Deliberate Roth conversion with no earned income?

[Fermion]

Can you legally (no criminal consequences) make a Roth contribution if you have no earned income and just pay the 6% per year penalty until you withdraw the contribution?

If yes, then is it true that you only have to withdraw the contribution and not the earnings?

If I had a risky investment I wanted to make, but did not want to be taxed on the possible gains, I might be willing to pay an extra 6% for the option to have those gains be tax free.

An example might be buying $10,000 of stock options in XYZ using a non eligible Roth contribution, paying $600 in penalty, selling the options for $50,000 then withdrawing the $10,000 and leaving the $40,000 in the Roth.

Legit?

Also, would entirely losing the $10,000 in the option play count as withdrawing it, or how would one withdraw from an account with zero balance?

 

[Fermion]

I think I found another source which seems to contradict the first source and says you must pull out the contribution AND the earnings.

 

[Fermion]

No, back to the original question because if you wait more than a year and go ahead and start paying the 6% penalty, you don't have to withdraw the earnings, only the original contribution.

 

[Fermion]

Sorry for the confusion but I think now that it does work how I outlined it in the first post and it is something I possibly would use in the future for certain high reward high risk investments (gambles).

The mining company junk bonds I bought in early 2016 are a good example. I bought 12.5% coupon bonds at 20% of par and six months later they were called at 100% of par. The 6% Roth penalty would be negligible compared to the 500+% gain that you would not have to pay tax on.

 

[NgineER]

Roth Rollover

Wouldn't a Roth Rollover be an option? You wouldn't need any earned income to do this. If you do the Roth IRA horse race, you'd only pay taxes on the conversion if it is successful otherwise you'd recharacterize and not pay the taxes on the conversion

 

[RunningBum]

Fairmark says you only have to withdraw the original contribution. I assume that's one of the sources you looked at.


The failure scenario one is the one I'd worry about. You may owe the $600 penalty indefinitely. Maybe they've made a provision in case you simply don't have the funds in the account to withdraw the original contribution, but if they don't, you may have to work with the IRS. They may waive the penalty since it's impossible to withdraw, or they may say you have to withdraw it from another Roth IRA account (if you have one), or they may say it's your problem, you took the risk, you still owe $600 each year, especially in a case like this where it seems obvious you are trying to game the system. I only did a quick search out of mild interest. Fairmark doesn't seem to cover it, and I'm not looking through IRS pubs.

 

[Fermion]

Wouldn't a Roth Rollover be an option? You wouldn't need any earned income to do this. If you do the Roth IRA horse race, you'd only pay taxes on the conversion if it is successful otherwise you'd recharacterize and not pay the taxes on the conversion

I am in a situation where I have limited traditional IRA money available for a rollover but I have done what you suggested in the past with some success.

This situation now would be because we are retired with no earned income. I currently make these risky plays in a Roth but would consider moving some to this strategy and paying the 6% gambling fee to the casino (really not that bad of a fee to avoid taxes).

 

[Texas Proud]

I have not idea concerning the penalty of your question...

But, I will say that if you convert from a tIRA to a ROTH and then convert back... they convert the original amount plus earnings...


I do not see how they would allow you to keep the earnings without some kind of penalty or tax... IOW, you would have to pull out the contribution and the earnings and since the earnings would now not be in a tax advantaged account would have to be put on your tax return....

But as I said, I have no knowledge either way....

 

[Texas Proud]

OK... did a search and saw this on Vanguard... this sentence would indicate to me that you have to remove earnings also...

I will look a bit more...


What the penalty could be

The IRS will charge you a 6% penalty tax on the excess amount for each year in which you don't take action to correct the error.
For example, if you contributed $1,000 more than you were allowed, you'd owe $60 each year until you correct the mistake.
If you remove your excess contribution plus earnings before either the April 15 or October 15 deadline, the earnings are taxed as ordinary income.
And if you're under 59½, you'll be subject to a 10% early withdrawal penalty.

 

[Fermion]

Two sources I read seemed to indicate that after you pay the first year 6% penalty, you only have to remove the original contribution in later years to avoid additional penalty (the gains can stay).

 

[Texas Proud]

How about taking the word of a tax program....


How to treat withdrawn contributions. Do not include in your gross income an excess contribution that you withdraw from your traditional IRA before your tax return is due if both of the following conditions are met.

• No deduction was allowed for the excess contribution.
• You withdraw the interest or other income earned on the excess contribution.

You can take into account any loss on the contribution while it was in the IRA when calculating the amount that must be withdrawn. If there was a loss, the net income you must withdraw may be a negative amount.

In most cases, the net income you must transfer will be determined by your IRA trustee or custodian. If you need to determine the applicable net income you need to withdraw, you can use the same method that was used in Worksheet 1-3, earlier.

If you timely filed your 2015 tax return without withdrawing a contribution that you made in 2015, you can still have the contribution returned to you within 6 months of the due date of your 2015 tax return, excluding extensions. If you do, file an amended return with “Filed pursuant to section 301.9100-2” written at the top. Report any related earnings on the amended return and include an explanation of the withdrawal. Make any other necessary changes on the amended return (for example, if you reported the contributions as excess contributions on your original return, include an amended Form 5329 reflecting that the withdrawn contributions are no longer treated as having been contributed).

How to treat withdrawn interest or other income. 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. Your withdrawal of interest or other income may be subject to an additional 10% tax on early distributions, discussed later in the publication.




https://www.taxact.com/support/1280/2015/ira-or-roth-ira-excess-contributions

 

[Texas Proud]

OR... how about the IRS....

It appears that any earnings on an excess contribution is earned in the year of that excess contribution... unless you pay the penalty, but that still does not mean you do not have to take out any earnings...


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. If you timely filed your 2016 tax return without withdrawing a contribution that you made in 2016, you can still have the contribution returned to you within 6 months of the due date of your 2016 tax return, excluding extensions. If you do, file an amended return with “Filed pursuant to section 301.9100-2” written at the top. Report any related earnings on the amended return and include an explanation of the withdrawal. Make any other necessary changes on the amended return.



https://www.irs.gov/publications/p590a/ch02.html#en_US_2016_publink1000231024

 

[pb4uski]

You might be overthinking this one.

If you have a risky investment, wouldn't the potential 15% capital gains tax be a small price to pay for being able to deduct the loss if the deal goes bad?

So if you invest $10k and it grows to $50k, then $6k in CG tax is a pittance on a $40k gain... but if it ends up in a total loss then saving $1.5k in CG taxes would be nice.

Also, wouldn't paying 15% be better than paying 6%/year and losing the potential for any tax benefit? (You get no tax benefit from losses in a Roth).

 

[Fermion]

You might be overthinking this one.

If you have a risky investment, wouldn't the potential 15% capital gains tax be a small price to pay for being able to deduct the loss if the deal goes bad?

So if you invest $10k and it grows to $50k, then $6k in CG tax is a pittance on a $40k gain... but if it ends up in a total loss then saving $1.5k in CG taxes would be nice.

Also, wouldn't paying 15% be better than paying 6%/year and losing the potential for any tax benefit?

These are short term returns, taxed at regular income tax rate.

Also there are special circumstances when one is trying to control MAGI for ACA reasons where a $40,000 gain in a taxable account might mean a $10,000 extra "tax" from loss of ACA subsidy.

It does sound as if the answer of if you have to withdraw the earnings is muddy at best.

 

[pb4uski]

Ah.... I see.

 

[Texas Proud]

It does sound as if the answer of if you have to withdraw the earnings is muddy at best.

Well, muddy at best, or crystal clear that you need to withdraw them at worse....


Where do you see that you do not have to withdraw them I have shown a tax program and an IRS publication that says you do...

 

[RunningBum]

Excess Contributions to Roth IRAs - Fairmark.com Fairmark.com

Later withdrawal. If you fail to take a corrective distribution within the time period described above, you’ll incur the excess contribution penalty for the year of the contribution and incur it again for each subsequent year it remains uncorrected. You can prevent it from applying to a subsequent year by withdrawing the excess from your Roth IRA, but the rules here are different than for the type of correction described earlier:

• You need to act by the end of the year, not by the due date of the return for that year. If your excess contribution was made in 2014, you must act by December 31, 2015 to avoid a penalty for 2015. Note that this is only 2½ months after the deadline for correcting the original year, as described earlier.
• When using this correction method you don’t have to withdraw earnings. You simply withdraw the amount of the excess contribution.

 

[Texas Proud]

Excess Contributions to Roth IRAs - Fairmark.com Fairmark.com

I actually saw that one first... but I still think the tax prep software and the IRS website will trump that one... the tax prep company has to back what they have and the IRS is... well, the IRS... the group that gets to decide who is really correct...

I also do not know how good that site is... nor do they cite why they think it is that way... it could be correct as it states a withdrawal in a 'later' year than when it was invested... and does talk about taking out earnings to fix the 'current' year, which is the next year since we are talking about filing the tax return...

Any other site that says you do not have to take out earnings

IMO, it just does not follow what is done in other situations... IOW, it just not 'feel' right that you can leave any earnings in when a contribution was not legal.... I know that feeling has zip to do with law, but in other situations you have to take into account earnings which is why I say what I say...



Edit to add.... I knew of someone who had read that you did not have to pay taxes if you were some kind of offshore or some other kind of BS person.... who never opened up a checking account etc. etc.... we all now that is BS, but I am sure it is out there on some web page...

 

[RunningBum]

I'm not going to spend any more time than this post arguing about something that isn't that clear and isn't anything I plan to do, but I think the places you cited all have to do with withdrawing the money before the tax return is due. The fairmark quote is the case where you don't address the excess contribution until a later year, and is probably an extension of this in the IRS pub you cite:

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.

The above quote means that if you contribute $1000 too much to a Roth, the next year you can make up for it by contributing $1000 less. Note that they don't say anything about factoring in earnings. I guess they figure the 6% penalty makes up for the earnings, or decided it was too complicated.


In the OP's case, he can't contribute anything without earned income, so he can never make it up that way. That IRS pub doesn't cover that case, but Fairmark has either extrapolated or found elsewhere that he could just withdraw it in a future year without taking out the earnings.

 

[kaneohe]

I actually saw that one first... but I still think the tax prep software and the IRS website will trump that one... the tax prep company has to back what they have and the IRS is... well, the IRS... the group that gets to decide who is really correct...

I also do not know how good that site is... nor do they cite why they think it is that way... it could be correct as it states a withdrawal in a 'later' year than when it was invested... and does talk about taking out earnings to fix the 'current' year, which is the next year since we are talking about filing the tax return...

Any other site that says you do not have to take out earnings

IMO, it just does not follow what is done in other situations... IOW, it just not 'feel' right that you can leave any earnings in when a contribution was not legal.... I know that feeling has zip to do with law, but in other situations you have to take into account earnings which is why I say what I say...



Edit to add.... I knew of someone who had read that you did not have to pay taxes if you were some kind of offshore or some other kind of BS person.... who never opened up a checking account etc. etc.... we all now that is BS, but I am sure it is out there on some web page...

You or OP could post question at the fairmark.com site (Retirement Forum) and request backup link verification.

 

[Texas Proud]

I'm not going to spend any more time than this post arguing about something that isn't that clear and isn't anything I plan to do, but I think the places you cited all have to do with withdrawing the money before the tax return is due. The fairmark quote is the case where you don't address the excess contribution until a later year, and is probably an extension of this in the IRS pub you cite:



The above quote means that if you contribute $1000 too much to a Roth, the next year you can make up for it by contributing $1000 less. Note that they don't say anything about factoring in earnings. I guess they figure the 6% penalty makes up for the earnings, or decided it was too complicated.


In the OP's case, he can't contribute anything without earned income, so he can never make it up that way. That IRS pub doesn't cover that case, but Fairmark has either extrapolated or found elsewhere that he could just withdraw it in a future year without taking out the earnings.

I am not arguing, just trying to get an answer.... but, it seems that the answer is 'it depends on who you ask'.... from what I read, if it is a regular IRA there is no question that the income earned needs to come out... but that same source said there is no similar language for ROTHs... so different people have interpreted it differently...

I found another source that is good IMO saying you do not have to remove it... Turbo tax answer to a question that is directly related to this...

It is a bit long, so I will not post the whole thing....


https://ttlc.intuit.com/questions/2580116


I just wanted a source that referenced the IRS.... but the one I did not put here said that the IRS has not made it clear... and as we can see, two ways of thinking has emerged....