Purposely over-contributing to a Roth IRA?

[eLiu]

Hi all,
In the process of fixing some tax-fail that I recently had, an idea struck me:

The Roth IRA over-contribution penalty is 6% of the over-contributed amount. If you have an over-contribution sitting in the acct at the end of the tax year (first year) and end of a calendar year (subsequent years), you have to pay the penalty.

Doesn't this mean that it is potentially advantageous (i.e., if you're an active trader) to purposely over-contribute? The risk you take is that you're unable to earn 6%+margin (where margin depends on your current tax bracket & your estimated retirement bracket). Also it'd be more useful to someone who's young & is starting out, b/c you could quickly jump-start the amount of money in the Roth, get some earnings going, and then withdraw all over-contributions to stop the penalty.

After that, the earnings stay and you can continue to build on earnings+std contributions.

For example, if you make speculative, short-term plays w/stocks, it could be very advantageous to do this. Like say XYZ has big news coming and you want to gamble 10k. You could contribute 10k to the IRA & buy XYZ. If the news is good & say XYZ doubles, then you have 10k untaxable (i.e., the earned 10k is untaxed & anything you do w/it subsequently within the roth is untaxed) dollars at the cost of $600.

If XYZ fails, you can just withdraw what's left of your 10k from the Roth since you can always remove roiginal contributions penalty-free. If the contribution amt is still too large, as long as you withdraw before the end of the tax year (April 15 + extensions), you will not be liable for over-contribution fees (nor early withdrawal since you lost money). Though the added downside here is that you cannot claim capital losses. Though you can mitigate your capital losses by converting the lossy bits to a traditional IRA, I believe.

Thoughts? I don't plan on doing this or anything like it, but I'm pretty sure the steps are valid b/c the IRS told me so--I had to resovle some over-contribution situations due to previous errors of mine. But I'm unsure of whether there's actually any benefit to be had.

-Eric

 

[Elbryn]

your theory is flawed. when one over contributes and withdraw the excess contributions, you also need to withdraw the gains on that excess contribution. The gains on the excess contribution are treated as earned. see irs pub 590

"Withdrawal of excess contributions. For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made."

That also means the gains made on the excess contribution are considered income and therefore taxed as such at your marginal tax rate. you're better off stashing into tax deferred account or tax efficient funds in the taxable side of things. or just planning on speculating and paying the short term cap tax rate which is the same as income.

 

[nickbits]

Also the penalty is incurred every year not just the year you made the contribution

 

[Capt Caveman]

The above two posters are correct. Earnings and contribution are penalized and must be withdrawn. For such a long OP, it's completely flawed.

 

[eLiu]

The above two posters are correct, but their statements are also not relevant.

Elbyrn: That's only relevant if you are trying to avoid the 6% over-contribution fee and withdraw everything in the first year. My point is that you could gamble on making much more than that fee, so it would be worthwhile to pay the fee. If you are in the negative, withdrawing earnings is moot b/c you have no earnings.

nickbits: Yes, also true. This is why you withdraw the contribution (tax-free since it's a Roth) as soon as you have enough foundation in the acct for it to stand on its own.

Let me give a concrete example. I'm a graduate student paid on fellowship--I receive no W2 and thus I have no income (so my allowable IRA contribution is 0).

Last year, I mistakenly opened & contributed to a Roth. I put in $5k and earned $3k on it. Now, I have 2 options:
1) withdraw everything to avoid the 6% fee on $5k; this closes my Roth. But instead pay (on the $3k), 15% federal income, 10% early withdraw penalty, 0.05% state income. (Let's not even count future capital gains taxes I save by investing in a Roth...)
2) withdraw only the $5k by the end of this year, incurring only a *one time* 6% tax. My Roth still has $3k in it.

Tax-cost to me:
1) 900
2) 300 (and I keep $3k in the roth)

Obviously I'm taking the second path. I'm annoyed at the 6% fee, but that was my mistake for not reading carefully enough. But it seems like you could take the same steps, but do it on purpose. At (hugely?) increased risk, you could open the potential to rapidly grow the value of a Roth IRA account, enabling you to tax-shield a lot more money than typically possible.

Edit: though normally, the trade off is btwn my case 2 and the following:
1) Paying short-term capital gains taxes (state+federal) on the earnings. In this case, my state's short term is 12%, so it's still worth it if I knew a-priori that I would earn $3k. If I only managed 500 of earnings, clearly it wouldn't have been worthwhile. *shrug*

 

[Capt Caveman]

You don't get it. You still need to pay taxes on the earnings the year that you made the excess contribution, even if you leave it in the Roth IRA.

IRS.gov

What if You Contribute Too Much?

A 6% excise tax applies to any excess contribution to a Roth IRA.
Excess contributions. These are the contributions to your Roth IRAs for a year that equal the total of:

1.

Amounts contributed for the tax year to your Roth IRAs (other than amounts properly and timely rolled over from a Roth IRA or properly converted from a traditional IRA or rolled over from a qualified retirement plan, as described later) that are more than your contribution limit for the year (explained earlier under How Much Can Be Contributed? ), plus
2.

Any excess contributions for the preceding year, reduced by the total of:
1.

Any distributions out of your Roth IRAs for the year, plus
2.

Your contribution limit for the year minus your contributions to all your IRAs for the year.

Withdrawal of excess contributions. For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made.

Applying excess contributions. If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year.

 

[jaha2000]

This is correct...

You don't get it. You still need to pay taxes on the earnings the year that you made the excess contribution, even if you leave it in the Roth IRA.

IRS.gov

 

[dullard]

2) withdraw only the $5k by the end of this year, incurring only a *one time* 6% tax. My Roth still has $3k in it.

From the instructions of form 5329 (the additional tax form that covers excess Roth contributions, link):

You can withdraw some or all of your excess contributions for 2009 and they will not be treated as having been contriubted if:
* You make the withdrawl by the due date, including extensions, of your 2009 tax return, and
* You withdraw any earnings on the withdrawn contributions and include the earnings in gross income...

So according to the IRS form 5329, your option #2 is not allowed, you must withdraw the earnings too. In order to withdraw the $5000 and avoid the 6% tax on the $5000, you must also withdraw the $3000.

Thus your real choices are:
1) Withdraw the full $8000.
2) Leave the full $8000 in there and pay 6% tax on the entire amount every year until the problem is fixed. I think you can fix it by earning $5000 this year and contributing $0 and applying last years contribution to this years Roth. Meaning, you'd only pay the 6% one time. Of course, if you don't earn $5000 this year, you'll have to keep paying that 6% until you do earn it AND don't contribute to an IRA that year.

 

[dullard]

1) withdraw everything to avoid the 6% fee on $5k; this closes my Roth. But instead pay (on the $3k), 15% federal income, 10% early withdraw penalty, 0.05% state income.

Your numbers are wrong.

If this counts as a capital gain, then short term federal capital gains are only 10% for someone with a low income, not 15%. If it counts as standard income, you might have earned so little that the tax is even lower (due to the standard deduction). Also, your state isn't taxing you at 0.05% either.

Finally, this might be a legal strech, but you can withdraw from a Roth for educational purposes and avoid the 10% early withdrawal penalty.

 

[Suspicious-Teach8788]

Eh I overcontributed big time. I just withdrew the overcontributed amount + the earnings.

The earnings are taxed at 10% for early withdrawl.

I blame the stupid 401k company for not catching it. I asked our HR if it would cap my conributions, and she said yes. Well I actually dumped money into my retirement early 2009. I knew stocks would rally pretty well the whole year, so I contributed as early as possible. It did cap my 401k at 16.5k, but it failed to cap my Roth 401k (not IRA) which should add with the 401k to make 16.5k. So instead I uberly overcontributed (that's why it makes more sense why I didn't have as much money last year to play around). Ugh. What's worse is they're taking forever to give me the reimbursement. It's almost April 15th dammit.

BTW OP, why not just invest that money in a regular investment account at like Fidelity and make whatever you can make with your "overcontribution." If you can make 40% returns on your Roth IRA this year, why can't you make 40% on your own in a traditional investment? What the hell is the point of taking a 6% hit? If you're good at trading and make 40%, that 6% might not hurt as much, but seriously, you might as well just invest on your own.

 

[eLiu]

You pay taxes on the earnings if you withdraw the over-contribution + earnings with the intention of avoiding the 6% fee on the over-contribution.

You guys keep highlighting the small bits of the IRS documents pertaining to AVOIDING the 6% fee in the FIRST year. If you remove over-contribution+associated earnings in the first year, you can pretend that the contribution never happened & treat the earnings as income. What I'm doing is accepting the penalty in the first year, and removing the contribution in the second year. According to the IRS, there is no language that prohibits this.

I am NOT trying to avoid the 6% fee in the first year!

dullard: No my numbers are not entirely wrong. An IRA distribution never counts as capital gain. The value of the distribution is FMV when you take the distribution. It counts as part of your income. So you will pay federal & state income taxes at your regular tax bracket. But yeah, my state is taxing me at 5.3%, oops (and 12% for short term capital gains).

Also yes, you're right I'm assuming that you're at least in the 15% tax bracket (>$8000 income). I think that's reasonable for someone working out of college or a graduate student. But sure, anything that decreases your tax liability from income decreases whatever appeal my plan may/may not have.

If you withdraw from Roth for education, I think you have to spend it on "qualified" educational expenses. Like the same kind of expenses you can take Lifetime Learning or American Opportunity for. So if you ever get audited... could be trouble.

Also, according to the IRS, I have a third option:
3) Withdraw only the original contribution ($5000) before Dec31st of the calendar year following the contribution [tax] year. (This is my case 2.) Here I will pay the 6% fee on the $5000 but only in the contribution year. I have confirmed w/the IRS that there is no language prohibiting you from leaving the earnings in the IRA account. The language you (and others) are citing states that you must withdraw over-contribution+earnings (in the first year) to pretend that the contribution never happened. But I claim that pretending that the contribution never happened is not always the best plan.


I dunno. Am I (and the IRS guys) just completely wrong on this? I spent many hours reading the publications & form/schedule instructions, then I spent many hours talking to the IRS over the phone, during which time I made sure to repeatedly clarify the validity of my intentions.


DLeRium: the point of the 6% hit is that it's a 1 time hit on say $5000. Any money you earn on that is untaxed... for all time. So if I eventually turn $3000 into $30,000 or whatever, I'll avoid like... anywhere from 10-30+% tax on the gains.

Edit: I will try calling etrade tomorrow (IRA is w/them) to see if their retirement/tax dept has anything to say. I guess I could call the IRS again too? Though waiting 2hrs to talk to someone blows. It would be bad if the guys I talked to on Monday were misinformed.

Edit2: Basically the deal is that I had a $4000 over-contribution from 2008 as well. I didn't realize it was a problem (and didn't pay 6% fee in 2008) b/c I didn't realize I have no earned income from my fellowship.

So I called the IRS to ask about how to fix: 1) $4000 over-contributoin in 2008; 2) $5000 over-contribution in 2009. In discussing the 2008 part, I was told that I will owe the 6% fee on my 2008 taxes (need to amend) and my 2009 (b/c I didn't withdraw by Dec31 '09). But as long as I withdraw the $4000 by Dec31 '10, I can avoid any future 6% fees. I asked if I also need to withdraw the earnings, and he said "not unless you want to." But why would I?

That is when I realized that I should do the same thing for my 2009 contribution. Take the 6% penalty once but leave the earnings alone.

 

[Capt Caveman]

I have yet to find an article or publication that allows you to keep the earnings from an excess contribution in the Roth IRA.

Undoing a Roth IRA Contribution

When you withdraw an excess contribution, it is important to note that you also are required to take out any earnings (or losses) that are attributable to the original contribution.

 

[dullard]

After reading this over again, I have four thoughts.

1) You should put all the info in the original post next time. First you say "Last year, I mistakenly opened & contributed to a Roth" but now you say "Basically the deal is that I had a $4000 over-contribution from 2008 as well". It is quite confusing to us that you opened it last year but also had it in 2008.

2) The Publication 590 is quite detailed about penalties and requirements for an IRA excess contribution withdrawal. But, it has almost nothing regarding a Roth IRA excess contribution withdrawal. For example, I now think you are correct that it doesn't explicitly state you have to remove the earnings if it is a Roth.

3) However, if you don't withdraw the excess earnings, you certainly are going against the spirit of publication 590 (see the much stricter IRA section). While the IRS may allow it now, you can't guarantee it'll be allowed in the future. So, I wouldn't count on this as a loophole strategy (especially since gains of your size are unlikely to happen very frequently). Instead, I'd just play it safe and get back in line with the spirit of the IRS. Either withdraw the full $3000 and pay the minimal tax (heck with a gain of $3000, you should be happy even after tax). Or, if you have qualified education / house / medical / disaster / etc expenses, withdraw it penalty free. Or, if you have income this year, apply that $3000 to this years' Roth contribution. Then you won't have to worry about this problem ever again. It isn't worth the headache for such small amounts. And honestly, in the scheme of things, you are talking very small amounts of tax difference.

4) If you really wanted to put more into retirement accounts, find a way to open a SEP. The LEGAL contribution limit of $49,000 in 2010 makes your Roth overcontribution loophole of $3000 (in a fantastic stock year) seem quite small.

 

[eLiu]

After reading this over again, I have four thoughts.

1) You should put all the info in the original post next time. First you say "Last year, I mistakenly opened & contributed to a Roth" but now you say "Basically the deal is that I had a $4000 over-contribution from 2008 as well". It is quite confusing to us that you opened it last year but also had it in 2008.

Sorry, I thought I would be able to make the situation less complicated by ignoring just considering the most recent over-contribution. I guess this didn't really come out well in words? Fail.

2) The Publication 590 is quite detailed about penalties and requirements for an IRA excess contribution withdrawal. But, it has almost nothing regarding a Roth IRA excess contribution withdrawal. For example, I now think you are correct that it doesn't explicitly state you have to remove the earnings if it is a Roth.

I think what I'm claiming is also valid with a Traditional IRA. The rules appear to be very similar. p.48 of 590 discusses: "Tax on Excess Contributions"; "Excess Contributions Withdrawn by Due Date of Return"; and "Excess Contributions Withdrawn After Due Date of Return." I don't think any of these have specific language about what to do with earnings on excess contributions, where the excess is withdrawn 'after due date of return'.

3) However, if you don't withdraw the excess earnings, you certainly are going against the spirit of publication 590 (see the much stricter IRA section). While the IRS may allow it now, you can't guarantee it'll be allowed in the future. So, I wouldn't count on this as a loophole strategy (especially since gains of your size are unlikely to happen very frequently). Instead, I'd just play it safe and get back in line with the spirit of the IRS. Either withdraw the full $3000 and pay the minimal tax (heck with a gain of $3000, you should be happy even after tax). Or, if you have qualified education / house / medical / disaster / etc expenses, withdraw it penalty free. Or, if you have income this year, apply that $3000 to this years' Roth contribution. Then you won't have to worry about this problem ever again. It isn't worth the headache for such small amounts. And honestly, in the scheme of things, you are talking very small amounts of tax difference.

I can't say I would ever do this intentionally. Like if I had been initially aware that you can't contribute to an IRA without "earned income," then I wouldn't have opened one in the first place, even if I knew about this loophole.

I don't have any way of withdrawing it penalty free (read up all the possibilities, I think anyway), and I won't be eligible to contribute until 2012 at the earliest. My fellowship lasts for 4 years (started in fall of '08), and they 1) don't issue W-2s; and 2) don't allow you to do any outside work for pay.

Yeah in the scheme of things it's a very small amount of difference, but at the same time I don't have enough money right now to pay the cost associated with withdrawing the earnings on everything & closing the account. Also I'm 23 right now and $2000 sure feels like a ton of money, haha. Really the tax burden there is relatively high. The distribution will get 15% (fed income), 10% (fed penalty), 5.3% (state income). I'd like more than double my income before hitting the 25% bracket. Then since they're securities, any future gains will at least be subject to federal capital long-term gains (5-10%) and state gains (5.3%). And I'm not really inclined to do so even if I did have the money available.

First I don't see why students in my position should not be allowed to open retirement accounts. All the financial advice I've ever received has always strongly suggested that I open a retirement acct ASAP and start saving. But now I can't? Worse, if there is to be a distinction between earned income and income, why isn't it stated more clearly? I self-report my fellowship earnings on the same line that you report your W-2 totals. Then I go on and calculate my AGI and MAGI like anyone else. If you look at Wikipedia's (or many other sources) article on Roth IRA, the stated limitations are on your MAGI... which I satisfy. From my searches, the fellowship (or more specifically earned income) limitation is discussed on other forums (where people made the same mistake), and on 1 single sentence on the IRS website (that I apparently missed in 2008).

This limitation is just as important as the other limitations they discuss at greater length. On the IRS page, it's 1 sentence... not even on a bulleted list or a "am I eligible" flow-chart. I guess I just don't feel bad following the exact statement of the law rather than the spirit.

I dunno. I guess I'm way off topic now, but I feel very frustrated at this whole thing. It is really entirely my fault, but the rules could have been much more clear. Searching "roth ira fellowship" shouldn't just bring up discussions from other people who failed in the same way.

4) If you really wanted to put more into retirement accounts, find a way to open a SEP. The LEGAL contribution limit of $49,000 in 2010 makes your Roth overcontribution loophole of $3000 (in a fantastic stock year) seem quite small.

I'd looked at that (and the individual 401k). I don't really see much that I can legally do. I'm pretty sure it'd be in violation of my fellowship contract. Even if they never found out, I'm not sure I have the time (or even the marketable skills, haha) to hold down some kind of freelance job.

lol I didn't say $3k is a lot. (Well, it's a lot for me.) But it just seemed interesting that this possibility exists... and since I'd never heard of this happening or seen any references elsewhere online, I thought it could be worth discussing here.

Edit: Also, thank you (and others) for looking through the details of this matter. This whole mess has been exceedingly confusing.

 

[Elbryn]

I think you're right that you can pay the $240 for 2008, 240 for 2009, 300 for 2009 and keep the 3k earnings in the account. there isnt any language that states what happens to earnings should you pay the excess contribution and there is literally not alot of guidance on the subject. everyone i think always removes earnings along with it.

 

[dullard]

First I don't see why students in my position should not be allowed to open retirement accounts. All the financial advice I've ever received has always strongly suggested that I open a retirement acct ASAP and start saving. But now I can't?

I believe the reasoning is two-fold. First, the goverment (or similar entity) is already giving you free money, tuition, and possibly materials/travel. Thus, the government thinks you are doing well enough. That money is intended to be used to get you an education--not for sports cars, retirment accounts, yachts, etc.

Second, I believe that all fellowships are payroll tax free and unemployment tax free, (my fellowship was, as were all my collegues, friends and family). That means you shouldn't be paying 15.3% for social security or medicare on that income and you aren't paying whatever your state charges for unemployment insurance.

So the theory goes: you got free money explicitly for education with lots of tax breaks, why should you also get to use it instead for tax saving retirement accounts?

Put the money in a taxable account. You can still get all the compound growth advantages of saving early. You'll just pay a bit more tax until you are in a position to do something like open a 401k+Roth, Simple IRA, SEP, etc. And with your income, those additional taxes aren't THAT much. For example, after you graduate the $600 difference between your original option #1 and #2 probably is 2 or 3 days of income. Meaning, you'll have to retire 2 or 3 days later to break even if you took option #1. Keep that in perspective, that tax money may sound like a lot to you now, but the actual effect on your life is minimal.