Roth IRA recharacterization: income tax question

[dullard]

I screwed up on my Roth IRA in 2016. I calculated my income level once all bonuses were paid out and all raises were in. I figured out that I'd be right in the middle of the reduced Roth IRA limits due to income values. I contributed to the Roth IRA a bit less than what I figured that I could contribute just in case. Did the same with my wife's Roth IRA. All seemed fine.

Then late December came along and my wife got an unexpected additional bonus. We no longer qualified for the Roth IRA. I called Vanguard and asked if I can undo the Roth IRA contributions as I didn't qualify for them. They said it was unwise and that I should instead recharacterize it and I could then convert it back to the Roth IRA as if nothing ever happened. So, I did that (mistake #2).

Oops, I wasn't informed that they'd also recharacterize $600 of other Roth IRA money into the traditional IRA (basically the earnings throughout 2016) as required by the IRS. So, if I covert it to the Roth IRA, I'll be taxed on that $600 (basically a $200 mistake for me and another a $200 mistake for my wife) just so the $600 can go from my Roth IRA ultimately back to the Roth IRA.

Is there any way out of this? Can I undo the original contribution as if it never happened? Or am I out $400?

 

[Fern]

The remedy for excess IRA (Roth or regular) contributions is simply to withdraw it.

If your total IRA contributions (both Traditional and Roth combined) are greater than the allowed amount for the year in your situation, and you have not withdrawn the excess contributions, you must complete Form 5329 to calculate a 6% penalty tax on the excess contribution. This penalty tax will continue to be assessed every year on ALL excess contributions (those from prior years along with any in the current year) until you withdraw the excess contributions.

Avoid this tax by withdrawing any excess amount before the due date.

https://www.taxact.com/support/1280/2016/ira-or-roth-ira-excess-contributions

Fern

 

[quikah]

You can withdraw contributions from Roth IRA anytime you want tax/penalty free.

The gain needs to be handled differently. No idea how that works, it needs to be taxed as normal capital gain AFAIK.

 

[dullard]

The remedy for excess IRA (Roth or regular) contributions is simply to withdraw it.



https://www.taxact.com/support/1280/2016/ira-or-roth-ira-excess-contributions

Fern

From that link: "You must include in your gross income the interest or other income that was earned on the excess contribution. Report it on your return for the year in which the excess contribution was made."

The contribution was to a money market account with virtually zero income, but since 2016 was a good stock market year, the IRS rules state that I have to withdraw the percent of the average gain of the whole Roth IRA ($600). Which would be taxable, plus 10% penalty. So, I'm back where I started?

If only there was a "I filed in in the wrong type of IRA" form because if this was a non-tax deductible IRA contribution instead I'd be fine. But I don't think one exists.

 

[purbeast0]

Holy shit I was not aware of the limit on a Roth IRA. I am well over the limit with mine and my wife's salary and I am $250 outside of the limit. From what I just quickly read I am not allowed to contribute at all to a Roth? If that is the case, WTF do I do with the money I contributed?

EDIT:

I guess I have to do a bit more reading, I don't know if it's gross income or taxable income yet.

 

[dullard]

Holy shit I was not aware of the limit on a Roth IRA. I am well over the limit with mine and my wife's salary and I am $250 outside of the limit. From what I just quickly read I am not allowed to contribute at all to a Roth? If that is the case, WTF do I do with the money I contributed?

EDIT:

I guess I have to do a bit more reading, I don't know if it's gross income or taxable income yet.

Pub 590-A Worksheet 2-1, page 42 to calculate Roth contribution income limit (it is almost your gross income with a few adjustments).

https://www.irs.gov/pub/irs-pdf/p590a.pdf

 

[purbeast0]

Pub 590-A Worksheet 2-1, page 42 to calculate Roth contribution income limit (it is almost your gross income with a few adjustments).

https://www.irs.gov/pub/irs-pdf/p590a.pdf

Thanks.

So I'm over this year and I was over in 2014 by like $1k to contribute anything. 2015 is when my son was born so my wife didn't work much.

So wtf do I do now?

 

[PowerEngineer]

This is why I stopped making IRA contributions of any kind until I am able to complete my tax return for that year. That way I can clearly see what I am allowed to contribute, and can make those contributions for that tax year before actually filing my tax return. I know that I'm theoretically giving up a year's worth of "time value of money", but to do otherwise seems like a crap shoot if your income is approaching the limits.

 

[dullard]

This is why I stopped making IRA contributions of any kind until I am able to complete my tax return for that year. That way I can clearly see what I am allowed to contribute, and can make those contributions for that tax year before actually filing my tax return. I know that I'm theoretically giving up a year's worth of "time value of money", but to do otherwise seems like a crap shoot if your income is approaching the limits.

Lesson learned. But, even if I repeat this mistake, it could be almost a wash. The lost $5500 * 8% return is about the same as the few hundred that I am losing.

 

[dullard]

Thanks.

So I'm over this year and I was over in 2014 by like $1k to contribute anything. 2015 is when my son was born so my wife didn't work much.

So wtf do I do now?

Going over this year would put you where I am. You can withdraw it and pay tax/penalty (depending on your age). Or you can recharacterize it to a traditional IRA. Then, since there is no income limit to convert a traditional IRA to a Roth IRA, you can convert it right back. The complications come in where excess earnings have to be handled as well though (which is where I'm unhappy that I didn't just put it into the traditional IRA to start with).

As for the year 2014, I would talk to a tax expert.

 

[MomentsofSanity]

Going over this year would put you where I am. You can withdraw it and pay tax/penalty (depending on your age). Or you can recharacterize it to a traditional IRA. Then, since there is no income limit to convert a traditional IRA to a Roth IRA, you can convert it right back. The complications come in where excess earnings have to be handled as well though (which is where I'm unhappy that I didn't just put it into the traditional IRA to start with).

As for the year 2014, I would talk to a tax expert.

Be careful if you rechar to a Traditional IRA if you have already have pretax money in IRAs. There's a little known "Pro-Rata Rule" that people doing backdoor contributions get burned on.

Essentially if you convert money from a Traditional to a Roth, the IRS doesn't let you say I'm only converting the after tax money in the Traditional. They pro rate the conversion based on your total IRA money. So if you have pretax funds in IRAs already then the converted amount will end up taxable. So if 90% of your money is pretax, 90% of the converted amount is taxable as income.

To answer the original question if it's a 2016 contribution you do a removal of excess as well as removing what's called Net Income Attributable. Basically any profits above the contribution come out too and those are taxable.

 

[Scarpozzi]

Maybe I should ask my question in this thread and attempt a hijack!

My employer has a meager 401k match. I've essentially got a pension in addition to this, so I've only ever contributed what they match (why turn down free money, right?).

In that 401k, I don't contribute much, but they give me 2 options for the 401k....either set it up as a traditional or roth account. I went with traditional when I set it up 15 years ago...

If I want to open an IRA, do I need to deduct the 401k contributions from my max? My annual household income is below the line for married households, so I don't worry about that. I just don't want to contribute too much when we really start throwing money at our retirement. (we're already contributing, but pushing to pay off the mortgage before we really double down on our future)

EDIT: I should be clear that I asked this question of my employer's Voya account representative and I think she's a complete idiot. She stated that the 401k contributions counted against the IRA max and I disagree because they're different account types. I just wanted to get someone else to confirm that she's an idiot. =) Thanks.

 

[dullard]

Maybe I should ask my question in this thread and attempt a hijack!

My employer has a meager 401k match. I've essentially got a pension in addition to this, so I've only ever contributed what they match (why turn down free money, right?).

In that 401k, I don't contribute much, but they give me 2 options for the 401k....either set it up as a traditional or roth account. I went with traditional when I set it up 15 years ago...

If I want to open an IRA, do I need to deduct the 401k contributions from my max? My annual household income is below the line for married households, so I don't worry about that. I just don't want to contribute too much when we really start throwing money at our retirement. (we're already contributing, but pushing to pay off the mortgage before we really double down on our future).

Roth 401k didn't exist 15 years ago, so of course you had a traditional 401k.

You are both partly correct.

You are correct that the IRA or Roth IRA are different account types. So you can contribute both the maximum $18000 to the 401k and the maximum $5500 to the IRA + Roth IRA assuming you qualify.

She is correct that 401k contributions do have an impact however. 401k contributions don't count as income when you are seeing if you can contribute to the Roth IRA. So making more 401k contributions could possibly help you there someday (I know you said you aren't near the limit now but that could change). Also having a 401k available makes it more difficult to qualify to have a tax deduction on an IRA.

 

[dullard]

Be careful if you rechar to a Traditional IRA if you have already have pretax money in IRAs. There's a little known "Pro-Rata" that people doing backdoor contributions get burned on.

Essentially if you convert money from a Traditional to a Roth, the IRS doesn't let you say I'm only converting the after tax money in the Traditional. They pro rate the conversion based on your total IRA money. So if you have pretax funds in IRAs already then the converted amount will end up taxable. So if 90% of your money is pretax, 90% of the converted amount is taxable as income.

Yes, I try to keep the IRA balance at $0, so I can convert to Roth IRA without that complication.

To answer the original question if it's a 2016 contribution you do a removal of excess as well as removing what's called Net Income Attributable. Basically any profits above the contribution come out too and those are taxable.

What I screwed up on was the Net Income Attributable part. The excess money was in a money market account with just a dollar or so of income. But, the formula doesn't let you look only at the money that you accidentally overcontributed, instead you have to look at all profits. I should have realized this but I was too busy and overlooked it. (Or even better, not contribute until all unexpected earnings are in).

 

[MomentsofSanity]

Yes, I try to keep the IRA balance at $0, so I can convert to Roth IRA without that complication.

What I screwed up on was the Net Income Attributable part. The money was in a money market account with just a dollar or so of income. But, the formula doesn't let you look only at the money that you accidentally overcontributed, instead you have to look at all profits. I should have realized this but I was too busy and overlooked it.

Yeah this is what I deal with all day every day this time of year. Most people don't understand that it doesn't matter if the over contributed funds were invested. You have to weigh the performance of the entire account to determine what comes out/stays in when removing the excess.

Edit: I specialize in retirement accounts so if you have questions on the rules, technicalities etc... and I can answer feel free to let me know.

 

[Scarpozzi]

Roth 401k didn't exist 15 years ago, so of course you had a traditional 401k.

You are both partly correct.

You are correct that the IRA or Roth IRA are different account types. So you can contribute both the maximum $18000 to the 401k and the maximum $5500 to the IRA + Roth IRA assuming you qualify.

She is correct that 401k contributions do have an impact however. 401k contributions don't count as income when you are seeing if you can contribute to the Roth IRA. So making more 401k contributions could possibly help you there someday (I know you said you aren't near the limit now but that could change). Also having a 401k available makes it more difficult to qualify to have a tax deduction on an IRA.

Actually, Roth IRA did exist 15 years ago. I only know because I had the discussion with HR about it....the google says 1997....I started taking benefits around 2001/2002. The 401k has a roth option, but I think that question was asked by my HR department because of when they took the money out. They may not have that account distinction anymore because it seems like a loophole...I'd have to check.

In any case....I've got debt to blaze through before I really start looking at more intensive savings options. I just know I want to save up about 10 times what I have now before I stop working and will likely try to contribute another $30-40k annually between my wife and I once these pesky kids are out of daycare and we have the house paid off. We'll probably shoot for maxing the Roth first, then fall back to the 401k so we can have a tax-free income stream to use when we don't want to flip brackets in retirement.

 

[dullard]

Actually, Roth IRA did exist 15 years ago. I only know because I had the discussion with HR about it....the google says 1997....I started taking benefits around 2001/2002. The 401k has a roth option, but I think that question was asked by my HR department because of when they took the money out. They may not have that account distinction anymore because it seems like a loophole...I'd have to check.

In any case....I've got debt to blaze through before I really start looking at more intensive savings options. I just know I want to save up about 10 times what I have now before I stop working and will likely try to contribute another $30-40k annually between my wife and I once these pesky kids are out of daycare and we have the house paid off. We'll probably shoot for maxing the Roth first, then fall back to the 401k so we can have a tax-free income stream to use when we don't want to flip brackets in retirement.

I thought you were talking about your 401k; a Roth IRA has been around a long time but a Roth 401k was started in 2006.

Sounds like you have a good plan. Roth IRA first (after 401k company match) gives you more investment options than the limited options your HR department lets you invest in. Plus, you are correct that it gives you income source options in retirement to minimize taxes. Paying off debt vs retirement savings now is debatable; but to let you know I chose the pay off debt option myself too.

 

[Scarpozzi]

I thought you were talking about your 401k; a Roth IRA has been around a long time but a Roth 401k was started in 2006.

Sounds like you have a good plan. Roth IRA first (after 401k company match) gives you more investment options than the limited options your HR department lets you invest in. Plus, you are correct that it gives you income source options in retirement to minimize taxes. Paying off debt vs retirement savings now is debatable; but to let you know I chose the pay off debt option myself too.

2006....That I didn't realize, but sounds about right. I remember having the talk about the Roth 401k with my HR person...probably around 2006 when the employer match increased and I adjusted my contribution. I just made the assumption it was offered previously and I missed it. I get it now. Thanks. =)

I'm 36 so I probably have 29-31 years to save before I'm ready to cash out. I'll really start pushing the extra investments at 40. I'm hoping we'll be able to pay the house off by then and have some real cash to start putting up.

 

[Schfifty Five]

Maybe I should ask my question in this thread and attempt a hijack!

My employer has a meager 401k match. I've essentially got a pension in addition to this, so I've only ever contributed what they match (why turn down free money, right?).

In that 401k, I don't contribute much, but they give me 2 options for the 401k....either set it up as a traditional or roth account. I went with traditional when I set it up 15 years ago...

If I want to open an IRA, do I need to deduct the 401k contributions from my max? My annual household income is below the line for married households, so I don't worry about that. I just don't want to contribute too much when we really start throwing money at our retirement. (we're already contributing, but pushing to pay off the mortgage before we really double down on our future)

EDIT: I should be clear that I asked this question of my employer's Voya account representative and I think she's a complete idiot. She stated that the 401k contributions counted against the IRA max and I disagree because they're different account types. I just wanted to get someone else to confirm that she's an idiot. =) Thanks.

I somewhat feel bad that I'm helping your thread hijacking but felt I could provide you with some answers:

A 401(k) and IRA are two completely different retirement accounts.

Both 401(k) and IRA have pre-tax (traditional) and after-tax (Roth) contribution types (though for 401(k)s, Roth may not be available depending on how your plan is setup).

For 401(k)s, you can contribute up to $18,000 in 2016 and it can be all traditional, all roth, or a combination of both, so long as the total sum of 401(k) contributions is not more than $18,000 (or $24,000 if over 50 years of age).

For IRAs, same deal, except the limit is $5,500. You can do all traditional, all roth, or a combination so long as the total is no more than $5,500 and you met the income limits.

It's possible that the voya cusomter service person was confusing the Roth IRA with a Roth 401(k).

 

[Scarpozzi]

It's possible that the voya cusomter service person was confusing the Roth IRA with a Roth 401(k).

I don't doubt she was confused because I mentioned the IRA and 401k in my question. When I got a different answer than what I expected, I didn't correct her because she's the expert. I backed away and stopped asking questions.

I used to work for a different outfit that had the same exact retirement benefits (different state entity in a different city). Because it was more population-dense, we had multiple vendors meet with us on a regular basis. Now that I live in no-man's land, I'm stuck with this piece of work and none of the other vendors show up. No worries, I can manage my accounts online without having to deal with her...but it sucks that they can't give us a knowledgeable broker if she's going to be fielding all questions related to the system...

Thanks for the response. I'll step off my soap box and let the thread go back in its original direction.