Resolving excess IRA contribution (earned income too low)

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Resolving excess IRA contribution (earned income too low)

Postby gradStudentInvestor » Mon Mar 04, 2013 3:31 pm

In 2012, I contributed $5000 to my Roth IRA with Vanguard (for the 2012 tax year). I just realized that I only have about $2000 of 2012 W-2 income (as a graduate student, sometimes income is reported in strange ways that the IRS does not consider "earned"), so $3000 of the original contribution was in excess of the limit. I want to make sure that I'm taking the correct steps to undo this excess contribution. I've tried my best to read through the relevant IRS & Vanguard information, and I've searched this forum for similar threads, but I'm a little bit lost at this point and hoping for some guidance.

The usual advice involves recharacterizing contributions from Roth to non-deductible traditional IRA, but that doesn't apply here since I'm hitting the earned income limit, rather than seeing a phase-out in Roth eligibility due to high income. I've found forms on the Vanguard website for performing such a recharacterization, but they all seem to apply only when changing the contribution from one type of IRA to another. Will Vanguard have a similar process for withdrawing the excess contribution, or do I just need to go through the normal process of taking an early distribution? (I've asked Vanguard about this as well, and have not yet heard back, but I know that sometimes they can get things wrong when it comes to uncommon situations like this one.)

If the latter, I assume that I will have to calculate the correct amount to withdraw myself. But since the balance will be changing every day, there's no way to know the exact amount to withdraw. Should I just take out a little extra to be safe? Also, how will I make sure this is reported correctly on my 2012 tax return? Vanguard won't prepare a form to reflect this withdrawal for several months, and even then I assume that it won't make it clear that this was a withdrawal of the excess contribution.

Based on my reading of Pub. 590, I have calculated the adjusted opening and closing balances for the Roth IRA (pretending the recharacterization took place today), which shows a gain of about 6%, meaning that I'll actually need to withdraw about $3180 in order to remove the entire excess contribution along with its earnings. There are several years' worth of contributions in the IRA, so the total contribution basis is well over $3180. Will this entire withdrawal count as a withdrawal of contribution basis, or will the $180 be counted as earnings and therefore subject to a 10% penalty (I am in my mid-20s, so nowhere close to retirement age)?

Thanks in advance for all your help!
gradStudentInvestor
 
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Re: Resolving excess IRA contribution (earned income too low

Postby Alan S. » Mon Mar 04, 2013 3:47 pm

It's a simple excess IRA contribution, and you normally would request a return of the excess amount ASAP. VG will calculate the allocated earnings or loss in determining how much you get back. You need the earnings figure because any earnings will be taxable on your 2012 return and also subject to 10% penalty. You are correct that recharacterization does not apply in your situation.

If you were fairly sure your income in 2013 would be sufficient, you could also leave the excess in the IRA and pay a 6% excise tax on Form 5329 with your 2012 return, then apply the excess as a 2013 contribution this year. But this only makes sense if you have had huge earnings, usually 30% or more on your contribution, and you are far short of that.

Using the usual excess contribution corrective distribution, VG should have this done within a week of your request. All you have to do is look at your check or on line statement to see how much was earnings (the amount your check exceeds 3k). That is what you will report on line 15b of your Form 1040 if you use a 1040. The 10% penalty on the earnings goes on line 58. You should also include an explanatory statement showing the amount of your excess contribution, and date and amount of the corrective distribution. Having done the math yourself, you have a question to ask Vanguard if they are very far off your figure of $180 of earnings (penalty of $18).
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Re: Resolving excess IRA contribution (earned income too low

Postby gradStudentInvestor » Mon Mar 04, 2013 4:24 pm

Thanks Alan! That all makes sense and should help me quite a bit. Does anyone have experience with entering this sort of thing into TurboTax? I found the following post in the TurboTax forums, and I'm wondering if anyone can confirm its accuracy. The part I'm most unsure about is the codes on line 7 of the substitute 1099-R.

In turbo tax, it seems that you enter the information just as if you HAD received a 1099-R for 2012 (even though you won't receive it until 2013). I entered the full amount of contributions and earnings as the Box 1 Gross Distribution. Then I entered the earnings only in the Box 2 Taxable Amount [this is where you enter your earnings amount.] In Box 2b I checked Full Distribution (we had to withdraw everything unfortunately.) For the Box 7 Codes, I listed "8 - Return of contribution taxable in 2012" and "J - Early distribution from a Roth IRA". Turbo Tax asked me for an explanation which I said our MAGI was over the limit as a reason for the early distribution. When I did this, the full distribution amount is on my form 1040 line 15a, and the taxable earnings only are on line 15b (you are taxed on the earnings only if withdrawn before April 15!) Then, because of the early distribution, the 10% fee (on the earnings amount) is listed on form 1040 line 58.
gradStudentInvestor
 
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Re: Resolving excess IRA contribution (earned income too low

Postby Alan S. » Mon Mar 04, 2013 4:55 pm

If you have to complete a substitute 1099R, the box 7 code should be 8J. Even though the real 1099R will be a 2013 1099 with the codes PJ, when 2013 arrives the P means the taxable amount is for the prior year (ie 2012). The actual 1099R should therefore be coded differently than you substitute will be to reflect the proper year for the earnings to be taxed ie 2012.

The forum quote is for a similar situation as yours. Note that while 15a is not a taxable line, the substitute 1099R will cause the 15a entry to show the total distribution in 2012 even though you don't receive it in 2012. While this is technically incorrect, it's unavoidable using a fake year 1099R substitute. It should not cause a problem though since your explanatory statement will indicate that you received the corrective distribution in 2013 even though the earnings are taxable in 2012.

It's all fairly confusing, but the IRS uses 15a for general 1099R matching purposes. 15b is the line of consequence and the substitute 1099R will cause the correct entry there.
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Re: Resolving excess IRA contribution (earned income too low

Postby gradStudentInvestor » Tue Mar 05, 2013 11:07 am

Alan, thanks again for all your help with this. I'll have a much easier time making sure this is reported correctly now that you've explained everything.

For future reference, here is Vanguard's reply to my question. I did not find the "IRA and ESA Excess Contribution Removal" form at the link they provided. I'll post an update once I've obtained the form.

Although we can't advise you on whether or not you should remove an excess
IRA contribution, we can inform you of your options.

To avoid a 6% federal penalty, you must remove the excess contribution by
the correction deadline. Generally, the deadline for removal of an excess
IRA contribution is October 15 of the year following the tax year of that
contribution. If you remove the excess contribution, Vanguard will report
the transaction on IRS Form 1099-R. You may also need to file IRS Form 8606
and/or IRS Form 5329 with the IRS. Your options for handling an excess
contribution are:

* Remove the excess and any attributable earnings before the deadline. You
will not be subject to the 6% penalty. If you have contributed to both a
Roth and a traditional IRA, IRS regulations require you to remove the
excess from your Roth IRA first.

* Remove the excess after the deadline. You cannot remove the attributable
earnings after the deadline has passed. You will be subject to a 6% penalty
tax on the amount of any excess each year it remains in your account.

* Leave the excess amount along with any earnings in the IRA and apply it
to a later year. Vanguard will not change any account records or report any
additional information to the IRS. You will be subject to the 6% penalty on
the excess amount for each year that it remains in the IRA as an excess
contribution.

To request removal of an excess contribution, please complete and return
the Vanguard IRA and ESA Excess Contribution Removal Form, which you can
access though the following link:

http://personal.vanguard.com/us/literat ... counts/ira

If you have questions related to your specific situation, please consult
with a tax professional or the IRS.
gradStudentInvestor
 
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Re: Resolving excess IRA contribution (earned income too low

Postby Alan S. » Tue Mar 05, 2013 1:39 pm

While not an issue in your situation, VG has taken a very conservative position with respect to the following:

* Remove the excess and any attributable earnings before the deadline. You
will not be subject to the 6% penalty. If you have contributed to both a
Roth and a traditional IRA, IRS regulations require you to remove the
excess from your Roth IRA first
.

I do not believe the IRS Regs require this treatment before the deadline, although they clearly do after the deadline. Before the due date after which the final contributions are locked in, a taxpayer who has overcontributed to a combination of TIRA and Roth accounts can choose the IRA type for a return of contribution. If he wants to keep his Roth contribution, he can request a return of his TIRA contribution, and the TIRA contribution would be returned with earnings and therefore treated as never made, and the Roth would not become an excess contribution. This is important if your Roth contribution has generated some nice earnings and you want to preserve them in the Roth.

However, once the extended due date has passed, if the combination of contributions still exist, then the Roth is the one on which the 6% excise tax must be paid and must either be removed or applied to prevent the 6% tax from recurring each year. The VG comment therefore should be included in the bullet point for "after the deadline", not before it.

To get around this at VG, suggest requesting a return of contribution rather than referring to an "excess contribution". They are treated the same way prior to the deadline.
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Re: Resolving excess IRA contribution (earned income too low

Postby gradStudentInvestor » Tue Mar 05, 2013 8:00 pm

gradStudentInvestor wrote:I did not find the "IRA and ESA Excess Contribution Removal" form at the link they provided. I'll post an update once I've obtained the form.

It turns out that they were able to handle this request over the phone. I just told them the amount of the excess contribution, and they're taking care of the rest. They said that the effective trade date would be tomorrow (just like any other sell transaction would have been), but it may take them a few more days before they actually get around to calculating the correct amount to withdraw. I guess they'll just backdate the transaction once that's done.
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Re: Resolving excess IRA contribution (earned income too low

Postby gradStudentInvestor » Wed Mar 06, 2013 2:11 am

One more TurboTax question:
TurboTax is asking for the value of the Roth IRA on Dec 31, 2012. It says, "Note: Include any contributions made after December 31, 2012 that were designated for 2012." Should I subtract this distribution of excess contribution from the Dec 31 value? If so, should I subtract the entire distribution amount ($3180) or just the amount of excess contribution that was returned ($3000)?

Also, why is TurboTax asking for this? I don't think it should have any impact on my return.
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