From a Reader: A Roth IRA Excess Contribution Question
By CHM on Jan 21, 2008 in Featured, Roth IRA Contribution Limits
Subscribing to my site guarantees you don't miss any new content. Choose either E-Mail Feed or RSS Feed. Thanks for visiting!
Every week I’m becoming more and more comfortable in my blogging skin.
Each day I’m becoming more and more comfortable with the responsibility that goes along with writing this blog. And trust me it’s a responsibility, but one I am more than happy to accept.
This blog is now officially my baby! And like having a baby there comes a few little side effects…
Most nights I go to bed with email requests, post titles and blogging ideas swimming through my head, often waking up in the middle of the night. But I’m learning to deal with the sensory overload and I realize it can only get better as time goes by. (I hope;)
I’m here to help
One of the blogging responsibilities, that I hadn’t thought of early on, is reading and answering email. For me, it certainly sets me back (time wise) but it’s also what I enjoy doing most; it makes me feel good to know visitors are getting something out of Chance Favors and that I can genuinely help them.
So from time to time I’d like to highlight some reader emails and my responses. I received the following email about a potential Roth IRA excess contribution, about a week or so ago:
From a Reader:
I am just starting to learn (I should have started 10 years ago, but I was caught up in a typical younger mind set… buying stuff) about both IRA’s and Roth IRA’s and I have a question about eligibility. I currently qualify to make full contributions, but due to possible commissions later in the year, may become ineligible. I do not know if they will occur or not, but how does one handle the situation of starting a year eligible and ending the year not eligible?
My response:
That’s an excellent question and the situation you describe doesn’t come up that often. First things first, I’m not an accountant and although I have a working knowledge of tax, I would suggest speaking with a CPA to put your mind at ease and get advice that you can act on.With that said, let’s look at a couple of different scenario.
If you make a 2008 Roth contribution and the extra commissions don’t kick in, then you’re fine, your contribution can remain in there for the life of the account. As much as I love the Roth IRA, if you have a significant commission coming in, well that’s a very nice problem to have and I hope it happens for you.
Let’s look at the second scenario: you make the contribution early in the year and then later in the year these commissions hit. The IRS doesn’t care when the income that pushes you over the eligibility limit kicks in. As far as they’re concerned, you have made an excess contribution when you shouldn’t have.
Under IRC section 4973 there would be a 6% excise tax assessed on your $5000 (for 2008) contribution until you remove it. You would have the choice to re-characterize this Roth contribution before you file your taxes in April of next year and move those monies back to a traditional IRA.
In the end, it’s up to you whether or not you want to take a chance and make the contribution. If having to do much of the above gives you a headache, then you may want to hold off. Instead, make a traditional IRA contribution (deductible or not) and then convert it to a Roth IRA in 2010.
I call this maneuver ‘backdooring into the Roth” and talk about it on my blog. Here’s a couple posts I wrote dealing with ‘backdooring’ into a Roth IRA if you’re not contribution eligible now, or in your case, if you’re unsure of your status.
http://chancefavors.com/2007/07/jumpstart-your-roth-conversion
http://chancefavors.com/2007/07/roth-ira-conversionsAgain, I urge you to check or double check what I’ve said with your accountant. Hope this helps and I hope you continue to read my blog. If you haven’t yet subscribed to my RSS feed yet, please do:)
Good luck
Has anyone had a similar experience to this reader?
Footnote: This post was written while wearing ear plugs.
Tags: 2010 Roth IRA Conversion Event, excise tax, Roth IRA Contribution Limits, Roth IRA Conversion
hank | Jan 23, 2008 | Reply
Hey Ciaran - a few things to note for the reader:
1. You should know if you’re at the phase out schedule for your IRA contributions - check your MAGI score and estimate what you’re heading toward at the end of the year.
2. If you ARE getting close to the magic MAGI number, look for ways to offset that $$$. 401k fills that void perfectly. Paying to your 401k offsets that MAGI score and drops you down BELOW the limit again, if only for 1 more year.
3. If you’re making that kind of money, don’t worry about it that much.
You’re still able to contribute to a Traditional IRA or other investments.
CHM | Jan 23, 2008 | Reply
Thanks Hank, well said.
Bill | Feb 3, 2008 | Reply
I had this problem in 2006 when my wife decided to work full-time longer than I expected after our daughter was born. The choice I made was between applying the contribution towards 2007 (paying the 6% tax on the contribution) or withdrawing the contribution along with any gains (paying my marginal tax rate plus a 10% penalty on the gains). By my calculation, withdrawing the money and redepositing it in 2007 should have been less costly.
Removing the money wasn’t too difficult, but one thing I learned the hard way: if you have made multiple contributions for the year, don’t expect your fund company to back out each transaction separately. They have a formula dictated by the IRS that assumes you made your entire contribution on the date of your first contribution and calculates the gain accordingly. In my case, the shares I purchased in January 2006 gained a lot more than the shares I purchased in August (we had made monthly contributions). My fund company withdrew an amount equal to my total contribution plus the rate of return on the January purchase applied to the total contribution. I think that if I had submitted separate withdrawal requests for each contribution in reverse order with several days between each I might have avoided this but that is a lot of extra hassle. I’m close to the cutoff this year but in my case just had to wait until last week to learn what my bonus will be to know for sure. I’ll use my 401(k) as suggested above to make sure we’re eligible.
In case anyone is interested, the formula my company used follows:
Excess Amount X (Ending Balance - (Beginning Balance + 2006 contribution))
All divided by (Beginning Balance + 2006 contribution)
The Beginning Balance was as of the day before I made my first contribution. The Ending Balance was as of the day they processed my request to remove the contributions and earnings. The Excess Amount is equal to the 2006 contribution in this case.
CHM | Feb 3, 2008 | Reply
Bill,
Thanks for sharing your experience.
I think it reinforces the fact that if you’re up against any eligibility thresholds, it’s important to know the potential fallout before acting.
If you contribute, knowing you may be forced to back it out at some point, make sure to check with the broker to see how everything is reported.
Good information, thanks again.
CibSciexiaSoxbrab | Sep 2, 2008 | Reply
wow !!
its very unconventional point of view.
Nice post.
realy good post
thx
John Waterhouse | Sep 24, 2008 | Reply
I have been an overseas taxpayer since 1990, and I’ve used the foreign earned income exclusion (form 2555), and so my AGI for most years has been zero. In several years, my wife and I made Roth IRA contributions. My understanding now is that all of these are “excess contributions”. The first of these Roth IRA contributions goes back to 2001. How should I handle this?