Removing earnings on excess contributions in a Roth
Have a client that was making monthly Roth contributions of $580 ($6,960 by year’s end). However, client had a “better than anticipated” 2020 and made well over the Roth MAGI limits for MFJ. All 2020 contributions and earnings will need to come out of the Roth. Client is over 59 1/2. Does each contribution get its own earnings calculation, or is it one calculation for the entire $6,960? I haven’t actually put pen to paper yet. Is there even a difference in the two calculations? It’s tax season, and my brain is tired 🙂 Thanks!
Permalink Submitted by Alan - IRA critic on Mon, 2021-04-19 22:49
The earnings calculation should be done as if the entire contribution was made on the date of the first monthly contribution. That makes the calculation much easier. It would be worthwhile to attempt to determine approximately what the earnings are if the Roth has heavy stock investments, given 2020’s large gains. If the gains are large enough, it may cost client less to pay the 6% excise tax for 2020 to protect the earnings which can then stay in the Roth. To cure the excess client could then take a flat 6960 distribution late in the year and that would hold the excise tax to one year. However, if client’s MAGI will drop back down in 2021 instead of making the distribution, client could assign the 2020 excess to 2021 on Form 5329. In short, will client’s 6% excise tax be less than the ordinary tax on the earnings withdrawn?
Yet another option if client does not have any pre tax IRA balance is to recharacterize the Roth contribution as a non deductible TIRA contribution and then convert it to Roth. Client would owe tax on the earnings converted.
Alot of options to digest, but 2020 stock gains were so high that removal creates a high tax for higher marginal rate clients, such that the excise tax for 1 year may be less.
Permalink Submitted by Connie Walsh-Toler on Thu, 2022-03-31 21:36
Can you explain what you mean re: “it may cost client less to pay the 6% excise tax for 2020 to protect the earnings which can then stay in the Roth.”? I have a client that has growth of approx. $3K since their initial 2021 (now ineligible due to unexpectedly high earned income) contribution in Jan. 2021. They are under 59.5, so they would also pay a 10% penalty on the growth.If they pay 6% excise tax on the $6K contributed, would the $3K growth be able to remain in the Roth forever? If yes, when would they remove the $6,000 overcontribution? Prior to April 15 (they already filed their taxes), or after? And, when/how would they pay the 6% excise tax?Thank you!
Permalink Submitted by Alan - IRA critic on Fri, 2022-04-01 00:30
If client has 50% growth on a 2021 Roth contribution (properly allocated across the entire Roth account), paying the 6% excise tax with the 2021 return would cost $360. Having the contribution returned would produce 3000 of taxable gain, and at a combined 30% tax rate plus 10% penalty, this would cost 1200.
Client would then wait until late this year and simply request a distribution of 6000 without mentioning an excess contribution or gain. The 3000 of gain remains in the Roth IRA, and the 6000 distribution will be tax free, coming from client’s regular Roth contribution basis.
Filing requirement – Form 5329 for 2021 with a 1040X return to pay the 6% excise tax and delete any explanatory statement already made regarding excess removal. Form 5329 with the 2022 return to report the removal of the excess in 2022 to eliminate any more excise taxes, and Form 8606 with the 2022 return to report the 6000 non taxable Roth distribution.
But be sure that the 50% growth in the Roth that received the contribution is accurate, and adjust to the actual marginal rate that would be owed if the excess were removed.