Fixing excess Roth IRA contribution

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  • #71331
    thales
    Participant

    I contributed max $7K to Roth IRA in January 2020 for year 2020, but later my AGI turned out well above the $139K limit for Roth contribution. Never had it happen to me before, so I only became aware of the problem some time this month (Oct. 2021). I did some research on how to fix it, and have already contacted brokerage to withdraw the $7000 and its earnings from my Roth account. Below is my understanding (please correct if wrong) and some questions:

    (1) I need to fill out Form 5329 for Year 2020 just to compute the 6% penalty (7000×6%=420).

    Form 5329 is not needed for Year 2021. (correct?)

    (2) I need to fill out Form 1040-X for Year 2020 to amend my original 1040 for that year.
    The part to correct (Column B, increase) is: Capital Gains (= earnings from the $7000 between contribution date and December 31, 2020–I have asked brokerge to calculate for me).

    Therefore the Schedule D should also be different—do I need to enclose a revised Schedule D? Or is the 1040-X sufficient? Also, should that earnings be treated as Short-term or Long-term capital gain?

    (3) When I file tax return for Year 2021, I should include the earnings from the $7000 between Jan. 1, 2021 and date of withdrawal of that $7000 (and its earnings) from my Roth IRA account in the Schedule D Short-term Capital Gains.

    (4) Should I put the 6% penalty ($420) on the 1040-X for Year 2020, or should I put it on the Form 1040 for Year 2021? Which line does it belong? Or should I mail the check payment separately from the tax returns? Do I mail Form 5329 with the check payment?

    To summarize my understanding:
    What I owe is simply 6% penalty + earnings on the $7000 in year 2020 and 2021.
    Form 5329 is only for Year 2020.
    Form 1040-X is also only for Year 2020.
    1040 for Year 2021 is to be filed early next year.

    Please let me know if the above is correct. If not, please correct me.
    Many thanks!

    Happy Halloween! 🙂

    #71332
    Kaye Thomas
    Moderator

    Your situation is actually quite a bit simpler. Yes, you need to file Form 5329 and pay the 6% penalty. But you don’t have to withdraw the earnings. You can leave them in the IRA, permanently, without further penalty. They aren’t taxable income for 2020 or 2021. Once you incur the 6% penalty, you can correct the excess contribution without withdrawing the earnings.

    Furthermore, depending on this year’s income, and this year’s contributions, you don’t necessarily even have to withdraw the $7,000. You can “correct” an excess contribution by keeping the current year’s contribution below your allowed contribution by that same amount. So, if you qualify to contribute $7,000 for 2021, but you contribute $0 for 2021, then you’ll be treated as having corrected your 2020 excess of $7,000. If either of those is untrue (either your income is again too high or you already contributed for 2021) then you have to withdraw the $7,000 by December 31 to avoid incurring another $420 penalty. But you don’t have to withdraw the earnings.

    #71334
    thales
    Participant

    Thank you so much for the quick response, Kaye!

    a) I did make 2021 max contribution this past January (I always do it in January).
    b) I’ll make sure my 2021 income will be below $125,000 to make it simple (as long as I postpone a Roth rollover/conversion from 403b to later). So this year’s $7000 should not be excess.

    From your answer, it sounds like the only money I owe is the 6% penalty?
    I thought everything should be reverted to as if the excess contribution were not made, so why can I keep the earnings in the Roth account?

    (I get it that if the earnings stays in the Roth, then it’s not taxable.)

    If earnings can stay in Roth, then I don’t need to have the brokerage calculate it, and don’t need to report it?
    (I read from https://www.investopedia.com/articles/retirement/04/042804.asp

    this formula: Net income=excess contribution×(ACB−AOB​)/AOB

    Is it not relevant to me?)

    Do I need to file 1040-X amended return?

    Thank you very much!

    #71335
    thales
    Participant

    Also, do I mail the check $420 penalty with the Form 5329?

    Thanks.

    #71336
    Kaye Thomas
    Moderator

    As to why you can keep the earnings in the Roth, that’s just the way it works. You need to pull out earnings if you’re avoiding that first year 6% tax. Once you incur that tax, the law no longer requires you to remove earnings to correct the error. Note that although the 6% isn’t based on earnings, in effect it’s a high rate of tax on those earnings unless you had stupendous returns, and is often greater than the amount of those earnings, so a tax of more than 100%.

    Because this doesn’t affect anything on your 2020 income tax return, just send in the 5329 with your check for $420. You shouldn’t have to file a 1040X.

    Don’t forget, you still have to pull out $7,000 by the end of this year to avoid incurring another $420 penalty.

    #71337
    thales
    Participant

    Thank you so much for the good news! Makes my life much easier 🙂

    Best wishes! Thank you for your service–I’ve used these forums for years.

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