Excess Roth IRA contribution
I have a client who made a Roth contribution of $7,000 for 2019 although her income was over the AGI threshold.
Can she recharacterize the contribution as a non-deductible IRA contribution or does she just have to pay the 6% per year penalty?
Permalink Submitted by Alan - IRA critic on Thu, 2021-02-25 18:43
The deadline for removal of the excess with earnings or to recharacterize was 10/15/2020. Therefore client owes the 6% excise tax for 2019, and most likely for 2020 as well. However, if she did not make an IRA contribution for 2020, and qualifies for a Roth contribution using 2020 MAGI, she can apply the excess from 2019 to 2020 on Form 5329 and avoid the tax for 2020. Otherwise, she should request a distribution of 7000 (no earnings) before year end to prevent a third year of excise taxes. At least, any earnings on the excess can stay in the Roth since when the excise tax is paid, earnings are not distributed.
Permalink Submitted by Greg Martinez on Fri, 2021-02-26 20:23
Does the excise tax only apply to the contributions, not the earnings? Does California conform to the federal in this area?This client already made a Roth contribution for 2020. Can she apply the excess to 2021?
Permalink Submitted by Alan - IRA critic on Fri, 2021-02-26 20:56
The excise tax is only levied on the contribution, not the earnings. The excess could be carried over and possibly applied to 2021, but the tax would still be due for 2019 and 2020. Applying to 2021 does not change the excise taxes, it just avoids taking a 7000 distribution this year and making a 2021 contribution.
If the gains on the 2020 contribution are small, there is another alternative. The 2020 contribution could be returned with earnings to open up the 2020 space to apply the 2019 excess to 2020. This eliminates a 2020 excise tax since the excess would be eliminated in 2020. However, tax and possibly penalty (under 59.5) will be due instead. Which method will cost less? It depends on the 2020 marginal tax rate and the amount of gains on the 2020 contribution v. the excise tax of $420.
Ca has it’s own early withdrawal penalty of 2.5% if taxpayer is under 59.5 or does not qualify for another penalty exception. Therefore, the cost of removal of earnings is somewhat higher in CA and this makes it more likely that the excise tax will cost less than removal of the excess and earnings if client is under 59.5.
Note that either way, the client will lose the contribution space for 1 year. Either the 2019 excess is removed without earnings, or the 2020 contribution is removed with earnings and the 2019 excess assigned to 2020 to replace the 2020 contribution that has been removed with earnings.
Of course, client will need to figure the amount of earnings accrued on the 2020 contribution in order to decide which course to take.
Permalink Submitted by Greg Martinez on Sun, 2021-02-28 08:27
How are the earnings related to the excess contributions taxed? Are they taxed only when distributed? If they are only taxed when distributed then in the situation we are discussing the earnings would not be taxed until tax year 2021.
Permalink Submitted by Alan - IRA critic on Sun, 2021-02-28 16:33
Earnings are only distributed if client decides to remove the 2020 contributions to make room to assign the 2019 excess amount to 2020. Earnings on the 2019 excess are not removed and remain in the Roth since the excise tax for 2019 cannot be avoided. Earnings on the 2020 contribution (if removed) are taxable in the year in which the 2020 contribution was made. She probably made the 2020 contribution in 2020, but could also have made the 2020 contribution this year, since she has until 4/15 to make a 2020 contribution. Again, earnings removed in the return of a contribution are not taxed in the year distributed unless they were contributed in that same year.