Excess Roth IRA contribution - very bizarre situation

[itworks]

I think I am running into a bizarre situation and need help here.
1. Sometime in September 2012, I transferred most of the assets in my Roth IRA account in Fidelity to Vanguard, and leave about $300 in Fidelity
2. Throughout year 2012, I contributed about $400 to my Roth IRA account in Fidelity; I did not contribute any to the Vanguard Roth
3. Now I realized my income is over the limit, and I cannot contribute any to Roth

I am researching how to work with Fidelity to withdraw the excess $400 contribution. The question is, I have only $300 there. How can I withdraw $400? Do I need to transfer some assets back from Vanguard to make it?

Thanks.

[Alan S.]

Vanguard should be able to handle the distribution of your excess contribution. Just tell them the amount of your excess contribution and don't tell them about the Fidelity account remnants. They can calculate the earnings by the difference between the current value of the account and their opening value. For example if your current value is 10% higher than the day of the transfer, they would return $440 to you. The $40 would be taxable and subject to 10% penalty unless you qualify for a penalty exception.

If the VG account dropped, then you get back less than $400 and there will be no tax or penalty.

[itworks]

Thank you Alan. I think I get the gist of your proposal, but still not clear about the details. Three questions:

1. I also transferred another Roth account from TD Ameritrade to Vanguard in 2012, and it looks like those from Fidelity and those from TD Ameritrade are already mixed together and recategorized into two Roth accounts, as "mutual funds" and as "brokerage". Do I need to tell Vanguard to only calculate based on the portion from Fidelity?

2. The $400 contributions to Fidelity were made throughout the year, all 5 contributions, as early as January 2012. But your proposal implies the "earning" is to be calculated from September 2012. Isn't that not "scientifically" correct?

3. All contributions to Fidelity were simply parked as cash, so no earnings (probably $2 dividend), whereas the ones transferred to Vanguard are generating some earnings. Is it better to do the earnings calculation on Fidelity side?

I understand whichever way to calculate the earnings, it is not a huge number, thus the income tax and early distribution penalty will not be a big number. Just want to make sure I understand them -- having been murky with my investment for a long time, and until recently I seriously start to follow bogleheads philosophy.

[Epsilon Delta]

Vanguard should be able to handle the distribution of your excess contribution. Just tell them the amount of your excess contribution and don't tell them about the Fidelity account remnants. They can calculate the earnings by the difference between the current value of the account and their opening value. For example if your current value is 10% higher than the day of the transfer, they would return $440 to you. The $40 would be taxable and subject to 10% penalty unless you qualify for a penalty exception.

If the VG account dropped, then you get back less than $400 and there will be no tax or penalty.

If this is true then there may be a large loophole.

Suppose I contribute $5000 to a Roth at Fidelity and it doubles. I then find out I am ineligible to contribute to a Roth. If the above is true I could transfer the entire $10,000 to a Vanguard MM Roth account and withdraw $5000, leaving $5000 in the Roth IRA.

I won't say it doesn't work that way, but it's sufficiently weird that it requires more discussion. Is Notice 2000-39 the most recent document?

[Alan S.]

Yes, Notice 2000-39 is the most recent guidance:

http://www.irs.gov/pub/irs-drop/n-00-39.pdf

Examples included do not address this exact situation, but the account that the excess contribution is made to (or contains the contribution) is the one that funds the corrective distribution, and calculations do not include multiple accounts or multiple calculations. The Notice does include various compromises for the purpose of simplification to what otherwise would be a technically correct calculation. The IRS does not expect that transfers would have to be reversed in order to require the first custodian to do the corrective distribution.

In your example, there is really no loophole even if Vanguard processes the final corrective distribution as expected. Assume this is your only Roth. Fidelity issues a 5498 for the 5,000 contribution. Vanguard issues a 1099R for the early distriubution of 5,000 and another 1099R for the corrective distribution showing no earnings. These corrective distributions are not reported on Form 8606. When you complete the 8606 with your tax return, you would show not show any regular contributions because the corrective distribution 1099R erased your contribution. Therefore, you have no balance in regular contributions and the early distribution therefore must be earnings. You end up with tax and penalty on the 5,000 anyway.

[Epsilon Delta]

In your example, there is really no loophole even if Vanguard processes the final corrective distribution as expected. Assume this is your only Roth. Fidelity issues a 5498 for the 5,000 contribution. Vanguard issues a 1099R for the early distriubution of 5,000 and another 1099R for the corrective distribution showing no earnings. These corrective distributions are not reported on Form 8606. When you complete the 8606 with your tax return, you would show not show any regular contributions because the corrective distribution 1099R erased your contribution. Therefore, you have no balance in regular contributions and the early distribution therefore must be earnings. You end up with tax and penalty on the 5,000 anyway.

I'm afraid I'm not following this. How many dollars would Vanguard send you? I'm assuming they send you $5,000 and leave $5,000 in the Roth, and send you a single 1099R showing a $5,000 corrective distribution with zero earnings. Why would they send you a second $5,000 and a second 1099R?

It's leaving $5,000 in the Roth that I consider to be the loophole, since if you asked Fidelity to calculate the earnings they would send you the entire $10,000 and leave you with zero in the Roth. Having $5000 in a Roth instead of a taxable account has value.

Are you saying that in this case the taxpayer is supposed to calculate the earning himself and ask Vanguard to distribute the entire $10,000? I.e. that you couldn't ask Vanguard to calculate the earnings. If that's the case how would the tax payer calculate the earnings, since notice 2000-39 tells you not to consider multiple Roths?

[Alan S.]

Sorry, I misunderstood your example, thinking you wanted to get the earnings out of the Roth tax free sooner rather than later.

Instead, if the new custodian is told to correct a 5k excess contribution in this transferred Roth and they use the 10k opening and closing balance as expected, you would get the 5k distributed with no earnings showing on the 1099R. You would be left with 5k in the Roth that would be earnings barring any later developments, such as losses on future contributions in any Roth you own. You could not withdraw the earnings tax free until the Roth is eventually qualified. The chance of the IRS wondering how your Roth has a year end value of 5k after withdrawing your contribution is essentially nil.

Some of these rare situations just happen by accident, but others can be created by manipulative transfers, although such things as 100% gains in a period of several months is very rare for an entire account, and most people just make new Roth contributions to their existing Roth.

The same considerations obviously also apply to recharacterizations of contributions and for the big money, of conversions. Certain interim transfers could result in a Roth conversion being recharacterized to eliminate the tax bill producing an artifically low amount transferred back to the TIRA with the difference left in the Roth.

I think if anyone got carried away with repeated manipulative transfers, the amount of activity would eventually be discovered by the IRS.

The legal resolution to this example of 100% gains is to pass up the corrective distribution entirely. Right after the extended due date you remove the 5k in a non corrective distribution. The cost is the 6% excise tax on excess contributions equal to $300. You end up spending $300 out of pocket and now your 5k of gains remain in the Roth. You would file a 5329 to report the excise tax for the contribution year and another 5329 the following year showing the distribution that eliminated the excess amount. Also, an 8606 to report the tax free distribution of your contribution in the second year.

[Epsilon Delta]

Thanks Alan,

You've given me plenty to think about.
I'll leave it here lest I go off piste.

[itworks]

What is being discussed by both of you are a bit beyond my comfortable zone. Thanks a ton anyway!

I called Vanguard, and the customer service thought the best option is to have Fidelity calculate the gain from Jan. to Sep., then Vanguard will continue calculating the gain from Sep. to Dec. And, Fidelity would issue a 5498 form, and Vanguard would issue 1099-R form, both forms with exactly same amount to make the net 0.

I am still very puzzled by how this "gain due to excess contribution" is calculated. My contribution was made in May., Jun. Jul., Oct. and Dec. Is it calculated based on "percentage of amount" multiplied by "prorated based on contribution date"?

[Alan S.]

Yes, the discussion got pretty complex, but your situation fits right in there.

I am quite sure that Fidelity and Vanguard will not effectively collaborate on this, particularly since when Fidelity calculates the gain on your contributions, their balance is far short of the amount needed to transfer to a TIRA at Fidelity. If they will do anything at all, it would be to simply transfer the small balance they have to a TIRA, either opening one at Fidelity or transferring it to a Vanguard TIRA. If Vanguard wants Fidelity's figures to determine how much should be transferred to a TIRA based on the FIdelity closing balance, then Vanguard could add that amount to their own calculation and it would make sense. That said, this is purely improvisation and I have never heard of it being done this way, even though it would actually produce an equitable result. Fidelity would have to issue a 1099R also, since they would be transferring their balance to a TIRA. Note that Notice 2000-39 supports a single recharacterization calculation and Vanguard now holds the bulk of the assets involved. The following is from the Notice:

In the case of an individual who owns multiple IRAs, the net income calculation
is performed only on the IRA designated by the owner as containing the contribution
that is to be distributed as a returned contribution, and that IRA is the IRA that must
distribute the contribution.

It would be easier if you just transferred the Fidelity balance to Vanguard like you probably should have done in the first place, and then have Vanguard process the recharacterization. It would be much simpler and eliminate a separate calculation for each contribution date. Vanguard would just do one calculation but exclude the $300 from it since that would be an interim transfer. You would end up with all your IRAs at Vanguard which is where you want them and there will only one recharacterization 1099R. Why not run that idea past Vanguard, since this is easier for them also.

You did not say how large your existing Roth was before you made this year's contributions, but it sounded like you did have a prior balance and therefore would still have both a Roth and a TIRA balance at Vanguard. You probably cannot get this done in 2012, but that's not a major problem. It just means that all recharacterization reporting will not be done till Jan, 2014 instead of Jan,2013. Those forms will be coded to show that the recharacterization applied to your 2012 Roth contribution.

Just for the record, if you had left the Roth with Fidelity and ordered a recharacterization of your periodic contributions, FIdelity should do a separate calculation of earnings on each individual contribution, which sounds like a mess, but they have software to handle this correctly. That said, another poster reported that the custodian did not imput the correct amount into their software and I think that custodian was Fidelity.

[itworks]

Thanks Allan. No, I do not want to do recharacterization to a TIRA. I just want the excess contribution (and earnings) returned to me, and I will pay income tax and 10% penalty on the earnings (which should be a small number anyway). This leaves me a clean plate for me to do back door Roth IRA.

What you said regarding transferring the remaining $300 from Fidelity to Vanguard seem the best idea, and indeed proposed by Fidelity Customer Service. I just do not want to pay the $50 account closing fee. Well, if there is no better outcome, I might have to bite the bullet.

Regarding the prior balance, it was $25,000 total transferred to Vanguard, and $301 left-over in Fidelity. I do not have any Traditional IRA in any institution so far.

I understand this could not be done in 2012, but I hope I can get this resolved soon, say, Jan. 2013. Could you elaborate why it might be dragged into 2014? Note I do not need recharacterization.

I want to my back door Roth IRA to be done before Apr. 15, 2013 (as contributions to year 2012), which is why I want to get this resolved as soon as possible.

[Alan S.]

Particularly if you have gains, you should recharacterize to eliminate tax and penalty on the gains returned to you. That's even more true in this atypical situation where you don't know for sure how much in gains they will come up with. With recharacterization. you still have a clean slate for a back door Roth. Remember, Vanguard must use the investment results on the entire 25,000 balance to determine the % of gains or losses.

To examine 4 different options:
1) Return of your excess contribution and there are earnings - you would be taxed on the earnings amount and penalized 10% on the earnings. Then I presume you would recontribute your max allowed non deductible IRA contribution for 2012 and convert. Conversion would be tax free.
2) Recharacterization if there are earnings - net adjusted amount is transferred to a TIRA, you report your original non deductible contribution and convert. The amount of the gains will be taxable, but no 10% penalty. If you had $400 in gains, avoiding the penalty saves you $40.
3) Return of your excess contribution, but earnings are negative (a loss) - There is no tax, but you get back less than you contributed.
4) Recharacterization if there is a loss - the reduced amount goes to your TIRA, and your conversion will be tax free since you are converting less than your contribution.

In summary, return of contributions is preferable if you have a loss, and recharacterization is preferable if you have gains. And with recharacterization, you don't have to turn around and make new contributions for 2012 prior to 4/15. If the calculations are about even, it does not matter much which way you proceed. Either way, this weird calculation must take place to determine earnings before anything can be done, so I don't see how you can complete any of the steps before year end. It all might be less confusing to start the process the week of Jan 7th.

With respect to the 2013 1099R you will get in Jan 2014 whether you recharacterize OR ask for a return, those forms are coded to apply to the 2012 tax year, but neither you OR the IRS sees the forms for purposes of your 2012 return. Either way, the IRS instructions indicate that you should need to include an explanatory statement with your 2012 return what you did, eg " I made periodic Roth IRA contributions to Fidelity in 2012 of x$, transferred the account to Vanguard and on (date) I (recharacterized or had contributions returned) to me in the amount of x$." Tailor the explanation to what you choose to do. The IRS will depend more on this explanation if you don't complete this in 2012 because they don't know that you ever corrected your Roth excess. Once you include that explanation, you are done and your 2013 return is not affected by the corrective distribution or recharacterization because it applied to 2012. So if that Jan, 2014 is correct, just keep it and otherwise ignore it.

[Epsilon Delta]

It may be that the easiest way to handle this is to wait until after the deadline for corrective distributions, Oct 15 2013.

Then you can instruct Vanguard to distribute $400 exactly and you will owe a 6% penalty or $24. That way there is no ambiguity, you are clearly within IRS guidance, and you don't need to get Vanguard and Fidelity to cooperate or perform any calculations.

It may not be the best possible outcome money wise but it may save a lot of time.

[Alan S.]

I agree that just paying the penalty is a viable option. If you know that you are going to do that, just report the excess contribution with your 2012 return by completing Form 5329 and paying the $24. Then make a note to remind yourself to remove the $400 exactly after 10/15/2013 but before year end 2013. You would report the $400 distribution on your 2013 Form 8606, but it would be tax free since it is a return of your regular contributions. You also need a final 5329 for 2013 to show the prior excess has been distributed, and there is no further penalty.

This also avoids the unpredictable result you might get from Vanguard performing an earnings calculation in an unusual situation, and if there WERE any positive earnings, this way they get to remain in your Roth IRA. The 6% excise tax is mutually exclusive with the removal of earnings. It's one or the other, and separated by the extended due date 10/15/2013.

[itworks]

Paying 6% penalty sounds a good solution. I can certainly pay $24 to save the headache. My question is, do I need to ONLY pay $24 for 2012, or pay another $24 for 2013 as well?

Here is what I cut from a Vanguard form (bold added by me):

If you remove the excess contribution after the applicable correction deadline, the earnings stay in your account and the excess principal is generally subject to a 6% federal penalty tax each year it remains in your account. The penalty tax also applies to the year for which the excess was contributed.

Because earnings stay in the account, Vanguard will not calculate any earnings on the excess.

Vanguard will send you IRS Form 1099-R (for an IRA) or IRS Form 1099-Q (for an ESA) in January of the year after the excess was removed. You may also need to file IRS Form 5329 (or IRS Form 1042S if you are a nonresident alien) to indicate the additional 6% taxes due.

[Alan S.]

You only pay the penalty for 2012. Each additional year when the excess is not removed is another 6% penalty. That's why you need to ask for the $400 distribution before the end of 2013, but after 10/15. If you do that there is no penalty for 2013. Relating this to the VG quote, your penalty is for the year of contribution (2012), but not for 2013 because your $400 will not remain in your account as of 12/31/2013. There is no penalty when the excess is in the Roth for part of the year, but not there at the end of the year.

When removing the $400, do not ask for a corrective distribution. Just ask for an early distribution of exactly $400, not mentioning a specific year for the contribution.

[itworks]

Thanks Alan for the very clear explanation. I noticed your advice above is to pay $24 and report it in Form 5329 with 2012 return, and then pay $0 and report it in Form 5329 with 2013 return. Why not simply paying $24 in 2013 and reporting it in 2013 return, if I only need to pay the "penalty for year 2012" in "year 2013"?

And, do you mind explaining why I should not ask for corrective distribution? My guess is that I've already paid the 6% penalty hence there is nothing further to correct. Is that right?

Thanks!

[Epsilon Delta]

When removing the $400, do not ask for a corrective distribution. Just ask for an early distribution of exactly $400, not mentioning a specific year for the contribution.

Is this just a suggestion about how to do the paperwork?

Vanguard's forms includes an option to request a corrective distribution after the deadline. Perhaps I am naive in assuming that using Vanguard's form is the path most likely to get the desired result. The instructions indicate that at least somebody at Vanguard is on the ball.

The Vanguard form is currently at:
https://personal.vanguard.com/us/litera ... Input=S373
If they move it you can search for "IRA and ESA Excess Contribution Removal Form".
It contains the following tick boxes.

3. Information About Your Excess Contribution
Check one.
■ The deadline has passed for withdrawing excess contributions from my IRA or ESA to
avoid the 6% federal penalty tax.
■ The deadline has not passed.

[Alan S.]

Thanks Alan for the very clear explanation. I noticed your advice above is to pay $24 and report it in Form 5329 with 2012 return, and then pay $0 and report it in Form 5329 with 2013 return. Why not simply paying $24 in 2013 and reporting it in 2013 return, if I only need to pay the "penalty for year 2012" in "year 2013"?

And, do you mind explaining why I should not ask for corrective distribution? My guess is that I've already paid the 6% penalty hence there is nothing further to correct. Is that right?

Thanks!

Since your excess contribution is for 2012, the excise tax is due for 2012, not 2013. The 2012 5329 will indicate that you have an excess contribution that has not been corrected by the due date. The 2013 5329 basically shows that you entered 2013 with an excess of $400, but you withdrew the $400 by the end of 2013, and therefore 400 less 400 equals 0 remaining excess. Because the excess has been withdrawn, there is NO excise tax due for 2013. Many people do not know for years that they made an excess contribution, but the IRS is very slow to notify taxpayers. If you discover 3 years later that you made an excess contribution in 2009, you will owe a 6% excise tax for 2009 plus late interest, another 6% for 2010 plus late interest, another 6% for 2011 plus late interest, and will need to file a 5329 for each year. In your case, if you do not pay the $24 by 4/15, the IRS will start adding on late interest to the date you do pay it.

With respect to forms, many IRA custodians do not have forms to clearly address a corrective distribution done AFTER the due date. Even Vanguard's form could be misleading in trying to simplify the options for handling excess contributions. While earlier, we said you should wait until after 10/15 to withdraw the $400, you can do it in January if you want to make sure you don't forget. Usually, if someone has an excess contribution on which they are paying the 6% tax, they are better off to wait until the end of the year to withdraw it and let it generate earnings that will stay in the Roth IRA. But let's say in your case, $400 is small and you just want to make sure it is withdrawn in January so you don't forget to do it later. In that case, neither of Vanguard's options apply because the deadline has NOT passed and you are choosing to pay the 6% excise tax for individual reasons. Their form is fine if you choose to wait until after 10/15, but if you wanted to take care of it next month, I would just ask for a $400 distribution. If you choose to pay the 6% excise and are just removing the contribution amount itself, it is better not to even mention an excess contribution since that can trigger more questions and confusion from the custodian.

Summary:
1) If you choose to go this route to avoid calculation chaos, and you want to leave the contribution in till after 10/15, use Vanguard's form and indicate the deadline has passed.
2) If you want to get the $400 out in January so you don't forget, don't use Vanguard's form since it does not address your situation. Just ask for a distribution of $400. Your 2013 5329 and 8606 will be done exactly the same way whether you take out the $400 in January, mid year, or December.

While you are doing this to avoid earnings calculation headaches, some people do the same thing when their excess contribution (or the IRA holding the contribution) has big gains. Assume a 5,000 contribution that gains 30%. If you remove the contribution in the usual fashion, you will have ordinary tax on 1,500 of income and a penalty of $150. Assuming 20% combined fed and state rates, you would pay $450 and 6,500 is distributed from your Roth.

Compare that to paying the 6% excise tax. You pay 6% of 5,000 or $300 and only 5,000 comes out of your Roth. You save $150 and the 1,500 of earnings gets to stay in your Roth to generate future tax free earnings.

[itworks]

Thanks Alan. I will follow route #1 and do the Corrective distribution after 10/15/2013, using the Vanguard form and indicating deadline has passed. I will create a multi-day all day event in my calendar to make sure I do not forget!

Your example of someone choosing 6% penalty intentionally is fascinating. Assuming earning is X, income rate is 20%, X(10%+20%) vs 6%, so long the return X is bigger than 20%, the 6% seems a much better deal, as those earnings got to stay.

Last question (hopefully), can I go ahead to contribute $5000 to a non-deductible Traditional IRA (for the back door) for year 2012? I mean I do not need to wait for this $400 to distribute. (Note I do not have any other Traditional IRA).

[Alan S.]

Yes, you can make the non deductible TIRA contribution and convert it when you wish. That date and the date of your $400 distribution do not affect each other.

[itworks]

Thank a ton Allan! I already opened Traditional IRA accounts for spouse and myself with Vanguard, and funded $5000 each. I will call Vanguard to do the conversion soon.

Still, isn't it weird if I do the conversion before 2012 tax filing? I mean, IRS clearly knows I am over income limit, but here we go, I contributed $5000 to a Roth IRA account, as if there is no such limit! Assume I do the conversion in January, won't that mean I will get some tax forms from Vanguard for 2012 tax return?

[Alan S.]

The IRS will not look at your Roth conversion of a non deductible TIRA contribution as a regular Roth contribution, and conversions and regular contributions have very different rules. In any event, you and the IRS will get a 5498 showing 2012 contributions of $400 to your Roth and 5,000 to your TIRA, which totals to an excess contribution.

The corrective distribution of the $400 after 10/15/2013 will clear up the excess contribution question along with your Form 5329 reporting the excess contribution on your 2012 return, meaning that no part of your 5,000 non deductible contribution is excess. The conversion date for your 5,000 TIRA contribution only matters to the extent that if you do it Monday for 2012, you and the custodian will report the conversion in 2012. If you wait till January or beyond, you will report the conversion in 2013 and the IRS will not know you converted until they get the 2013 1099R in Jan, 2014 and the 5498 even later.

The main point is that your Roth conversion is treated differently than a regular Roth contribution, so the date you do the conversion will only affect the tax year you report it. The $400 excess regular Roth contribution is being handled separately and does not affect your conversion.