Woohoo extra money... Oh no what about my Roth

U

upupandaway

Recycles dryer sheets
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Jul 22, 2019
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133
The title are the two thoughts that have gone through my head. My company is being acquired and this triggered a nice lump sum payment for myself. This is great and will help my FI plans however I fully funded my Roth and a spousal Roth IRA at the beginning of the year. Since I caught it in the same tax year my research leads me to believe I simply pull the contribution out of both Roth accounts and pay a 10% penalty on the earnings (I'm younger then 59.5) but avoid the 6% penalty on the contribution. Does this sound correct to the knowledgeable folks here?

PS I believe I have to claim the earnings as income

Thanks
 
You are correct in how to handle it and the tax implications only on the earnings portion.
 
just curious how the 2 events are related?
 
Can you recharacterize them as nondeductible IRAs and then convert them back into Roths? You would still pay the tax on the earnings. This won't work if you have traditional IRAs.
 
I would check with the IRA custodian to see if they have a Return of Excess Contributions form to ensure that this gets accounted for and reported correctly.
 
+1 Need to do return of excess contributions.... return of contribution will be tax free and you'll pay tax and the 10% penalty on earnings.
 
After removing the contributions from your Roth (however is the best way to do that), if you don't have any other pre-tax IRAs, you could set up a traditional IRA, fund it with after-tax dollars, and then roll that into your Roth. This way you'll still make your same Roth contributions.

Though, this being said, I don't know if removing your prior contributions from your Roth would change the availability of doing a Roth conversion this year. Hopefully someone more knowledgeable on this will chime in. I just did my first Roth conversion this year (wish I knew about this earlier), so I'm far from an expert on it.
 
Interesting. So the ROTH IRA is at vanguard and I also have a rollover tIRA there as well. I have plenty in the tIRA to do a conversion to ROTH with older dollars if I withdrew the invalid ROTH contribution this year and instead placed that in my tIRA. Then perform a Roth conversion from the existing funds. Am I understanding the basics of this right. Would I have to pay tax on the roth conversion at my current bracket. If that is the case I will have to review the brackets again and see where I fall after this lump sum is realized.
 
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upupandaway said:
Interesting. So the ROTH IRA is at vanguard and I also have a rollover tIRA there as well. I have plenty in the tIRA to do a conversion to ROTH with older dollars if I withdrew the invalid ROTH contribution this year and instead placed that in my tIRA. Then perform a Roth conversion from the existing funds. Am I understanding the basics of this right. Would I have to pay tax on the roth conversion at my current bracket. If that is the case I will have to review the brackets again and see where I fall after this lump sum is realized.
Click to expand...

You'd have to pay taxes at your current bracket, correct. If you wanted to avoid that, if you have a current 401K, you could rollover your rollover IRA into the 401K. This would then give you a clean slate to set up a tIRA and fund it all with after tax dollars the same way you would your Roth IRA in a year where you weren't over the income limits, and then do a Roth conversion with this. But, the downside to this is that you won't have as many investment options in a 401K as you would in the IRA if you were to roll that over.
 
If you going to put the funds back in the TIRA, why not just recharacterize the Roth contribution to a TIRA contribution. That way you won't have to pay the 10% penalty and the earnings stay within the IRA shelter.
 
I will look into this I just don't know anything about recharachterizing a contribution. New territory for me
 
I need a little more help on this. I have maxed out my 401K for 2019 as well as my ROTH IRA. I also maxed out my wife's "Spousal" ROTH IRA as she is a stay at home Mom. She currently does not have a TIRA setup anywhere. In this situation can I still re-characterize mine into my TIRA as Vanguard suggests? Can I create a new TIRA at Vanguard and re-characterize her's as well? What would be the tax treatment on these?

Thanks

Thank you for taking the time to contact us.

If you determine you weren't eligible to make a Roth IRA contribution
because of your modified adjusted gross income (MAGI), you have two options
for reversing the excess contribution. You can either complete an excess
IRA contribution removal or recharacterize the excess contributions to a
traditional IRA.

Excess Removal >>
With an excess removal, the contribution, plus or minus any earnings or
loss, is either mailed back to you as a check or you can request it be
moved to a nonretirement account here at Vanguard. The contribution would
not be subject to income tax or penalty if removed by the tax filing
deadline, plus the IRS allowed extension. If there are any earnings on the
contribution, they will be subject to ordinary income tax and, if you are
under the age of 59-1/2, a 10% premature distribution penalty. Please look
to the IRS Form 8606 and its instructions as well as the IRS Form 5329 and
its instructions for more information.

Recharacterization >>
You can recharacterize assets to a traditional IRA as long as you have U.S.
earned income and you don't exceed the annual IRA contribution limits.
However, if you (or your spouse) actively participated in an employer plan
during the tax year of the contribution, you may or may not be able to
deduct the contribution. If you (and your spouse) didn't participate in an
employer plan, you may be able to fully deduct your contribution regardless
of your modified adjusted gross income. Please look to the instructions
within the IRS Publication 590-A for additional information on how to
report the contribution.

You can access our online form to process an excess contribution removal or
recharacterize a Roth IRA contribution, at the web page below:
Click to expand...
 
dirtbiker said:
Though, this being said, I don't know if removing your prior contributions from your Roth would change the availability of doing a Roth conversion this year. Hopefully someone more knowledgeable on this will chime in.
Click to expand...

The two are independent of each other.

upupandaway said:
I need a little more help on this. I have maxed out my 401K for 2019 as well as my ROTH IRA. I also maxed out my wife's "Spousal" ROTH IRA as she is a stay at home Mom. She currently does not have a TIRA setup anywhere. In this situation can I still re-characterize mine into my TIRA as Vanguard suggests? Can I create a new TIRA at Vanguard and re-characterize her's as well? What would be the tax treatment on these?

Thanks
Click to expand...

Yes, you can still recharacterize both yours and your wife's Roth IRA contributions (plus any associated earnings, which Vanguard will helpfully calculate for you) into a traditional IRA. Contact Vanguard and have them do this before 4/15/2020; I'm fairly certain that if the recharacterization happens after that date then you would owe a 6% excess contribution penalty (see Form 5329 part IV).

The tax treatment is as pb4uski previously stated. You'll owe income taxes plus a 10% penalty on the associated earnings (as calculated by Vanguard for you). I don't recall offhand whether the taxes and penalty would be done as part of your 2019 or 2020 tax return. Take a look at Form 8606 and Form 5329 part I.

If you elect to do the backdoor Roth IRA with your 2019 contribution, I believe you would be subject to pro-rata rules since you currently have a Rollover IRA. (I'm assuming your rollover IRA is from pre-tax contributions.)
Two things:

1. It may make your life easier to open a separate traditional IRA to receive your recharacterized 2019 Roth IRA contribution. You'd still be subject to pro-rata rules if you subsequently chose to convert that 2019 contribution back to your Roth, but the accounting would perhaps be easier to trace.

2. It may also be easier just to withdraw the excess contributions from your Roths and don't bother with the complexity this year. What people are suggesting can be done, but it is pretty complicated and it sounds like you're still learning.
 
SecondCor521;2350285]The two are independent of each other.



Yes, you can still recharacterize both yours and your wife's Roth IRA contributions (plus any associated earnings, which Vanguard will helpfully calculate for you) into a traditional IRA. Contact Vanguard and have them do this before 4/15/2020; I'm fairly certain that if the recharacterization happens after that date then you would owe a 6% excess contribution penalty (see Form 5329 part IV).........................
Click to expand...

Thanks for your detailed reply. I certainly wouldn't have a problem opening two new IRA's one for my wife and one for myself to keep it clean because as you mentioned the roll-over IRA I have is pre-tax she does not currently have anything other then the ROTH.

My final questions (I think :) )

1. If I go the form 8606 route and create new "Non-Duductable" IRA's and have the contributions recharacterized into them then I can't find in the documents where it says the earnings would be taxed or not. I also can't seem to see if there would be any penalty applied. I'm not sure why the earnings would be taxed if I would have been allowed to put that after tax money in an IRA and have it grow anyway. The Vanguard response doesn't mention this.

2. The other option would be to take the money out but then due to both of our ages I will pay a 10% penalty on the growth of 12K that I put in VTIVX in Jan/2019 which Vanguard says YTD as of 12/31/2019 was 24.94%. Which by my math is around $300 penalty.

Although I'm pretty new to this stuff I love learning about it. I don't want to eat the penalty but I can if I have to. Also would there be any benefit to the "Non-Deductible IRA" afterwards or would it just be that I could convert that to Roth later on?

Thanks Everyone
 
upupandaway said:
Thanks for your detailed reply. I certainly wouldn't have a problem opening two new IRA's one for my wife and one for myself to keep it clean because as you mentioned the roll-over IRA I have is pre-tax she does not currently have anything other then the ROTH.

My final questions (I think :) )

1. If I go the form 8606 route and create new "Non-Duductable" IRA's and have the contributions recharacterized into them then I can't find in the documents where it says the earnings would be taxed or not. I also can't seem to see if there would be any penalty applied. I'm not sure why the earnings would be taxed if I would have been allowed to put that after tax money in an IRA and have it grow anyway. The Vanguard response doesn't mention this.

2. The other option would be to take the money out but then due to both of our ages I will pay a 10% penalty on the growth of 12K that I put in VTIVX in Jan/2019 which Vanguard says YTD as of 12/31/2019 was 24.94%. Which by my math is around $300 penalty.

Although I'm pretty new to this stuff I love learning about it. I don't want to eat the penalty but I can if I have to. Also would there be any benefit to the "Non-Deductible IRA" afterwards or would it just be that I could convert that to Roth later on?

Thanks Everyone
Click to expand...

There is no tax due on the recharacterization from the Roth to the non-deductible traditional IRA. In general, a recharacterization just allows you to change your mind and it is as though you originally made the contribution to the receiving IRA in the first place, so there are no taxes (or penalties) due.

The tax on the earnings would only kick in if you chose to subsequently convert the non-deductible traditional IRA back into your Roth IRA. Since you would be doing the conversion in 2020, the tax and penalties would be reported on your 2020 return. What will happen is Vanguard will send you 2 1099-Rs about a year from now reporting the gross amount converted. You'll report the gross amount converted (~$7.5K for you, ~$7.5K for your wife) as well as the basis of the gross amount converted ($6K for your wife, $6K * some ratio for you, based on the fraction of your IRAs which are pre-tax vs. after-tax). This will generate a Form 8606 for you with part I filled in, and likewise one for your wife. The ratio stuff for you will end up on lines 11 and 12 of Form 8606. The $1.5K gain for your wife's Roth will end up on line 18 of your wife's 8606; your prorated number will be on the same line on your Form 8606.

In reading further, the 10% penalty would apply to any distribution from a traditional IRA before age 59 1/2, but converting those funds to a Roth is an exception to that 10% penalty, so as long as you convert the entire amount (and don't divert any of it to anywhere other than your Roth IRA), you would escape the 10% penalty.

Having a separate IRA for the conversion from your Roth IRA isn't necessary - the IRS treats all of your traditional IRAs as one giant IRA for tax purposes. It just could make it easier for you when going through the process with Vanguard and in looking back a few years to remember what happened. Also (and someone more advanced than me would have to comment here), I believe that your rollover IRA needs to stay separate if you ever decide to work somewhere and roll that rollover IRA into your future employer's 401(k). Come to think of it, if you decide to do the second step of converting that contribution back to your Roth, then the IRS will deem the conversion to come pro-rata from your rollover IRA and your nondeductible IRA (even if the funds actually come entirely from the nondeductible IRA), so I think that might affect your ability to later move that rollover IRA into a future 401(k).
 
Since your spouse doesn't have a tIRA you could recharacterize her contribution to a new non-deductible tIRA and then convert it to a Roth and totally avoid the penalty and the tax.... essentially a back-door Roth contribution.

Your situation is trickier since you have a deductible IRA. I would avoid having a non-deductible IRA, even if in separate accounts. So I would withdraw yours which will cut the penalty in half.
 
The other thing to point out is the pro-rata rules, which I alluded to in my previous posts, but it bears pointing out something:

Once you have a mix of deductible and non-deductible traditional IRAs, then any Roth conversions are done pro-rata and affect the basis, which you then have to keep track of from year to year. That is to say, you create a multi-year tax tracking issue for yourself. There are talented CPAs out there who can keep track of basis over years and years, but I find it difficult. What I ended up doing was rolling my deductible IRA into my 401(k) and then I didn't have to worry about doing pro-rata stuff.
 
I just want to thank you guys for the help and taking the time to explain the nuances to me. I've learned a lot from this experience. As I have no intention of creating a lifelong record keeping burden for the sake of $150 I think I will take the penalty for myself and convert DWs to a non-deductible then perform the ROTH conversion.

Thanks Again
 
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