Roth IRA contr for foreign income tax exclusion

Client (U.S. taxpayer and citizen) has worked in Germany for a mission for 15 yrs and receives a foreign income tax exclusion from paying U.S. tax, therefore having no reported income to U.S.

Since 2002, she has made annual contributions to a Roth IRA. We thought that MAGI included adding back the foreign earned exclusion (page 125).

But more recently, we’ve been shown page 25 of IRS publication 54, and advised that she can’t make Roth IRA contributions.

Could you comment on the interpretaion of the rules, and whether she was permitted to contribute to a Roth IRA in any of the years since 2002, and if not, starting in which yr the rule changed to disallow her contribution?

The fewer penalized re characteriztions we have to do, the better!

Thanks



  • The foreign earned income exclusion has always eliminated the excluded income from the definition of taxable compensation for regular IRA contribution purposes. Further, there is no statute of limitations for excess IRA contributions, so unfortuneately client has several years of accumulated excess contributions to correct, and only the 2013 and 2014 contributions can be removed using the usual rules that apply for removal prior to the extended due (10/15/2014 for 2013 contributions if 2013 was filed on time or an extension was filed). All prior years must be withdrawn (not recharacterized), but would ordinarily not be taxable since they would be a return of regular contributions. Earnings on the 2012 and prior excess contributions can remain in the Roth IRA. The distribution is reported on Form 8606 for the pre 2013 contributions. Earnings on the 2013 and 2014 contributions will be distributed and are taxable and subject to 10% penalty for the tax year IN WHICH they were made. The costly part is the 6% excise tax that applies each year to the accumulated excess contribution balance, and Form 5329 must be filed for each year starting in 2002 to report and calculate the excise taxes. For these 5329 forms, client may wish to attempt filing them stand alone, but the 5329 Inst technically ask for a 1040X, which is actually unnecessary. Hopefully, client has records of the amount of each year’s contributions (Form 5498), or if not if only one custodian has been used, the custodian may have records, The withdrawal of the pre 2013 excess amount should be done by year end to avoid another round of excise taxes for 2014 which accrues 1/1/2015. May as well wait until Dec to take the distribution as the 2013 excise taxes have already been accrued and another 4 months before withdrawal results in a chance for more tax free earnings to accrue. But the 2013 excess needs to come out prior to 10/15 so that should be done first. IRS may well bill late interest on all the pre 2013 excise tax payments, so payment should not be delayed too long. 
  • Client should take the time to verify that earnings were less than the exclusion for each year. Also, if married and filing jointly, a spousal contribution may eliminate the problem if income is not too high for Roth contributions.


Thank youSingle clientEarnings on the 2012 and prior excess contributions can remain in the Roth IRA.  Yet earnings on the ’13 and ’14 contributions must be withdrawn and subject to tax and 10% penalty.  Wow!  Very surprising that the IRS would permit continued tax free growth of earnings in an account thay was incorrectly established.Please define “accumulated exces contribution balance” as it relates to the 6% excise tax.  Is it just the contributions, and not the growth?  For simplicity, if the client made excess contributions of $3k/yr for 10 yrs, is the excise tax simply $1800 ($180 x 10 yrs), plus possibly IRS interest?Also, assuming the client’s foreign exclusion amount far exceeds her income for each of the years in question, which of the 3 potential taxes (ordinary income, 6% excise, and 10% penalty) could be reduced, if not fully covered?        



The excise tax is figured on the outstanding amount of excess contributions. For example, if 5k of excess contributions were made in 3 consecutive years, the first year tax would be 6% of 5k, the second year would be 6% of 10k and the third year 6% of 15k. So you can see how expensive this gets over a period of 10 years when the total excess grew each year. Using your example of 3k for 10 years, the total excise tax is 6% of 165k or 9,900 plus interest. The excise tax is charged only on the contribution amount, not on the earnings. It is also mutually exclusive with the withdrawal and taxation of earnings. Therefore for years prior to 2013, the excise tax is due but the earnings stay in. For the 2013 and 2014 excess contributions, withdrawal of those contributions WITH earnings eliminates the excise tax for the contributions made for those two years, but the earnings on those contributions are distributed and taxed. But you still have the excise tax due for the prior excess contributions for 2013 because the accumulated excess amount was not withdrawn before 1/1/2014.  So to continue your example, there is a 6% excise for 2013 on 30k, but if the 30k is withdrawn before 12/31, there is no excise tax for 2014. The only potential reduction available here would be if client qualifies for an early withdrawal exception, the 10% penalty on the earnings on the 2013 and 2014 contributions can be waived by filing Form 5329 to claim the applicable exception. Ordinary income tax should be minor since distribution of regular contributions is tax free, so ordinary income tax only applies to the earnings on the 2013 and 2014 contributions. The excise tax is the killer.



OMG!  The only potential reduction that would apply would be from an early withdrawal exception (unlikely) that would only apply to the 10% penalty on the earnings from ’13 and ’14 contributions.Is there any way to to reduce the 6% excise tax for any reason, including if the foreign exclusion amount exceeds her earned income in any of the years.This client is a low income earner, age 52, with a net worth of only $70k.  This will be crushing.  I endorsed the idea of a Roth IRA with the blessing of an H&R block accountant in 2002.  Do we tap our E&O? 



You may have to. Was there any foreign housing exclusion involved, or just the earned income? Has there been any distributions taken from this Roth IRA to date? Was a 5329 filed in any of these years?  While the answer to all of these is probably “No”, they were each possible partial escape hatches against the total potential damages. I am not recommending this, but I know that some people in this situation have taken a distribution of all the excess contributions for which the extended due date as passed (pre 2013 contributions), but not report any excess contributions or pay the excise tax. That would at least stop the unlimited growth of excise taxes with the 2012 total accumulation. While I have not heard of anyone making this case, taxpayers could easily state that had the IRS notified them in a timely manner, this error would not have been carried on year after year. However, IRS oversight has been very spotty.



Thank youFor the IRA to have notified them in a timely manner the IRS would have to been notified of the Roth contributions.  Are annual Roth contributions reported on an annual 8606, and/or somewhere else?



Both the IRA owner AND the IRS receive a copy of Form 5498 in May for the prior year. This form shows IRA contributions of all types for all IRA types. Since a Roth contribution is not reported on a tax return, this form is the only way the IRS knows that a contribution was made. Apparently, their cumputer matching is deficient since they DO know about these Roth contributions.



The accountant for the client suggested amending the returns so that earned income would be shown (permitting the Roth contribution), but that still no taxes would be due. Can this be accomplished by showing the offset more as  a “tax credit” rather than a deduction, by applying the foreign earned income exclusion (or the likes of) futher down in the return?



That might work for open tax years. But only the last 3 years could be amended with the FTC applied instead of the FEIE. If a Roth contribution could be made using the FTC, the accountant could determine the net cost difference in wiping out 3 years of excise taxes vrs the new tax liability using the credit instead. But it will not help the excise taxes for years prior to 2011 and there might not be enough contribution space in those 3 years to apply all the prior years excess contributions, so some excise taxes might also remain due to 2011-2014.



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