Tax planning and compliance for investors
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By Kaye A. Thomas
Posted November 6, 2008
Corrective distribution not always required.
Recently someone contacted me with the following situation:
In 2006, my husband and I each contributed $4000 to our Roth IRAs. In 2008, we discovered we were not eligible to contribute anything. Since we had not made any contributions for 2007, I figured the 2006 excess would roll over into 2007, when we were both eligible (we will not be eligible in 2008). Now I am trying to fix this issue, but I have questions.
1. Does the excess contribution automatically roll over from 2006 into 2007? Are there any forms to fill out?
2. I understand that I need to remove the earnings on the excess contributions. Is that correct? If so, when is the "ending period" for the calculation? Since the 2006 excess was rolled over into 2007, do I calculate earnings from April, 2006 (when the contribution was made) through November 2008, or April 2006 through April 2007 (when it rolled over), or another date?
3. I know there is a penalty of 6% for the excess contribution. Will the penalty apply only for 2006, since the 2006 contributions rolled into 2007, or will there be an additional penalty for 2007 and another for 2008?
4. If the interest calculation on the excess contributions turns out to be negative, how is that handled?
Because you didn't qualify for a Roth contribution in 2006, you had an excess contribution that year. The law provides four distinct ways to correct an excess contribution, which my book Go Roth! explains in a chapter on troubleshooting.
Only two of the methods can be used to eliminate the penalty for the year of the contribution, and you are too late to use either of these. One would be to recharacterize the contributions so they go to a traditional IRA, assuming you're eligible to contribute to that type of IRA. The other is to take a corrective distribution that's adjusted for investment performance. Either of these actions, taken by October 15, 2007, would have eliminated the excess contribution penalty. You discovered the problem after the deadline had passed, so the 6% penalty applies. You need to file Form 5329 for 2006, completing Part IV, which deals with excess Roth contributions. You aren't allowed to combine the results for two individuals on this form even when filing jointly, so you'll prepare two versions, one for yourself and one for your husband. Each will show an excess of $4,000 and a penalty of $240.
This form can be filed on a standalone basis (there's a place for your signature) so you don't have to file Form 1040X to amend your original income tax return. Be sure to get the 2006 version of Form 5329.
Once you've missed the deadline for the two corrective actions described in the previous paragraph, your issue becomes how to avoid having the 6% penalty apply again in subsequent years. This penalty continues to apply every year until the excess is remedied, so you could owe another $480 each year. After October 15, 2007 you had two possible ways to correct the situation for 2007.
One would be to withdraw the excess by the end of 2007. Unlike the corrective distribution you make by October 15, this rule does not require you to withdraw earnings. Also, this rule doesn't give you until October 15 of the following year to act: you would need to pull the money out by December 31. You missed that deadline, so you would be out another $480 for 2007 if you had to rely on this rule.
Rules discussed in this article are covered in the chapter on troubleshooting in our book, Go Roth!
Fortunately, there's another way. After you've paid the penalty for an excess in the original year of the contribution, you can correct the excess in a subsequent year by contributing less than the amount allowed. You say you were eligible to contribute for 2007 and didn't make a contribution that year. Assuming the amount you were allowed to contribute in 2007 was at least equal to the amount of your excess from 2006, that excess was automatically corrected for 2007. You'll have to show this to the IRS so they won't try to collect the penalty for 2007. You'll do this by filing Form 5329 for 2007. Once again you file two forms, one for yourself and another for your husband. You'll see a line where they ask for the amount by which your contributions for that year were less than the amount you were allowed to contribute. In your case, that difference will eliminate the excess, so you owe no penalty for 2007 or later years.
When using this method to eliminate an excess contribution from a previous year, it isn't necessary to take any money out of the IRA.
To summarize, you'll need both the 2006 and 2007 versions of Form 5329. You can obtain these forms online from the IRS page for prior year forms. Prepare two version of each form, one for yourself and one for your husband. The 2006 forms will each show a penalty of $240 and the 2007 forms will each show elimination of the excess. Be sure to sign the forms, and send them to the IRS with your check for $480. You should expect the IRS to bill you for interest on this amount because you didn't pay the penalty when it was originally due.
I suggest enclosing a brief cover letter explaining that you recently discovered you weren't eligible for the 2006 contribution and are filing forms required for the 2006 penalty and the elimination of the excess in 2007.
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