Did I mess Up? Income used for 2023 Roth IRA

[Zane222]

This is my third year of self-employment and I recently opened a Roth IRA via Charles Schwab. When going through the application form, my 2021 earnings of $108,000 were pre-populated and without thinking I submitted the application. For 2022, my net earnings were $234,000 which makes me ineligible for contributing to a Roth IRA. For this tax year of 2023 I will likely show $0 in earnings. I funded the 2023 Roth IRA with $6500 cash but have not made any investments yet. Can I get in trouble with the IRS for doing this? If so, what actions should I take? Would it be best to pull the cash before making an investment? 

[Opus 17]

If you leave the ineligible contribution in the Roth IRA, it will be subject to a 6% penalty tax on your tax return this year, plus a 6% penalty for every future year that the excess remains in the account.

You have until the filing deadline (April 15) to remove the excess plus any earnings it has generated. If you remove the excess contribution, it will be treated on your tax return as if you never made it, and so it won’t be subjected to any penalties. If you earned anything from that cash, even a small amount of interest, it will be considered taxable income as of the date it is withdrawn (2023 or 2024) and subject to the 10% penalty for early withdrawal from an IRA.   

You could also re-characterize the contribution as a contribution to a traditional IRA, or you could withdraw the $6500 and then make a contribution of up to $6500 to a traditional IRA.  Because of your income, the contribution to the traditional IRA would not be tax deductible. However, depending on your other retirement account situations, you may be able to do a “back door“ Roth IRA conversion. Let us know if you want us to provide more details about that.  (The most important factor is whether or not you already have a traditional pre-tax IRA funded with tax deductible contributions.)

[Zane222]

Thank you so much for your insightful answer! I am thinking I will try to do the backdoor method as I do not have anything in a traditional IRA. Would contacting Schwab to set this up be a wise choice? 

[Opus 17]

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@Zane222 wrote:

Thank you so much for your insightful answer! I am thinking I will try to do the backdoor method as I do not have anything in a traditional IRA. Would contacting Schwab to set this up be a wise choice? 

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You can use any broker you want.  The important thing is to do it in the right order.  Hopefully they will have advisors who can help with this.  First, you have to recharacterize the Roth contributions to a traditional IRA.  Then, after that has completed, you do a rollover/conversion from the IRA to a Roth IRA.  (You may need to wait a few days for the first transaction to settle.)

The deadline to recharacterize the Roth contribution to a traditional IRA is the tax filing deadline (April 15, 2024).  The conversion will be reported on a 1099-R in whatever year it occurs (2023 or 2024) but since only the gains (if any) will be taxable, there's no special rush to get it done before the end of 2023 (and it might be impossible to complete both steps before the end of the year, since there are only 4 working days left in the year.  

On your tax return, you would report that you made a non-deductible contribution to a traditional IRA. This will generate a form 8606.  If you complete the conversion this year, that will also be on form 8606, if you do the conversion in 2024, you will use the information from the 2023 form 8606 to report the conversion on your 2024 return.  

[fanfare]

Find out what year the custodian filed the contribution for.

If somehow, you can earn $6,500 or more in 2023 you can apply your allowed 2023 Roth contribution amount to the excess of $6,500 for 2022 and resolve it.

@Zane222