Excess Roth IRA - MAGI Loop

[smn3]

In 2021, I made an excess contribution to my Roth IRA (I am under 59 1/2):

- Contributed: $6,000

- Maximum allowed: $1780 (due to MAGI between 125k & 140k)

- Excess Contribution: $4220

This month, I withdrew $4,456 from my Roth IRA ($4220 excess + $236 in earnings). I understand that next year I will receive a 2022 1099-R with this income, however, in order to avoid amending my 2021 return, I am attempting to include this in my 2021 return now.

I followed the instructions (create a 1099-R, check boxes P & J, select 2022 for the form year). As a result, the $236 in earnings is added to my 2021 1040, line 4b. However, this now increases my MAGI by $236 as well. TurboTax is now using that new MAGI to indicate that my max Roth IRA contribution is less due to higher income ($1680 versus $1780), and as a result, is calculating an excess contribution tax at 6% on that difference. How can I stop this from happening?

[DanaB27]

Yes, you will have to remove some additional excess contribution to avoid the 6% penalty and it is best to remove some extra if you had a lot of earnings to avoid this loop.

Please see What happens if I made an excess Roth IRA contribution for additional information.

[smn3]

@DanaB27 Thanks for your response. How would I do that? The more I take out, the more my MAGI increases (due to greater earnings), and therefore the lower my max contribution becomes. 

[dmertz]

This is a common problem for those in the phase-out range determined by MAGI.  You can take an iterative approach to figure out how much to really need to take out to eliminate the excess contribution with each iteration taking out a smaller incremental amount.  Either you'll eventually reach the point where the increment is small enough that the additional gain removed is less than a dollar and does not increase taxable income.  You can also take a trial-and-error approach where you try returns of different amounts until you find an amount that is large enough that you no longer have an excess contribution; this is likely to take fewer steps than the purely iterative approach.  You can do it as a binary search for the correct amount, each time trying an amount halfway between the lowest tested amount found to satisfy the excess and the highest tested amount that is insufficient to resolve the excess.  If you end up close to the upper end of the phase out range you, a third alternative is just to have the entire Roth IRA contribution removed.  Finally, you could just pay the 6% penalty and resolve the excess by making a regular distribution after the due date of your tax return but before the end of the year; this distribution would not need to include taxable earnings.

As an alternative to removal of the excess contribution, you can recharacterize the excess to be a traditional IRA contribution (potentially nondeductible) and not have go treat the gain as taxable income since it just moves to the traditional IRA with the amount that is recharacterized.