How to Deal with Improper Roth Contributions
There are three courses you can take if you've contributed to a Roth IRA when you shouldn't have.
Question: My customer "Katy" contributed $5,500 to a Roth IRA in 2017, but now that her income tax return is completed (it's on extension), we've figured out that she was not eligible to contribute to a Roth IRA--her income was too high. What penalties does Katy face for this improper Roth contribution, and what are her options for correcting the mistake, if any? She is younger than 59 1/2; her other options for 2017 were to make a nondeductible contribution to her traditional IRA or make no IRA contribution.
Answer: The first step is always to figure out exactly what "crime" has been committed. In Katy's case, the problem is an excess IRA contribution--she made a contribution to her Roth IRA that she was not eligible to make. This is an excess contribution because her legal maximum 2017 Roth IRA contribution was zero and she actually contributed $5,500. The penalty for an excess contribution is 6% of the excess contribution ($330), reapplied annually until the excess contribution is removed from the account (or treated as part of a legal contribution in a later year--see Option 3).
The good news is, there are two ways to repair this particular mistake, plus one more way to handle it, and Katy can take her pick.
Option 1: Make a corrective distribution. Katy can eliminate the penalty if she withdraws the contribution plus its net income by a certain deadline. The deadline is the extended due date of her 2017 tax return (provided she actually files that return by the extension date she has obtained). The code's treatment of such a "contribution returned before due date of return" (popularly called a corrective distribution) is that the contribution is deemed not to have been made, so the 6% penalty does not apply. Also, the distribution is not income-taxable because it is deemed to be merely a return of the nondeductible contribution. That's the good news.
The bad news is that, in order to eliminate the 6% penalty, a corrective distribution must include not only the contribution itself but also any net income (sometimes called "earnings") the contribution earned while it was living inside the Roth IRA. Such net income is subject to income tax and also is subject to the 10% penalty applicable to pre-age-59½ distributions.
Option 2: Recharacterize. A second route would be to recharacterize the Roth IRA contribution as a contribution to a traditional IRA. This is done by transferring the excess contribution of $5,500 directly (together with its earnings--see Option 1) from the Roth IRA into the client’s traditional IRA. Again, the deadline for this is the extended due date of her 2017 tax return (provided she actually files that return on time).
Although the Tax Cuts and Jobs Act of 2017 eliminated the ability to recharacterize Roth conversions, the recharacterization option still exists for regular contributions to traditional or Roth IRAs--like Katy's $5,500 contribution.
By recharacterizing instead of taking a corrective distribution, Katy would avoid the need to put the $5,500 back into her taxable account and would avoid the income tax and 10% penalty on the distribution of "earnings" that would be part of a corrective distribution.
However, before rushing into a recharacterization, she should be aware: By making a nondeductible contribution to a traditional IRA, you are creating a tax "basis" in the account. You can someday withdraw your basis tax-free (because you've already paid tax on it)--provided you can prove that you made these nondeductible contributions and how much they were.
If Katy has never previously made any nondeductible contribution to her traditional IRA(s)--so she currently has no after-tax money at all in her IRA(s)--by making a nondeductible contribution now to her IRA (through recharacterization), she will create the need for lifetime record keeping regarding this basis in her IRAs. As the IRS puts it (in its instructions for Form 8606), "To verify the nontaxable part of distributions from your IRAs ... keep a copy of the following forms and records ... Page 1 of Forms 1040 ... Forms 8606 ... 5498 ... 1099-R ..." until your IRAs have been completely distributed, i.e., they no longer exist! Otherwise she risks losing the benefit of her basis (investment in the contract) in a later year when she takes distributions from the account, due to lack of records.
This drawback does not apply if Katy already has after-tax money in her IRA(s), because she's already in this record-keeping hassle game; in this case recharacterizing her 2017 contribution would not materially increase her paperwork burden.
Option 3: Accept the excess contributions penalty for one year and move on. This alternative appears to be legal but seems like a loophole that could invite abuse. If Katy leaves the improper contribution inside the Roth IRA until after Oct. 15, 2018, she will have missed the corrective distribution and recharacterization deadlines and will unavoidably owe the 6% excess contributions penalty ($330) for 2017. If she's willing to accept and pay that penalty, she can then remove the $5,500 (without its earnings) by Dec.31, 2018, (or treat it as her 2018 contribution if that would be legal--if she meets the Roth IRA contribution income test for 2018), and she will not owe any further excess contributions penalty (she will not owe it for 2018 or later years), nor will she ever have to withdraw the earnings. This "loophole" option can make sense if the earnings on her excess Roth IRA contribution have been spectacular so that paying income tax and 10% penalty on the earnings would be more than $330, making the corrective distribution unattractively expensive.
Where to read more: For the penalty for an excess IRA or Roth IRA contribution, see Internal Revenue Code (IRC) § 4973. For "corrective distributions" see IRC § 408(d)(4). See also Treas. Reg. § 1.408A-6, A-1(d). For more on corrective distributions and recharacterizations, see Natalie Choate's downloadable Special Report: IRA Mistakes and How to Fix Them. For the limits on annual Roth contributions and income limits applicable to such contributions, see Denise Appleby's IRA Quick Reference Guides. For more complete explanation of basis in IRAs and how it is recovered, see Chapter 2 of Natalie Choate’s book Life and Death Planning for Retirement Benefits.
Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP specializing in estate planning for retirement benefits.The views expressed in this article may or may not reflect the views of Morningstar. The electronic version of Natalie's book, Life and Death Planning for Retirement Benefits, is now on a new platform with expanded features. The e-book gives you the entire book in word-searchable format, plus two chapters (on life insurance and annuities in retirement plans). Visit www.retirementbenefitsplanning.net to subscribe or learn more.