Excess Roth IRA Contributions

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Excess Roth IRA Contributions

Jake Kucheck
Residential Real Estate Agent · Costa Mesa, CA · Member since 2008 · 1k+ posts · 380 votes

Some holiday tax planning raised the following question:

Back in the glory days of yesteryear, when I had an Edward Jones guy, I unfortunately found myself overallocated in my Roth IRA, and attached to my return was a harsh note indicating that I needed to remove the excess amount immediately. In that particular tax year, I had no gains in my Roth IRA (I did however, have significant losses), so the amount attributable to the gain was moot, but the excess contribution (what was left of it) remained.

My question is- other than the 6% penalty on excess contribution (and the attributable gains), is there any penalty for utilizing ROTH funds as a tax free growth vehicle if you are over age 59 1/2?

Thus, could you theoretically dump $100K into a ROTH, knowing full well that it was in excess of your contribution limit (let's call this zero, due to a MAGI for a married filer in excess of $179K), but simply removing the excess (and attributable gain) tax free prior to filing the next year. Or, if you couldn't do this, could you leave the excess gain in the ROTH, electing to pay the 6% penalty, knowing that you would have to generate a return well in excess of 6% in order to justify this particular vehicle?

Hoping Steven the Tax Guy has an answer to this...

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    14y

    Jake,

    First of all you must remove the Excess contribution AND the excess gains or you will pay the penalty EVERY year until it is corrected. So that 6% penalty would be recurring.

    You are better off not doing that, and putting the income into another investment vehicle, that you can later roll over to the Roth account(pay the tax on then).

    I'm not familiar with how your business is set up; however, if you are self employed and have arranged a SEP or solo 401k you can contribute the maximum and then roll over the account later on to a roth IRA electing to pay the tax on it at that time.

    If you chose to just pay the 6% each year you would have to make a hefty return each year especially once you add in fees.

    You would not want to use that much to over contribute to the account for example if you flip a home with it in the account you will then have to pay tax at your regular rate on the home as it will not be considered IRA income as you have to remove both excess contributions AND gains on the excess contributions.

    You also could suggest that you use the excess toward the next year's contribution, provided you are eligible to make one. There is a great example at the end of the article I attached.

    Here is a reference for you: http://fairmark.com/rothira/excess.htm

    -Steven the Tax Guy

    Your guide to IRS laws, rules, and regulations.

    [email protected]224-381-2660
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  • Jake Kucheck
    OP
    Residential Real Estate Agent · Costa Mesa, CA · Member since 2008 · 1k+ posts · 380 votes
    14y

    Steven,

    Here's my thinking:

    You contribute a chunk (let's call it $100K) that makes a return over the course of the year. Prior to filing, you remove the excess contribution, but leave the gains. Let's say you make 20% on your $100K- you now have $120K, $20K of which is taxable at 6%. Since you've removed the initial excess, only the gains are taxed (I'm guessing the IRS can't tax a contribution that never should have been there to begin with and is removed by the time you file). If you would have otherwise paid more than a 6% tax rate on that $20K, how is it not better to have it in this vehicle than some other?

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    14y

    Jake,

    I see what you were getting at now; however, the IRS may not look too fondly on this distinct taking advantage of the system. They could and have before determined it was a deliberate attempt to deceive due to contribution limits (putting in 100k instead if the max 5k).

    There is a possibility of you doing that. You will have to pull the contribution out in another year. And after that point the gain will belong to the IRA, not to you personally.

    If you fail to take a corrective distribution within the time period described above, you'll incur the excess contribution penalty for the year of the contribution and incur it again for each subsequent year it remains uncorrected. You can prevent it from applying to a subsequent year by withdrawing the excess from your Roth IRA, but the rules here are different than for the type of correction described earlier. This was the example I gave you in the article.

    "You need to act by the end of the year, not by the due date of the return for that year. If your excess contribution was made in 2011, you must act by December 31, 2012 to avoid a penalty for 2012.
    When using this correction method you don't have to withdraw earnings. You simply withdraw the amount of the excess contribution."

    -Steven the Tax Guy

    [email protected]224-381-2660
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  • Jake Kucheck
    OP
    Residential Real Estate Agent · Costa Mesa, CA · Member since 2008 · 1k+ posts · 380 votes
    14y

    I'm probably not alone in saying that I'm absolutely thrilled to do something that the IRS does not look fondly on... so long as they have no recourse. Has there been any recourse in the situations you mention where they have determined this was a deliberate attempt to deceive? Is there a specific penalty for "deliberate attempts to deceive" in IRS code?

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  • Steven Hamilton IIPro Member
    Accountant, Enrolled Agent · Grayslake, IL · Member since 2011 · 5k+ posts · 2k+ votes
    14y

    Jake,

    I don't have any citations directly in front of me at the moment as I'm not near my office at the moment; however, I did read a case in which the IRS has completely reversed the IRA's contributions and taxed all gains including a 10% penalty. This is extreme and it was a repetitive situation such as you described above. This tax payer did this year after year with complete disregard for the rules. However, there is nothing wrong with contributing before you know that you can not contribute.

    Your best bet is to do as I mentioned and contribute maximums to an SEP or solo 401(k) and roll it over to the Roth account.

    If you put in your 5-6k(if you qualify for 6k) and have to withdraw it, you should be fine.

    -Steven the Tax Guy

    Your guide to the IRS laws, rules, and regulations.

    [email protected]224-381-2660
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