Roth IRA Disaster - Solutions, anyone??

[FEDUKE404]

A new client has encountered the AGI limitations for placing funds into a Roth IRA for the past several years. For 2006, we caught things in time and removed the 2006 funds, reporting only the earnings on the tax return.

The real problem is that excess contributions continue to exist for 2005, 2004, and even 2003 funds placed into the same account. Obviously those funds cannot now be removed prior to the filing date of the relevant tax return.

The way I read things, the excess funds penalty (6% via Form 5329 Part IV) applies for the funds from EACH year for so long as those funds actually remain in the account. The funds will be removed soon. This means that the 2003 excess funds will be subject to the 6% penalty for the 2003, 4, 5, and 6 amended returns, the 2004 excess funds will be subject to the 6% penalty for the 2004, 5, and 6 amended returns, and the 2005 excess funds will be subject to the 6% penalty for the 2005 and 6 amended returns. This entire issue should be N/A for 2007, with closer monitoring of the Roth account.

1 - Is this overall treatment of the excess funds via Form 5329 correct? (See 2006 Form 5329, lines 18 and 23 for comparison)

2 - What is to be done about calendar year 2003? Technically that year is "closed" for amended returns, although the 2003 excess funds DO become relevant for the entries on the 2004, 5, and 6 Form 5329. (See #1 !)

3 - Will the excess funds (principal) to be removed during 2007 be a taxable event? Answers range from "we don't know" to "no" to "Roth withdrawals never incur taxes." Obviously there is a LOT of confusion out there from the account managers, and they are the ones who issue the Form 1099-R next January.

BIG QUESTIONS: Does the IRS not monitor the incoming Forms 5498? Even a couple of nasty letters from the IRS (with a bill) would have been better than this scenario. Also, don't the account managers bear SOME degree of responsibility to remind the account holders of the dollar limitations that control allowable payments into the Roth IRA? The existing AGI limits are really quite modest, especially for a two-income family with some investment income.

Sorry for the long question. All input from board members will be gratefully accepted.

FE

[OldJack]

I do not know the answer.

If I was not the preparer for the taxpayer when the contributions were made I would simply let a dead dog lay until the stink has gone away. I expect that short of the IRS auditing your taxpayer for some other reason, the IRS has not and will not do anything now either.

[Bees Knees]

Assuming you did not exceed the annual contribution limitations for IRAs ($3,000 for 2003 and 2004, $4,000 for 2005 and 2006, more for age 50 and older), you do not have an excess contribution. The $150,000 AGI limitation for Roth IRAs ($95,000 for single) is a threshold for whether an IRA is a Roth, or a traditional IRA. The $150,000 limitation has nothing to do with the excess contribution penalty.

In other words, if you exceed those limits, it is automatically recharacterized as a traditional IRA, not a Roth. As a traditional IRA, you run the risk of it being a non-deductible traditional IRA.

If you try to pull the money out now after the due date of the returns, the distribution is treated as a distribution from a traditional IRA, as it did not qualify as a Roth IRA at the time it was contributed. Therefore, a portion of the distribution is tax free depending on your basis in all of your traditional IRAs, and the other portion will be taxable.

Leave the money in the IRAs and file Form 8606 for any applicable non-deductible contributions that were made in those years.

[FEDUKE404]

Use Form 8606 instead ?

Assuming you did not exceed the annual contribution limitations for IRAs ($3,000 for 2003 and 2004, $4,000 for 2005 and 2006, more for age 50 and older), you do not have an excess contribution. The $150,000 AGI limitation for Roth IRAs ($95,000 for single) is a threshold for whether an IRA is a Roth, or a traditional IRA. The $150,000 limitation has nothing to do with the excess contribution penalty.

In other words, if you exceed those limits, it is automatically recharacterized as a traditional IRA, not a Roth. As a traditional IRA, you run the risk of it being a non-deductible traditional IRA.

If you try to pull the money out now after the due date of the returns, the distribution is treated as a distribution from a traditional IRA, as it did not qualify as a Roth IRA at the time it was contributed. Therefore, a portion of the distribution is tax free depending on your basis in all of your traditional IRAs, and the other portion will be taxable.

Leave the money in the IRAs and file Form 8606 for any applicable non-deductible contributions that were made in those years.

Now I AM confused!

For starters, the client in no way, shape, or form qualifies (qualified) for a deductible traditional IRA. Reasons include income level, covered by employer retirement plan, etc.

My software automatically generates an entry on Form 5329, Part IV once the "Roth IRA" contributions for each of the appropriate years are entered in the applicable worksheets. Client has no traditional IRA (well, perhaps one from the 80's ?) and from past experience I've found little merit but a lot of redundant paperwork dealing with Form 8606 and "nondeductible traditional IRAs."

I guess I just cannot reconcile your "you do not have an excess contribution" statement with Part IV of Form 5329.

Otherwise, are you stating it might be better instead just to go the Form 8606 route? Would not those funds still have to exit from/be treated differently within the existing Roth IRA account, which does have some "allowable" funds remaining in it (not all prior years were limited to "zero.")? The fund manager/agent is already pulling his hair out on this mess.....called it "a worst case scenario."

Sorry to have so many questions, but you've opened new doors I did NOT expect!

Thanks again........................

FE

[Bees Knees]

IRC Section 408A(3) is the code section that gives you your $150,000 AGI limitations for making Roth IRA contributions. In that section, it says in part: “The rules of subparagraphs (B) and (C) of section 219(g)(2) shall apply to any reduction under this subparagraph.”

Section 219(g)(2) is the code section that gives you the phase-out of the deductible contributions to a traditional IRA when the taxpayer is an active participant in an employer’s pension plan.

In other words, if you contribute to a Roth IRA and exceed the AGI limitations under Section 408A(3), then it becomes subject to the Section 219(g)(2) limitations for making deductible contributions to a traditional IRA.

It is not an excess contribution. It is a contribution that is recharacterized as a traditional IRA, subject to the non-deductible contribution rules for taxpayers who are active participants in an employer sponsored plan.

You must file Form 8606 for all of those years to report non-deductible contributions to a traditional IRA. The penalty for excess contributions on Form 5329 has no bearing on this at all if none of the contributions exceeded the contribution limits to traditional or Roth IRAs for the year.

[Kram BergGold]

reply to Bees

I don't see how you can just say money put into a Roth when not eligible due to high income is automatically treated as a non deductible Traditional IRA.
For example. Client starts a Roth in 2003 and puts in $2,000. In this year he was eligible to do so. Then he puts in $2,000 in 2004 and 2005 but was ineligible to do so. His account is called a Roth IRA and now has $6,000 plus earnings in it. To me as a recharacterization was not done by Oct of 2005 and Oct of 2006 there is a problem.

[Bees Knees]

I don't see how you can just say money put into a Roth when not eligible due to high income is automatically treated as a non deductible Traditional IRA.
For example. Client starts a Roth in 2003 and puts in $2,000. In this year he was eligible to do so. Then he puts in $2,000 in 2004 and 2005 but was ineligible to do so. His account is called a Roth IRA and now has $6,000 plus earnings in it. To me as a recharacterization was not done by Oct of 2005 and Oct of 2006 there is a problem.

The code says what it says. Anything phased out under the $150,000 AGI limit rule makes it a code section 219(g) thing. Care to provide a cite that says otherwise?

But I do agree an actual recharacterization must be done along with Form 8606. The reason is that if you do not recharacterize it and file Form 8606 (or withdraw it by the return due date plus earnings), then the IRS will treat it as a contribution to a traditional IRA with zero basis. In other words, no deduction was taken when contributed, and 100% of it is taxable when withdrawn, including the non-deductible contributions. That is why you need to File Form 8606…to establish basis.

That is why the IRS doesn’t care whether you make a Roth IRA contribution when AGI exceeds the phase-out range. If you do nothing, you get the worst possible treatment for your IRA contribution. It does not matter what name is on the account. Its not a Roth, because you exceeded the AGI phase-out range. And its not a traditional IRA with a cost basis, because you forgot to File Form 8606. Do nothing, and its a non-deductible traditional IRA with zero basis.

Thems the rules.

[FEDUKE404]

About that 2003 return-Does statute of limitations apply?

IRC Section 408A(3) is the code section that gives you your $150,000 AGI limitations for making Roth IRA contributions. In that section, it says in part: “The rules of subparagraphs (B) and (C) of section 219(g)(2) shall apply to any reduction under this subparagraph.”

Section 219(g)(2) is the code section that gives you the phase-out of the deductible contributions to a traditional IRA when the taxpayer is an active participant in an employer’s pension plan.

In other words, if you contribute to a Roth IRA and exceed the AGI limitations under Section 408A(3), then it becomes subject to the Section 219(g)(2) limitations for making deductible contributions to a traditional IRA.

It is not an excess contribution. It is a contribution that is recharacterized as a traditional IRA, subject to the non-deductible contribution rules for taxpayers who are active participants in an employer sponsored plan.

You must file Form 8606 for all of those years to report non-deductible contributions to a traditional IRA. The penalty for excess contributions on Form 5329 has no bearing on this at all if none of the contributions exceeded the contribution limits to traditional or Roth IRAs for the year.

On a somewhat different note, does the (normal) three-year rule for the statute of limitations apply, or does the separate six-year rule for excise taxes apply?

IRC section 6501 contains the general statue of limitations rules (3 years except 6 years if 25% or more of gross income is omitted, etc.) The problem is that this section contains special rules for excise taxes.

Think carefully, as the 6% "tax" paid on excess Roth IRA contributions does appear to be an excise tax. The 2003 tax return as originally filed had no excise tax (and no Form 5329) payments shown, so the 25% issue is moot.

FE

[OldJack]

But I do agree an actual recharacterization must be done along with Form 8606. The reason is that if you do not recharacterize it and file Form 8606 (or withdraw it by the return due date plus earnings), then the IRS will treat it as a contribution to a traditional IRA with zero basis. In other words, no deduction was taken when contributed, and 100% of it is taxable when withdrawn, including the non-deductible contributions. That is why you need to File Form 8606…to establish basis.
Thems the rules.

I have no idea if "thems the rules" and don't have time from my goofing-off period to research the question... but them rules just don't seem right. The taxpayer has cost with proof filed (by the trustee) with the IRS, so how can they completely ignore his after tax contribution basis and claim it is taxable? Does "thems the rules" have a court case that clearified such situtaion.

[Bees Knees]

Does "thems the rules" have a court case that clearified such situtaion.

From Alpern, TC Memo 2000-246:

“Respondent determined that petitioner received taxable distributions from his IRA during the year in issue of $12,905.89 and that petitioner failed to include $6,905 of that amount in gross income for the 1996 taxable year. Petitioner contends that he is entitled to exclude from gross income $6,905.89 of the IRA distribution on the grounds that he had a basis in the IRA contributions.”

“Generally, a taxpayer is allowed a basis in IRA contributions to the extent the contributions are considered an “investment in the contract”. Section 72(e)(6) defines generally “investment in the contract” as being the consideration paid for the contract less amounts previously received under the contract that are excludable from gross income. Thus, nondeductible contributions a taxpayer has made to a retirement plan may be excluded from gross income when such distributions are made.”

“At trial…petitioner failed to produce any tax records which would have established nondeductible IRA contributions during, or before, the 1996 taxable year.”

“Petitioner failed to establish that he was entitled to exclude the $6,905 portion of his IRA distributions for 1996 from gross income for the taxable year in issue. Respondent is sustained on this issue.”

In this court case, the taxpayer failed to produce "tax records” to establish basis. The taxpayer also failed to produce other documentation. You could argue that producing broker statements showing the contribution went into a Roth might establish basis. But that doesn’t prove you didn’t take a tax deduction for the Roth contribution on your tax return. If the tax records are missing, how can you prove a negative?

[OldJack]

You could argue that producing broker statements showing the contribution went into a Roth might establish basis. But that doesn’t prove you didn’t take a tax deduction for the Roth contribution on your tax return. If the tax records are missing, how can you prove a negative?

Well.. seems to me that not having proof or tax records is a far cry from saying the basis is taxable because you didn't file form 8606.

You don't have to prove a negative if you have a positive such as the trustee's contribution statement and trustee's form filed with the IRS. Then, of course, the taxpayer doesn't deserve any proof if they didn't at least keep a copy of their tax return showing no deduction and their AGI. I have little sympathy for taxpayers that don't want to bother with keeping tax stuff.

[Kram BergGold]

A new twist for Bees

I have a client who in 2001 converted $15,000 from a Traditional IRA to a Roth. Problem is he did not tell me nor did he give me a 1099R. So the conversion was not reported and IRS never wrote to him. How do you think I handle this when he starts removing money when he is in his 60s or 70s?

[jainen]

You think

>>the conversion was not reported and IRS never wrote to him<<

You think both your client and the IRS missed a $15,000 1099R? Not bloody likely.

[Kram BergGold]

Whoa Jainen!

My client did recieve a 2001 1099R for $15,000. He just did not give it to me or tell me about the Roth conversion. And absolutely the IRS never caught it. I know this because he never got a letter from IRS. They do miss things from time to time. All of this came to light in March 2007 as we were talking about his IRA accounts

[jainen]

absolutely

>>absolutely the IRS never caught it<<

Then absolutely you are home free. The statute of limitations has absolutely expired. Hasn't it?