IRA Over Contribution by $3,334 - What's the best way to reduce taxes?

[Jgrabenbauer]

Hello all! I am new to this forum and have found it quite helpful so far so I would like to post a question of my own.

I just started working on my 2020 taxes and while inputting my Traditional and Roth IRA contribution data I was notified that I have $3,334 in excess Roth IRA contributions. When I first started all of this mid-2020 I did not realize that the $6,000 contribution limit was the combined total and not per IRA. (I am sure this happens to many newbies).

I was reading up a little bit regarding how to fix this but given that I am 30 years old and a lot of stocks in there will take a hit on short-term gains if I sell them, I am wondering what would be the best thing to do.

Thanks all!

 

[njhowie]

Pay the 6% penalty on the excess in 2020, then count the excess for the initial amount of 2021 contributions and you're golden.

I'm guessing that simply paying the 6% will outweigh selling stocks, withdrawing and paying the capital gains.

 

[Jgrabenbauer]

Pay the 6% penalty on the excess in 2020, then count the excess for the initial amount of 2021 contributions and you're golden.

I'm guessing that simply paying the 6% will outweigh selling stocks, withdrawing and paying the capital gains.

Thanks so much! That's exactly what I was thinking.

So if I count that excess towards my 2021 contributions then I will only be able to make $2,666 in additional contributions this year, correct?

Also, is the 6% taxed on just the contribution amount itself, or the capital gains on that contribution as well?

 

[cathy63]

Hello all! I am new to this forum and have found it quite helpful so far so I would like to post a question of my own.

I just started working on my 2020 taxes and while inputting my Traditional and Roth IRA contribution data I was notified that I have $3,334 in excess Roth IRA contributions. When I first started all of this mid-2020 I did not realize that the $6,000 contribution limit was the combined total and not per IRA. (I am sure this happens to many newbies).

I was reading up a little bit regarding how to fix this but given that I am 30 years old and a lot of stocks in there will take a hit on short-term gains if I sell them, I am wondering what would be the best thing to do.

Thanks all!

I don't understand what you mean by "will take a hit on short-term gains". If the stocks are in an IRA, you don't pay any tax on the cap gains when you sell them.

Assuming you made the over-contribution during the calendar year 2020, then you can correct it by changing the excess amount plus the earnings thereon into a 2021 contribution. Call your broker and ask them for help. This won't be the first time they've seen this issue. If you do it by April 15 (or October 15 if you file for an extension), there's no penalty.

 

[cathy63]

Thanks so much! That's exactly what I was thinking.

So if I count that excess towards my 2021 contributions then I will only be able to make $2,666 in additional contributions this year, correct?

Also, is the 6% taxed on just the contribution amount itself, or the capital gains on that contribution as well?

There should not be a 6% penalty if you correct this before you file your 2020 return. Yes, you will only be able to contribute $6000 minus the amount that's recharacterized into a 2021 contribution, and that recharacterized amount will include the earnings.

 

[njhowie]

I don't understand what you mean by "will take a hit on short-term gains". If the stocks are in an IRA, you don't pay any tax on the cap gains when you sell them.

Assuming you made the over-contribution during the calendar year 2020, then you can correct it by changing the excess amount plus the earnings thereon into a 2021 contribution. Call your broker and ask them for help. This won't be the first time they've seen this issue. If you do it by April 15 (or October 15 if you file for an extension), there's no penalty.

cathy is correct.

 

[Jgrabenbauer]

I don't understand what you mean by "will take a hit on short-term gains". If the stocks are in an IRA, you don't pay any tax on the cap gains when you sell them.

Assuming you made the over-contribution during the calendar year 2020, then you can correct it by changing the excess amount plus the earnings thereon into a 2021 contribution. Call your broker and ask them for help. This won't be the first time they've seen this issue. If you do it by April 15 (or October 15 if you file for an extension), there's no penalty.

You're absolutely right Cathy, I forgot that there wouldn't be any capital gains due since it's in an IRA.

When you are referring to "excess amount plus earnings", are those earnings from the capital gains or dividends, interest, etc? Also, if those earnings plus this year's contributions that I have added already end up over $6k again, will I need to do the same thing for the year after to get things back in check?

Thanks so much for your help!

 

[cathy63]

You're absolutely right Cathy, I forgot that there wouldn't be any capital gains due since it's in an IRA.

When you are referring to "excess amount plus earnings", are those earnings from the capital gains or dividends, interest, etc? Also, if those earnings plus this year's contributions that I have added already end up over $6k again, will I need to do the same thing for the year after to get things back in check?

Thanks so much for your help!

Yes, the earnings include realized and unrealized gains and interest and dividends. It's the entire amount that the $3334 would have grown to if it had been in an account all by itself. The IRS has a formula to use for figuring out how much that is. Your broker will know how to apply the formula to your account and they can easily tell you the exact amount that has to come out or be allocated to 2021 contributions.

If you have already made a contribution for 2021, then I would recommend getting the whole account straightened out now and taking out whatever you have to so that both your 2020 and 2021 contributions are exactly $6K. It gets more complicated when there are multiple contributions over multiple years and I'm not sure how the IRS will interpret the penalty rules if you allocate a 2020 excess contribution into 2021 and that creates another excess. That may result in a 6% penalty, I don't know. So call your broker and explain the whole situation and ask them for help straightening it out.

 

[SecondCor521]

@cathy63, I thought if a TP contributed excess in calendar year 2020 and then applied that to 2021, they would still owe the 6% excise tax on the excess on their 202 return.

I can see if the TP contributed in 2021 for 2020, and the 2021 amount exceeded the excess contribution amount that that situation might be worked out somehow.

I'd imagine a lot of people would prefund their year N+1 Roth IRA contributions in year N if there were a free ride way to do so.

 

[cathy63]

@cathy63, I thought if a TP contributed excess in calendar year 2020 and then applied that to 2021, they would still owe the 6% excise tax on the excess on their 202 return.

I can see if the TP contributed in 2021 for 2020, and the 2021 amount exceeded the excess contribution amount that that situation might be worked out somehow.

I'd imagine a lot of people would prefund their year N+1 Roth IRA contributions in year N if there were a free ride way to do so.

As far as I can tell, there's no penalty if you convert the 2020 excess into a 2021 contribution as long as you do it between 1/1/2021 and 4/15/2021 (or 10/15/2021 with extension). It's the same as if you walked into the IRA custodian's office and removed the excess in one transaction and then immediately redeposited it as a second transaction.

There's no financial benefit to funding the IRA a year in advance since you have to pay income tax on the earnings, so it's really not a free ride. It works out the same as if you had put the money in a taxable account in year N and then used it to fund your IRA in year N+1.

 

[SecondCor521]

As far as I can tell, there's no penalty if you convert the 2020 excess into a 2021 contribution as long as you do it between 1/1/2021 and 4/15/2021 (or 10/15/2021 with extension). It's the same as if you walked into the IRA custodian's office and removed the excess in one transaction and then immediately redeposited it as a second transaction.

There's no financial benefit to funding the IRA a year in advance since you have to pay income tax on the earnings, so it's really not a free ride. It works out the same as if you had put the money in a taxable account in year N and then used it to fund your IRA in year N+1.

When I went through this myself a few years back, since I was under 59.5, I had to pay ordinary income tax plus 10% early withdrawal penalty on the earnings. (I had no applicable exemption.)

So in the example in your first paragraph, I would think that, again assuming TP is under 59.5 and no applicable 5329 line 2 exemption reason, the removal of the 2020 excess plus associated earnings (in order to properly get under the 2020 contribution limit) would similarly generate ordinary income tax plus 10% early withdrawal on the earnings.

You could then turn around and put whatever you had left back in as a 2021 contribution, but there'd still be the loss of those taxes and penalty.

Yes? No?

 

[cathy63]

When I went through this myself a few years back, since I was under 59.5, I had to pay ordinary income tax plus 10% early withdrawal penalty on the earnings. (I had no applicable exemption.)

So in the example in your first paragraph, I would think that, again assuming TP is under 59.5 and no applicable 5329 line 2 exemption reason, the removal of the 2020 excess plus associated earnings (in order to properly get under the 2020 contribution limit) would similarly generate ordinary income tax plus 10% early withdrawal on the earnings.

You could then turn around and put whatever you had left back in as a 2021 contribution, but there'd still be the loss of those taxes and penalty.

Yes? No?

Looking at our 2011 return where DH had a similar issue, there's no penalty on it. As I recall, we made our 2011 contributions early in the year and DH mistakenly selected 2010 on his and then had to go back and fix it a couple of weeks later. I have a note on the spreadsheet I use to track our basis in these accounts, so I know that's the year it happened, but I don't see any evidence of it on our 2010 or 2011 returns and definitely no penalties of either 6% or 10%. I no longer have the 1099s from those years, and now I wonder if they even issued one. Maybe in our case they were able to move the entire contribution and earnings because we were already in 2011 when the contribution was made.

 

[SecondCor521]

Looking at our 2011 return where DH had a similar issue, there's no penalty on it. As I recall, we made our 2011 contributions early in the year and DH mistakenly selected 2010 on his and then had to go back and fix it a couple of weeks later. I have a note on the spreadsheet I use to track our basis in these accounts, so I know that's the year it happened, but I don't see any evidence of it on our 2010 or 2011 returns and definitely no penalties of either 6% or 10%. I no longer have the 1099s from those years, and now I wonder if they even issued one. Maybe in our case they were able to move the entire contribution and earnings because we were already in 2011 when the contribution was made.

Emphasis added. Yeah, I think that last part is the key difference. I think if your DH had made that same contribution prior to 1/1/2011 the tax result would have been different.

But the rules are complicated!