How to I Handle My Excess Roth IRA Contributions?

By Sarah Brenner and Jeffrey Levine
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This week’s Slott Report Mailbag looks at possible miscues and how to handle them. What constitutes an excess Roth IRA contribution? One individual below has to deal with the 6% penalty while another doesn’t. We explain why. As always, we stress the importance of working with a competent, educated financial advisor to keep your retirement nest egg safe and secure. Find one in your area at this link.

1.

Hello, I had a quick IRA question I have been tirelessly trying to get an answer to with no success. My wife started a Roth IRA a couple years before we were married. When we got married in 2010, our AGI (adjusted gross income) went over the phase-out range to contribute to a Roth IRA. The problem is that neither one of us knew that we needed to start using the backdoor conversion method and contributions were made directly. I didn’t know it was an issue until a few months ago when I opened my own IRA. I know I just need to recharacterize her 2015 contributions over to a Traditional then convert it back, but how do I fix her 2010-14 direct Roth contributions that should have been “back doored” instead, since those deadlines have passed? The IRS has never said anything about improper method on our taxes.

Should I just fix 2015 and go on? I just don’t want them to hit me with some big penalty down the road.

Answer:
First, here is the good news. You can recharacterize your 2015 Roth IRA contribution to a traditional IRA. The deadline for recharacterizing 2015 contributions is not until October 17, 2016 so you still have plenty of time. After recharacterizing, you can use the back-door strategy and convert those funds to a Roth IRA. Going forward, if your income remains too high to contribute to a Roth IRA in future years, you can continue to use the back-door strategy. There has been talk that lawmakers may do away with this, but for now it remains a valuable tool for you.

Now the not-so-great news, the deadlines for recharacterizing your 2010-2014 Roth IRA contributions to traditional IRAs have long since passed. In the past, the IRS has granted relief in private letter rulings for taxpayers who missed the deadline. However, this relief is expensive and not guaranteed. You currently have excess contributions in your Roth IRA. These excess contributions are subject to a 6% excess contribution penalty for each year that they remain in your Roth IRA. The 6% excess contribution penalty is reported on IRS Form 5329, which can be filed with your tax return or can be filed as a stand-alone return. If not filed, the statute of limitations never begins to run adding more penalties plus interest. The bottom line here is that you will want to see a tax advisor to be sure that any penalties owed are paid and that the excess contributions are properly corrected.

2.

My wife is self-employed with no employees during 2015 or at this time. She has a traditional IRA, SEP IRA, Roth and SIMPLE accounts that were used at one time or another. I am retired with no earned income. She made approximately $20,000 in 2015 as shown on her Schedule C. We file jointly. How can we make the largest tax deductible donation for her and a spousal for me? She and I are both over 50 years old.

It seems the best is she does an elective contribution of $15,500 plus $600 (employer matching). Then I can make a spousal contribution to my traditional IRA of the remainder of $20,000 minus $15,500, minus $600, minus deductible Social Security tax).

Answer:
Let’s consider your choices based on the different IRA options you have listed. What is the best way to reach your goal of the largest tax deduction for 2015?

If you are looking for a tax deduction, then Roth IRA contributions would not be what you are looking for because Roth IRA contributions are not deductible.

What about a SEP or SIMPLE contribution? Generally, for 2015 a SEP IRA contribution is limited to 25% of compensation or $53,000, whichever is less. Assuming the SEP contribution is based on $20,000 in compensation, after certain adjustments, such as for self-employment taxes, the most she could contribute would be about $3,700. Your wife most likely will not be able to make a SIMPLE IRA contribution for 2015. Why? A SIMPLE IRA must be established for an existing business by October 1. Therefore, the deadline for establishing a SIMPLE IRA plan for 2015 has passed.

Your best bet may be to make traditional IRA contributions. If you and your wife will still be younger than age 70 ½ at the end of the year, you may both contribute to traditional IRAs. Your wife can make a regular $6,500 contribution and you can make a spousal contribution of $6,500. Assuming neither of you participate in a company plan, you can deduct $13,000. Not a bad outcome!

3.

Hi Ed,

Can you give me some advice on my Roth IRA 6% penalty due to being over the income limit? Last year, I opened up a Traditional IRA with a catch-up contribution for 2014 and some contributions for 2015 with a total amount of $8000 with Vanguard. Then I had it converted to Roth IRA because I couldn’t do direct Roth IRA contributions thanks to exceeding the income limit. I hadn’t thoroughly researched that the Roth IRA income limit for single is $131,000/year until I was trying to file my income tax this year and found out I have to pay a 6% penalty for it unless I wipe my Roth IRA clean!

Currently, my Roth IRA value is about $2,500 less from the basis of $8,000. If I withdraw, will I be able to claim the loss and have it deducted on next year’s tax return?

Please advise. Thank you for your time and help.

Katherine

Answer:
Good news! The funds in your Roth IRA are not excess contributions. While there are income limits for Roth IRA contributions, there are no income limits for conversions. Because you funded your Roth IRA with conversions and not contributions, your income does not matter. You made traditional IRA contributions and then converted them. You have, in fact, used the back-door Roth IRA strategy successfully.