Excess Roth IRA Best (Taxwise) Fix

[Wonderer1]

Hi community,

I would like to understand the best way to fix an overcontribution to a Roth IRA.

Scenario: say the excess is $1000 (out of 6k) which has now grown to $9k.

Is the best option to recharacterize the full Roth and then do a Roth conversion (with income tax due on the $3k capital gain) ?

Is it possible to only recharacterize the excess and convert bath to a Roth ? meaning tax is only due on the $500 from the $1k excess. I was also thinking that distributing the excess will result in less tax, but the benefit is more in the long run if full tax is paid on the full gain, since that excess will grow (fingers crossed) exponentially. Please suggest the lowest tax/best fix ? 

Also I only have pre-tax contribution in traditional 401k, so I guess the pro-rata rule does not apply.

Cheers!

[macuser_22]

What tax year was the contribution for - 2020 or 2021?

If 2021 you have until the filing date of your 2021 tax return to either remove the excess as a "return of contribution" or recharactorize it as a Traditional IRA contribution.  Either way both the contribution or any earnings must be returned or recharactorized.

If you leave it in the IRA then after the due date it will have a 6% penalty that repeats each year until the excess is removed, but not the earnings.    Some people just leave the excess in the IRA and pay the 6% each year if it is earning much more than 6%.

[fanfare]

@Wonderer1 

your excess cannot grow.

If you put in $1,000 too much, your penalty is $60.

Important: If you wait until the tax filing date with extension for year of contribution has gone by,

you do not have to remove the earnings on your investment.

If you are eligible for a Roth next year, you can contribute $1,000 less than otherwise,

and that resolves your excess.

If you are not eligible, you can pay another $60 next year.

OR, you can take a distribution of $1,000 to resolve the excess. Any earnings remain in the account.

This is the way to do it when your Roth is increasing in value.

[Wonderer1]

@macuser_22 

"Either way both the contribution or any earnings must be returned or recharacterized." I agree with this. But recharacterization needs to be done for the full amount correct ? I cannot do it only for the excess and its gain. The point is I want the full $6k in the Roth with the least amount of tax. All this could have been avoided with a back door. Thanks.

[Wonderer1]

This is for 2021. I do not want to leave it in the ROTH. By "return of contribution" there will be income tax due on the gain from the excess. I had thought of this, but I wonder which is a better move in the long run, recharacterization ? Thanks

[macuser_22]

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@Wonderer1 wrote:

@macuser_22 

"Either way both the contribution or any earnings must be returned or recharacterized." I agree with this. But recharacterization needs to be done for the full amount correct ? I cannot do it only for the excess and its gain. The point is I want the full $6k in the Roth with the least amount of tax. All this could have been avoided with a back door. Thanks.

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A recharacterization simply treats the contribution as if it never happened in the Roth and it was to the Traditional IRA instead.  What ever was contributed to the Roth and earnings are simply treated as a Traditional IRA contribution by the financial institution.     That is usually simpler  than having the contribution and earnings returned to you and then you use the make a new contribution.   Of course if you do a backdoor Roth and earnings will be taxable, but the earnings are taxable if returned to you anyway.