IRA Contribution Mistake
My friends have made a big mistake with their IRA contributions. Since 2002, they have taken the maximum over-50 deduction for one IRA contribution (husband has 401k and is not eligible due to MAGI). Since they deducted the amount on their 1040, contributions should have gone into a regular IRA account. However, they opened a Roth IRA account instead and have been annually contributing the amounts to a Roth instead of a regular IRA. They use Turbo Tax and thought that since Turbo tax did the deduction, it didn’t matter what kind of account they put the money into.
How do they fix this? I researched and it seems that a recharacterization can only be done up until the latest filing deadline (October of year following tax year). Would all the Roth contributions be considered Excess Contributions? If that’s the case, do they transfer the money from the Roth to a regular IRA and pay the 6% tax for each year? It seems they shouldn’t have to amend their returns since the returns already show IRA deductions for a regular IRA.
Thanks in advance for your help.
Permalink Submitted by Alan Spross on Fri, 2008-12-12 05:04
If they took a deduction in a closed tax year (2002-04) for Roth contributions and the IRS has not contacted them, they do not have to amend those returns for the closed years. For 05 to 07 they should amend the return on Form 1040X to eliminate the deduction.
If Roth contributions were in fact made that were not allowed due to their modified joint AGI, then there are excess contributions that need to be corrected. They need to go back and determine which years the spouse that made the contribution was eligible to contribute, and if not they owe the 6% tax for each of those years and for each year thereafter that each contribution remained in the account.
A new 6% is due at the end of every year that this is not corrected, so correcting these prior to year end with prevent another 6% charge on the total of excess contributions. When the 6% excise tax is due, earnings do not have to come out, just the amount of the actual excess contribution. The IRA custodian does not need to know the details, just the amount to distribute. For example, if 5,000 was contributed but not allowed for 3 years, they would simply ask to have 15,000 distributed and report it on Form 8606. No tax would be due for the actual corrective distribution, but the 6% excise taxes would add up. In addition, the IRS will likely charge interest on the back taxes.
If a 2008 contribution has been made, that can still be corrected in the usual fashion by having it recharacterized as a non deductible TIRA contribution or simply returned after the earnings calculation.
This is a mess, and the very first thing is to sit down and start with the oldest year and work forward listing the actual type of contribution made for each spouse, identify if it was allowed based on their income, and determine what the returns for years 05-07 showed in relation to what was actually contributed.
Finally, they should not be doing their own taxes, since these messes that carry on for years can be very difficult and costly to correct. The IRS does not help by taking forever to contact taxpayers who make errors.
Permalink Submitted by Linda Taylor on Fri, 2008-12-12 05:43
Thank you for your very thorough reply. This was my first post to this discussion forum and I’m amazed at the speed and content of your reply.
Spouse was eligible for traditional or Roth contributions in all tax years, so either contribution would have been allowed.
A few questions:
1. They intended for these to be traditional IRA contributions. Since we are beyond the recharacterization period, do I understand that the best they can do is leave them as Roth contributions but pay the tax for 05-07 by amending returns and eliminating contribution?
2. If I’m correct about #1, do they still owe the 6% tax on “excess contributions”? If so, do they owe it for 02-07 or only for 05-07, since 02-04 are “closed tax years” (per your post)?
3. If I’m incorrect about #1, is there any way to remove the money from the Roths and contribute it all to a traditional IRA instead? Or to recharacterize the whole account to be an IRA instead of a Roth?
2008 contribution has not been made – to any kind of IRA. But they intended to contribute to a traditional IRA for the wife (spouse).
No problem sitting down and working forward from the oldest year. I’m just still not clear whether we’re somehow getting the dollars back to a traditional IRA where they intended or whether we’re leaving them in the Roth but amending returns to remove the deduction.
Not to complicate things, but somehow he was able to use Turbo Tax and take a deduction on page 1 of the return (on the IRA deduction line) and also filed Form 8606 for “nondeductible IRA contributions” for at least two of the years. I have that form for the 03 and 04 returns, which may be moot anyway.
I know it’s a mess and I did tell him that he needs an accountant to straighten it out. However, I wanted to be able to give him proper guidance as to what he can expect the fix to be.
Permalink Submitted by Alan Spross on Fri, 2008-12-12 06:37
1) Yes, you are correct that no recharacterizations can be made since we are past the deadline to recharacterize 2007 and no contributions have been made for 2008. Therefore, the Roth contributions that were actually made need to withdrawn to stop the 6% excise taxes from building up for another year on the total of all the excess Roth contributions. However, there is an inconsistency here, since you indicated that the spouse was eligible for a Roth every year. If the spouse was, so was the taxpayer because the joint modified AGI figure applies to both of them. So either neither was eligible for a Roth contribution or both were. Same for a partial contribution if the income was in the phaseout range that allows a partial.
An amended return is not needed to correct a Roth contribution because they do not get reported, but if a TIRA contribution was reported, then it needs to be amended either to eliminate the deduction or to eliminate the 8606 which reported a non deductible contribution. Either would be incorrect if they made a Roth contribution. Also, for earlier years an incorrect 8606 needs to be corrected because incorrect basis carries on for years and causes understatement of tax for all future TIRA distributions. Also, note that an 8606 is specific to each taxpayer as it holds only one of their SSNs, so there might be two of those filed each year.
2) Yes, for each year. These are reported on Form 5329 and it can be done stand alone, but if an amended return is otherwise needed it should be added to the amended return. These are also individual, a separate one for each spouse. I am not sure how far back the IRS can go for the excise taxes, probably best to forget the closed years. I think the IRS has some responsibility to respond on a reasonably timely basis and they apparently did not.
3) No way to change the past contributions now other than to remove them. If by chance there contributions to both a Roth and TIRA for the same taxpayer over the contribution limit, the Roth is deemed to be the excess one, but I don’t think they have this particular problem.
There is no way to amend this to what was intended, they can only change what was actually done once that recharacterization deadline passes. They cannot now get these funds to be TIRA funds instead of Roth funds. Between the tax returns and the forms that the IRA custodians sent out (Form 5498) it is amazing that IRS computers did not catch the obvious mismatches, not the least of which was claiming both a deduction and a non deductible TIRA contribution.
Better re check that the Roth contributions were actually excess. Because if one spouse can contribute, so can the other. Apparently, the difference is that spouse can deduct a TIRA contribution and taxpayer cannot because of 401k participation.
Permalink Submitted by Linda Taylor on Fri, 2008-12-12 16:26
Again, thanks so much for your reply. And again, I’m amazed and thankful for the detail.
Yes, both were eligible for a Roth each year. But for Traditional IRA, only the wife was eligible for a full contribution since husband participates in a 401k plan and was either above phaseout or in phaseout. At least that’s my understanding of the rules. He did make some nondeductible IRA contributions for those years and has since withdrawn them from his IRA. I think that’s a non-issue, other than the complication of those dollars also appearing on the Form 8606.
TIRA contributions were reported for all the years since 2002 and 8606 for nondeductible contribution was included for at least some of the years. Now that you pointed out that 8606 is specific to each taxpayer, the plot thickens. I checked and the 8606 had his name and TIN on it, yet the contributions were mostly intended for her (again, some portion did go to a nondeductible IRA for him).
The only years that I’m sure the 8606 was included are 2003 and 2004. Husband withdrew the funds from his nondeductible IRA this year, so I have no idea how IRS is going to deal with that. Is it still best to forget the closed years?
So, regarding the wife’s Roth contributions: Since there’s no way to go back, all these contributions need to be removed? There were only Roth contributions for wife – no TIRA. If returns are amended, they will pay the tax due on the improper IRA deductions. But if they remove those monies from the Roth, that’s a lot of money that they won’t then be able to re-contribute to her Roth in just one year. Is that correct? So they must remove the money and can then just start fresh with a Roth or TIRA contribution for 2008? Can the money removed be contributed to a non-deductible IRA for her for this year? I guess I’m unclear that if they amend the returns to fix the fact that they made deductions, couldn’t they then just leave the money in the Roth, since it wasn’t even an “excess” contribution to a Roth?