Capital Gains Rules and Ineligible Distributions: Today’s Slott Report Mailbag

By Sarah Brenner, JD
IRA Analyst
Follow Us on Twitter: @theslottreport

Question:

Dear Ed Slott team members,

Would you please address the following scenario.

You bought stock in an IRA for a $1000. Ten years later, it has appreciated to $10,000. If the stock was not in an IRA, you would owe capital gains tax on the gain of $9,000. 

My 1’st question is this – because the stock IS in an IRA, how is the capital gain tax applied. In other words, after the stock is sold, how much money is in the account. I’m looking for the meaning of the term “tax deferral” in this situation.

Question 2. When a withdrawal is made, is the tax owed based on ordinary

income tax rates?

Thanks for your answer.

Ron

Answer:

Hi Ron,

This is an area where we frequently get many questions. The bottom line is really pretty simple. The capital gains rules do not apply to IRAs. When we talk about “tax deferral” in an IRA, we mean there are no tax consequences as long as the funds remain in the IRA. Using your example, if a stock that is purchased for $1,000 appreciates to $10,000, there will be no taxation as long as it remains in the IRA. When the funds are distributed from the IRA, that is taxable event. Any distributions from an IRA are taxed at ordinary income rates. Capital gains treatment is not available. Continuing with your example, a distribution of the $10,000 stock would mean $10,000 in ordinary income will be reported to IRS and will be taxable to you.

Question:

Ed, Due to unexpected income I have made ineligible Roth IRA contributions for the years 2017 (qualified for reduced amount) and 2018. What is the best option to resolve this? What type of penalties can I expect? Since I am 40, is the withdrawn excess amount subject to an early withdrawal penalty?

Thanks,

Mark

Answer:

Hi Mark,

Excess Roth IRA contributions are a common problem. Fortunately, there are fixes available.

Let’s talk first about your 2017 Roth IRA contribution. You can fix this by taking a distribution of the excess amount. This will not be taxable. Unfortunately, you will also owe the 6% excess IRA contribution penalty because this was not corrected by the deadline of October 15, 2018. This penalty is paid on Form 5329. You will need to file the 2017 version of the form to report the penalty and the 2018 form to tell IRS the excess amount has been corrected, assuming you correct it before 12/31/18.

You can avoid the 6% penalty on the 2018 contribution. You will need to either withdraw it, plus earnings attributable, or recharacterize it to a traditional IRA by October 15, 2019.

Fixing excess contributions can be complicated but it is the smart thing to do. If an excess contribution is not fixed, it does not go away. Instead, the penalties will continue to accumulate and if Form 5329 is not filed the statute of limitations will never start to run, meaning the IRS could come back at any time.

Your best bet is to consult with a knowledgeable tax or financial advisor to be sure everything is done properly.