enough to make this a better choice. You can then either just withdraw the excess amount in late 2021 (without earnings because the earnings remain in the Roth), or if your income will allow a 2021 Roth contribution, Form 5329 will assign the 2020 excess to 2021. 
Do you expect your 2021 MAGI to allow a Roth contribution in 2021 or to again be over the limit? Do you have an idea of what the % gain in your Roth IRA is from the date you made the 2020 contribution until now?  For 2020 is your entire contribution excess or are you in the phaseout range?  
Yes, this is confusing because there are multiple ways to approach an excess contribution. Generally, you would want to avoid having to go through the same process every year. One way to avoid this in the future is to do a back door Roth if you do not have other IRAs (TIRA, SEP, or SIMPLE).  This involves making a non deductible TIRA contribution and converting it right away to Roth. SInce there is no income limit for non deductible TIRA contributions, you can do this early in the year and not be concerned about your income for the year. Do you have other IRA types?

Submitted by Kathleen Sonnabend on Wed, 2021-02-17 16:22

There are no existing tax deferred IRAs, only a current employer 401(k), so would it be better to do a recharacterization of the 2020 excess Roth to a 2020 non-deductible contribution to a traditional IRA followed by a Roth conversion be better?  Then the earnings would be taxable for 2021 and without the 10% early withdrawal penalty.  There is no 6% excise tax and everything in effect stays in the Roth?  Also the full 2021 elegible amount remains available.

Submitted by Grettis Grettis on Thu, 2021-02-25 13:17

Quote:

No. If you want to avoid the 6% excise tax, you will owe tax (and penalty if under 59.5) on the earnings. If you made the contribution in 2020, the earnings will have to be added to your 2020 tax return. The rest of the explanation involving 2021 assumes that instead of returning the excess and earnings to you, they will make a new 2021 Roth contribution with that amount, but not more than the contribution limit. Either way, you will owe tax and penalty on the amount of earnings, and will get a 1099R next January reporting a corrective distribution which by that time should have been included on your 2020 return.
Some people have generated substantial gains on their 2020 excess contributions and actually save money by paying the excise tax to avoid tax and penalty on the earnings. A gain of 25% and up may be enough to make this a better choice. You can then either just withdraw the excess amount in late 2021 (without earnings because the earnings remain in the Roth), or if your income will allow a 2021 Roth contribution, Form 5329 will assign the 2020 excess to 2021. 
Do you expect your 2021 MAGI to allow a Roth contribution in 2021 or to again be over the limit? Do you have an idea of what the % gain in your Roth IRA is from the date you made the 2020 contribution until now?  For 2020 is your entire contribution excess or are you in the phaseout range?  
Yes, this is confusing because there are multiple ways to approach an excess contribution. Generally, you would want to avoid having to go through the same process every year. One way to avoid this in the future is to do a back door Roth if you do not have other IRAs (TIRA, SEP, or SIMPLE).  This involves making a non deductible TIRA contribution and converting it right away to Roth. SInce there is no income limit for non deductible TIRA contributions, you can do this early in the year and not be concerned about your income for the year. Do you have other IRA types?

 how was the issue solved?   

Submitted by Alan - IRA critic on Wed, 2021-02-17 16:59

Yes, that would be the best option. The 2020 return should then include a Form 8606 to report a 2020 non deductible TIRA contribution, and an explanatory statement about the Roth contribution and the recharacterization, and how much was transferred to the TIRA account. No need to mention the conversion. This essentially starts the back door Roth for 2020, and it can be repeated each year until such time that it becomes obvious that the MAGI will fall under the Roth regular contribution income limits.

Submitted by Kathleen Sonnabend on Wed, 2021-02-17 18:48

Your last answer must have been on its way about the same time I was answering your earlier questions.  I just have one last issue to confirm.  The total earnings (on the recharacterized 2020 excess) will be determined as of the date of the conversion in 2021 and will be taxable in 2021, correct? Thank you again for your clear explanations and shared expertise.

Submitted by Alan - IRA critic on Wed, 2021-02-17 19:05

Yes, the earnings transferred from the Roth to the TIRA as modified by any changes in the TIRA after the recharcterization but prior to conversion will be taxable in 2021. Form 8606 for 2021 will report this conversion in Parts I and II. Any 2021 non deductible TIRA contribution will also be reported in Part I of that 8606.

Submitted by Kathleen Sonnabend on Wed, 2021-02-17 17:01

The gain is just over 25% at the moment.  With changing 401(k) Roth contributions to pre-tax, the full $6,000 MAGI for 2021 will be available.  The 2020 excess of $2,910 is in the phaseout range.  Because most of the Roth money is likely to be untouched for decades, I am thinking it would be better to keep as much in the Roth as possible as opposed to paying the 6% excise tax and distributing the excess after 10-15-2021.

Submitted by Alan - IRA critic on Wed, 2021-02-17 18:10

If due to MAGI phaseout, a partial regular Roth contribution of 2910 is allowed, it is best to only recharacterize the excess amount as a TIRA contribution, which would be most likely be non deductible. This avoids paying conversion taxes on half the gains when the recharacterized contribution is converted back to Roth.  There is no excise tax due or distribution using the recharacterizatio solution. Recharacterization is a direct transfer to a TIRA account including the amount of earnings allocated to the amount recharacterized. Looks like a little less than half the Roth contribution will be recharacterized, and roughly $740 will be the taxable amount for the conversion. 

Submitted by Kathleen Sonnabend on Tue, 2021-02-23 18:15

Makes sense.  Thank you!

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