Accidentally made direct Roth IRA contribution

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johnanglemen
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Accidentally made direct Roth IRA contribution

Post by johnanglemen » Tue Jan 16, 2018 4:17 pm

In September 2017, I inadvertently made a contribution directly to my Roth IRA. My income is too high to do this. I meant to make a nondeductible contribution to my Traditional IRA and then convert it immediately to Roth IRA. The IRA is held at Vanguard. I invested the contribution in Vanguard Emerging Markets Fund, which is up about 12% since my contribution.

What is the optimal way to fix this mistake? Do I have to pay ordinary income tax on the earnings on that contribution? And is that tax due for 2017 or 2018?

Thanks!

itstoomuch
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Re: Accidentally made direct Roth IRA contribution

Post by itstoomuch » Tue Jan 16, 2018 4:21 pm

yes. a small price to pay vs the penalty for keeping funds in the Roth. Error was made in 2017 and corrected in 2017. The tax on gains will be on 2017 filing, no later than 15Ap 2018, unless extended.
Biggest problem you will encounter is the additional form that you will need to complete. Do Not get the filing wrong. Check and double check and then check again. It is after all Money :twisted:
Rev012718; 4 Incm stream buckets: SS+pension; dfr'd GLWB VA & FI anntys, by time & $$ laddered; Discretionary; Rentals. LTCi. Own, not asset. Tax TBT%. Early SS. FundRatio (FR) >1.1 67/70yo

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Epsilon Delta
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Re: Accidentally made direct Roth IRA contribution

Post by Epsilon Delta » Tue Jan 16, 2018 6:13 pm

There are three ways to fix this excess Roth IRA contribution.

Given your facts the best way appears to be recharacterize the Roth contribution to be a non-deductible traditional IRA contribution. You ask Vanguard to do this and they will move the contributions plus earnings from the Roth to the tIRA. The earnings may surprise you if there are other assets in the Roth, because they are calculated using the entire Roth IRA and not simply the Emerging Market fund.
On your 2017 return you will report the non-deductible contribution on form 8606 and also attach a statement describing the recharacterization. No taxes will be due on the recharacterization, it's as if you made a non-deductible tIRA contribution in the first place.

Once 2017 is cleaned up you are free to convert whatever is in the tIRA to a Roth. The conversion will happens in 2018 (or later) and will be taxed in the year it occurs which will be 2018 (or later). You will need to file a 2018 form 8606 to report the conversion and calculate the tax free amount using the carry over basis from 2017.

johnanglemen
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Re: Accidentally made direct Roth IRA contribution

Post by johnanglemen » Tue Jan 16, 2018 6:48 pm

Epsilon Delta wrote:
Tue Jan 16, 2018 6:13 pm
There are three ways to fix this excess Roth IRA contribution.

Given your facts the best way appears to be recharacterize the Roth contribution to be a non-deductible traditional IRA contribution. You ask Vanguard to do this and they will move the contributions plus earnings from the Roth to the tIRA. The earnings may surprise you if there are other assets in the Roth, because they are calculated using the entire Roth IRA and not simply the Emerging Market fund.
On your 2017 return you will report the non-deductible contribution on form 8606 and also attach a statement describing the recharacterization. No taxes will be due on the recharacterization, it's as if you made a non-deductible tIRA contribution in the first place.

Once 2017 is cleaned up you are free to convert whatever is in the tIRA to a Roth. The conversion will happens in 2018 (or later) and will be taxed in the year it occurs which will be 2018 (or later). You will need to file a 2018 form 8606 to report the conversion and calculate the tax free amount using the carry over basis from 2017.
What does it mean that the earnings are calculated using the Roth IRA? Say my Roth IRA is up 50% overall. Does that mean that $5500 comes out and gets put in the nondeductible traditional IRA as basis, and $2750 comes out and put in there as earnings? That seems crazy / inequitable.

kaneohe
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Re: Accidentally made direct Roth IRA contribution

Post by kaneohe » Tue Jan 16, 2018 6:58 pm

johnanglemen wrote:
Tue Jan 16, 2018 6:48 pm
................................................
What does it mean that the earnings are calculated using the Roth IRA? Say my Roth IRA is up 50% overall. Does that mean that $5500 comes out and gets put in the nondeductible traditional IRA as basis, and $2750 comes out and put in there as earnings? That seems crazy / inequitable.
[/quote]

It's not how much the Roth IRA is up overall..........It's how much gain in the Roth during the period the incorrect contribution was in there.

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Epsilon Delta
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Re: Accidentally made direct Roth IRA contribution

Post by Epsilon Delta » Tue Jan 16, 2018 7:04 pm

johnanglemen wrote:
Tue Jan 16, 2018 6:48 pm

What does it mean that the earnings are calculated using the Roth IRA? Say my Roth IRA is up 50% overall. Does that mean that $5500 comes out and gets put in the nondeductible traditional IRA as basis, and $2750 comes out and put in there as earnings? That seems crazy / inequitable.
What Kaneohe said, but if the Roth is up 50% in that time frame that's what it means. It could also work to your advantage, if the rest of the Roth did worse than the particular fund.

Whether it is unfair is a matter of perspective. Instead of viewing it as contributing $5,500 to the EM fund in the Roth, view it as contributing $5,500 in cash to the Roth and then changing the AA inside the Roth. The general rule for IRAs is only money going into and out of the account matters, transactions that happens inside the account do not affect taxation.

If your Roth has gone up 50% you may want to perform a different one of the three corrective actions I mentioned earlier. Leave the 2017 contribution in the Roth until after October (extended tax deadline) pay the 6% excise tax on the excess contribution on your 2017 return and then take a withdrawal of only the contribution in late 2018. You may also be able to make a proper non-deductible tIRA contribution for 2017 and convert that, but I don't think you'll be able to do that at Vanguard.

johnanglemen
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Re: Accidentally made direct Roth IRA contribution

Post by johnanglemen » Tue Jan 16, 2018 7:10 pm

Epsilon Delta wrote:
Tue Jan 16, 2018 7:04 pm
johnanglemen wrote:
Tue Jan 16, 2018 6:48 pm

What does it mean that the earnings are calculated using the Roth IRA? Say my Roth IRA is up 50% overall. Does that mean that $5500 comes out and gets put in the nondeductible traditional IRA as basis, and $2750 comes out and put in there as earnings? That seems crazy / inequitable.
What Kaneohe said, but if the Roth is up 50% in that time frame that's what it means. It could also work to your advantage, if the rest of the Roth did worse than the particular fund.

Whether it is unfair is a matter of perspective. Instead of viewing it as contributing $5,500 to the EM fund in the Roth, view it as contributing $5,500 in cash to the Roth and then changing the AA inside the Roth. The general rule for IRAs is only money going into and out of the account matters, transactions that happens inside the account do not affect taxation.

If your Roth has gone up 50% you may want to perform a different one of the three corrective actions I mentioned earlier. Leave the 2017 contribution in the Roth until after October (extended tax deadline) pay the 6% excise tax on the excess contribution on your 2017 return and then take a withdrawal of only the contribution in late 2018.
Is it appreciation across all Roth IRAs in this timeframe, or only the account I contributed to? I would've assumed all, but Fairmark (http://fairmark.com/retirement/roth-acc ... ion-blues/) seems to suggest that it's only the particular account?
Epsilon Delta wrote:You may also be able to make a proper non-deductible tIRA contribution for 2017 and convert that, but I don't think you'll be able to do that at Vanguard.
Can you clarify this? Is it the third corrective action, or part of the excess contribution one? Why wouldn't I be able to do this at Vanguard?

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Epsilon Delta
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Re: Accidentally made direct Roth IRA contribution

Post by Epsilon Delta » Wed Jan 17, 2018 2:31 am

johnanglemen wrote:
Tue Jan 16, 2018 7:10 pm
Is it appreciation across all Roth IRAs in this timeframe, or only the account I contributed to? I would've assumed all, but Fairmark (http://fairmark.com/retirement/roth-acc ... ion-blues/) seems to suggest that it's only the particular account?
Just the account you contributed to. Multiple funds may be in a single account or they could be spread across multiple accounts. You may already know how your funds are allocated to accounts, but sometimes things get lumped or split depending on something you weren't paying attention to at the time you did them.
johnanglemen wrote:
Tue Jan 16, 2018 7:10 pm
Epsilon Delta wrote:You may also be able to make a proper non-deductible tIRA contribution for 2017 and convert that, but I don't think you'll be able to do that at Vanguard.
Can you clarify this? Is it the third corrective action, or part of the excess contribution one? Why wouldn't I be able to do this at Vanguard?
No it's related to the second corrective action.* If you correct the excess Roth contribution by withdrawing the contribution then when the dust settles you have not made any (allowed) contribution for 2017.

The rules say that if you contribute a combination to tIRA and Roth IRAs that is over the $5,500 limit, the excess is considered to be in the Roth. So if you contributed $5,500 to the Roth in 2017 and $5,500 to a tIRA for 2017 now, then the tIRA contribution is allowed and the Roth contribution is excess both because you are over the income limit and because you contributed too much. Fortunately you only have to correct it once, which you had to do anyway because of the income limit.

I could be wrong but I think Vanguard will limit total IRA contributions for a year to $5,500 (or $6,500 if you are older). This is to stop you making excess contributions. As you found out that doesn't always work.

* The three possible corrective actions are:
  • Recharacterize the contribution and earnings.
  • Pay 6% penalty and withdraw the contribution after the extended due date.
  • Withdraw the contributions and earnings before the extended due date.

johnanglemen
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Re: Accidentally made direct Roth IRA contribution

Post by johnanglemen » Tue Jan 23, 2018 5:59 am

Epsilon Delta wrote:
Wed Jan 17, 2018 2:31 am
johnanglemen wrote:
Tue Jan 16, 2018 7:10 pm
Is it appreciation across all Roth IRAs in this timeframe, or only the account I contributed to? I would've assumed all, but Fairmark (http://fairmark.com/retirement/roth-acc ... ion-blues/) seems to suggest that it's only the particular account?
Just the account you contributed to. Multiple funds may be in a single account or they could be spread across multiple accounts. You may already know how your funds are allocated to accounts, but sometimes things get lumped or split depending on something you weren't paying attention to at the time you did them.
johnanglemen wrote:
Tue Jan 16, 2018 7:10 pm
Epsilon Delta wrote:You may also be able to make a proper non-deductible tIRA contribution for 2017 and convert that, but I don't think you'll be able to do that at Vanguard.
Can you clarify this? Is it the third corrective action, or part of the excess contribution one? Why wouldn't I be able to do this at Vanguard?
No it's related to the second corrective action.* If you correct the excess Roth contribution by withdrawing the contribution then when the dust settles you have not made any (allowed) contribution for 2017.

The rules say that if you contribute a combination to tIRA and Roth IRAs that is over the $5,500 limit, the excess is considered to be in the Roth. So if you contributed $5,500 to the Roth in 2017 and $5,500 to a tIRA for 2017 now, then the tIRA contribution is allowed and the Roth contribution is excess both because you are over the income limit and because you contributed too much. Fortunately you only have to correct it once, which you had to do anyway because of the income limit.

I could be wrong but I think Vanguard will limit total IRA contributions for a year to $5,500 (or $6,500 if you are older). This is to stop you making excess contributions. As you found out that doesn't always work.

* The three possible corrective actions are:
  • Recharacterize the contribution and earnings.
  • Pay 6% penalty and withdraw the contribution after the extended due date.
  • Withdraw the contributions and earnings before the extended due date.
Hi Epsilon:

I greatly appreciate your help here. I wanted to follow up on something for clarification.

I only have a single fund in my Roth IRA, Vanguard Emerging Markets (VEMAX), which is up about 15% since I contributed last year. My marginal ordinary income rate for 2017 (including both federal AND state) is approximately 45%. My incorrect Roth IRA contribution was $5500, so my earnings are $825, for a total of $6325.

If I understand you correctly, my choices are to:

1. Leave the $6325 in the Roth, pay 6% penalty on $5500 ($330), and then withdraw $5500 after October 2018, while leaving the $825 of earnings in the Roth.

2. Recharacterize the $6325 to a nondeductible traditional IRA now and then immediately convert that to Roth IRA, paying 45% tax on the $825 of earnings ($371).

Comparing the two options above, #1 seems to come out ahead. Is my understanding correct so far?

However, if I do #1, then it seems I never actually get $5500 into an IRA for 2017. I lose the space for that year, which will overwhelm the minor difference in taxes ($330 versus $371) over the long run.

I think you said I could address this by making a new nondeductible traditional IRA contribution of $5500 for 2017 now (and then converting it to Roth), but that I would probably have to open an IRA elsewhere to do this.

Boiling all that down, I can choose between the following outcomes:

1. $6325 in a Roth IRA for 2017 + a tax bill for $330 -- requires new IRA at other firm
2. $6325 in a Roth IRA for 2017 + a tax bill for $371 -- all at Vanguard

Is my assessment correct? If so, it appears to come down to whether it's worth the hassle of opening an IRA at another firm to save $41 in taxes? Thank you!

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Epsilon Delta
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Re: Accidentally made direct Roth IRA contribution

Post by Epsilon Delta » Sat Jan 27, 2018 1:39 am

johnanglemen wrote:
Tue Jan 23, 2018 5:59 am

Is my assessment correct? If so, it appears to come down to whether it's worth the hassle of opening an IRA at another firm to save $41 in taxes? Thank you!
Your assessment matches mine in all particulars.

johnanglemen
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Re: Accidentally made direct Roth IRA contribution

Post by johnanglemen » Sat Jan 27, 2018 3:14 pm

Epsilon Delta wrote:
Sat Jan 27, 2018 1:39 am
johnanglemen wrote:
Tue Jan 23, 2018 5:59 am

Is my assessment correct? If so, it appears to come down to whether it's worth the hassle of opening an IRA at another firm to save $41 in taxes? Thank you!
Your assessment matches mine in all particulars.
I don't understand why the IRS allows the earnings to remain in the IRA when you withdraw the excess contribution after the return filing deadline. Doesn't this invite abuse? If you have an investment with a high expected return (say, pre-IPO stock), you could put $1 million into your IRA and shelter the earnings in the IRA forever for a one-time cost of 6% of your contribution. It seems like the IRS would want to avoid these kinds of asymmetric risk situations, where a taxpayer pays a fixed one-time cost in exchange for avoiding tax on variable, theoretically unlimited upside.

Obviously I am NOT recommending anyone do this. I'm simply asking the question to make sure my understanding of the rules is actually correct, since it seems odd.

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