Contributing to a Roth IRA with Scholarship income - Is it Excess or not?

[manii]

Hello,

I am the recipient of a full scholarship stipend, that goes towards both living and school expenses. As such, a large portion of the scholarship money is taxable income (about $13000 worth). My actual earned W-2 income was only around $1000 last year. I paid taxes on all of that income for 2019.

This year, I opened a Roth IRA account. I know the annual contribution limit is $6000 so I made a $6000 contribution for tax year 2019. However, now I think I may have made a mistake.

This website: https://www.investopedia.com/roth-ira-contributions-with-no-job-4770755 says that it is allowable for me to use the scholarship money in this way but other websites say I can only contribute the maximum of my earned W-2 income (so $1000) per year. I had not read about the earned income rule until after I opened up the Roth IRA account and made the contribution - I looked through several websites for information but this rule was well-hidden and I didn't realize until it was too late.

I am not sure if I made a mistake in characterizing the money for 2019. If I did, I will withdraw the excess contribution. Do you think I will need to do so? And if so, what are the penalties I will face? I already paid income taxes for 2019, but I know there's still time up until July 15th to fix things - will I owe an extra amount on my taxes for 2019?

Thanks so much in advance.

[macuser_22]

That reference you posted is incorrect or you misread it.  It should have reference IRS Publication 590A and not 970.

Publication 590-A (2019), Contributions to Individual Retirement Arrangements (IRAs)

https://www.irs.gov/publications/p590a#en_US_2019_publink1000230355

Says Scholarships are indeed earned income for IRA contributions but *only* if shown in box 1 of Form W-2.  In your contributions are limited to the $1,000 of your earned income.   Anything contributed in excess of that is an excess contribution that must be removed as a "return of contribution" before the due date of the tax return to avoid a penalty.

What Is Compensation?

[quote]

Generally, compensation is what you earn from working. For a summary of what compensation does and doesn’t include, see Table 1-1. Compensation includes all of the items discussed next (even if you have more than one type).

Wages, salaries, etc.

Wages, salaries, tips, professional fees, bonuses, and other amounts you receive for providing personal services are compensation. The IRS treats as compensation any amount properly shown in box 1 (Wages, tips, other compensation) of Form W-2, Wage and Tax Statement, provided that amount is reduced by any amount properly shown in box 11 (Nonqualified plans). Scholarship and fellowship payments are compensation for IRA purposes only if shown in box 1 of Form W-2.

[manii]

Okay, thank you for the clarification.

How do I go about doing this: 

Anything contributed in excess of that is an excess contribution that must be removed as a "return of contribution" before the due date of the tax return to avoid a penalty.

I know I will have to remove 6000-(the amount I contributed). I assume I will also have to remove the earnings on that amount - how should I calculate that? 

And do I have to report this on my taxes? I filed my tax return back in March 2020. But I opened the Roth IRA account and made the contribution for 2019 in April 2020. So I'm not sure if I need to file an amended return or leave everything as is.

I know I'll have to claim the excess earnings as income - can I just do that in 2020 to make things easier and avoid having to file an amended return?

[macuser_22]

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@manii wrote:

I know I will have to remove 6000-(the amount I contributed). I assume I will also have to remove the earnings on that amount - how should I calculate that? 

And do I have to report this on my taxes? I filed my tax return back in March 2020. But I opened the Roth IRA account and made the contribution for 2019 in April 2020. So I'm not sure if I need to file an amended return or leave everything as is.

The account custodian is required to calculate the earnings on the excess.    You only need to remove $5,000 excess if you had a W-2 with $1,000 in box 1.    Be sure to tell them that it is a "return of excess contribution" so they will remove the earnings and report it properly and not just as a normal distribution.

Since you already filed then you will have to amend, but not until next year after you receive the 2020 1099-R that reports the return of contributions with a code JP in box 7, next January.      That 2020 1099-R code JP must be reported on a 2019 amended tax return but only if box 2a contains an amount of taxable earnings.  If no earnings (or a loss) then amending will not be needed since the returned contribution itself is not reportable - only the earnings, if any, are.

[manii]

Okay, thanks so much for your help. I wish I had understood the rules more clearly upfront, but it doesn't seem like too difficult of a fix.

[macuser_22]

And BTW:   If you have at least $5,000 of taxable compensation in 2020 that would allow a 2020 Roth contribution, then you can just apply the 2019 excess as a 2020 contribution and not remove it at all.

[manii]

Oh, I will definitely have earned income in 2020 above that amount and was planning on making a 2020 contribution as well, applying the excess to 2020 would be very convenient. My brokerage is Schwab btw. I will contact their customer service and see how it goes.

[macuser_22]

For reference, see IRS Pub 590A

https://www.irs.gov/publications/p590a#en_US_2019_publink1000231024

Applying excess contributions.

If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in 1 year to a later year if the contributions for that later year are less than the maximum allowed for that year.

[dmertz]

The ability to treat certain non-tuition fellowship and stipend payments as compensation for the purpose of am IRA contribution applies to contributions for 2020 and beyond, not to contributions for 2019.

If instead of obtaining a return of the excess contribution made for 2019 you choose to apply the excess as part of your 2020 IRA contribution, you'll still owe the 6% excess-contribution penalty for 2019.  You'll need to prepare and file Form 5329 and pay the penalty.  Although this form is sometimes accepted without being accompanied by Form 1040-X, you might want to include Form 1040-X to show that there are no other changes with respect to your 2019 filing.

[manii]

@dmertz Oh no! Can you please clarify? I'm sorry, I'm so confused now.

Why would they include the information about "Applying Excess contributions" in this link if I would have to pay the penalty anyway? https://www.irs.gov/publications/p590a#en_US_2019_publink[phone number removed]

I have already contacted my brokerage and requested that they switch over the money to tax year 2020. I'm not sure if I can reverse this. Does this mean I will have to pay the penalty still? Even if I can reverse it, I would be withdrawing the money from 2019, then re-contributing the same money into my same Roth IRA account except for 2020. It seems like the same exact process but with more steps than necessary.

I don't understand. When I made the contribution in April 2020 after filing my taxes, I mistakenly put 2019 but could've easily put 2020 and avoid paying any penalty (because I *do* have eligible earned $6000 to contribute in 2020). Why would they penalize me for catching my mistake?

EDIT: Nevermind, thank you for bringing this to my attention. I did some further reading and I definitely acted too hastily. I was able to get my brokerage to reverse the request to carry over the funds to 2020, and withdraw them instead. Thanks!

[dmertz]

My comment about the penalty was in reference to what macuser_22 quoted from IRS Pub 590-A which is about leaving the excess contribution for 2019 unchanged, allowing the excess to carry over to 2020, then on your 2020 tax return applying the excess 2019 contribution as part of your 2020 contribution.  If you are able to switch the contribution to being one for 2020 (which can only be done before the deadline for making contributions for 2019 and only if the contribution for 2019 was made in 2020 as is the case here), there would be no contribution for 2019 that would be subject to penalty.

If the circumstances were such that you would not be able to have the custodian change the contribution to be a 2020 contribution (either if the contribution for 2019 was made in 2019 or the deadline for doing so had passed) and the Roth IRA saw substantial gains while the excess contribution was in the account, it can sometimes be advantageous to pay the 6% excess contribution penalty and apply the excess as part of the following year's contribution rather than obtain a return of contribution and be required to take out the gains which would be subject to tax and early-distribution penalty.  However, it's quite unlikely that you would have seen substantial gains in the short time that the contribution has been in the account in this case.

[Lg34]

I am confused by this response.  We have a similar situation (scholarship including room and board).  However, my read of Publication 590 Table 1.1 (the last row) suggests that we SHOULD consider the non-tuition portion (essentially a stipend) as compensation. I don’t see where it requires this to be reported on a W2.  One additional question though. The example provided discusses graduation students. What about undergraduates?  Do we take Table 1.1 as the full set of conditions (which doesn’t specify graduate or undergraduate), or should we read the example (grad student) to be an added constraint?  Note - turbotax did not ask for this detail.  Thanks!

[macuser_22]

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@Lg34 wrote:

I am confused by this response.  We have a similar situation (scholarship including room and board).  However, my read of Publication 590 Table 1.1 (the last row) suggests that we SHOULD consider the non-tuition portion (essentially a stipend) as compensation. I don’t see where it requires this to be reported on a W2.  One additional question though. The example provided discusses graduation students. What about undergraduates?  Do we take Table 1.1 as the full set of conditions (which doesn’t specify graduate or undergraduate), or should we read the example (grad student) to be an added constraint?  Note - turbotax did not ask for this detail.  Thanks!

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That is correct for 2020.  That was a tax law change that applies to 2020 and later.

The topic of this thread (a year ago) was about a 2019 tax return when the law was different and did not allow that.

[Lg34]

Great - thank you for your response! Does this apply to graduate and undergraduate students (as the table seems to suggest), or just graduate students (as the example seems to suggest)?  We have an undergraduate.

[macuser_22]

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@Lg34 wrote:

Great - thank you for your response! Does this apply to graduate and undergraduate students (as the table seems to suggest), or just graduate students (as the example seems to suggest)?  We have an undergraduate.

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Per IRS Pub 590-A

https://www.irs.gov/publications/p590a#en_US_2020_publink1000230355

Graduate or postdoctoral study.

Compensation includes any income paid to you to aid you in the pursuit of graduate or postdoctoral study.