Married filing separately and wife contributed to Roth IRA

[meaty_matt]

Married filing separately since 2012 in order to reduce the amount I pay for Income Based Fed Loans. Wife contributed to Roth in 2012 to 2016. She made over the $10,000 limit. What should we do? Can I transfer the $12,000 to a traditional to avoid further penalty? Can you explain my penalties? Is it 6% per year until the money is removed from the Roth? So do I owe $144 in 2012, $288 for 2013, $432 for 2014, $576 for 2015? Hopefully can transfer the $2400 to traditional before the 18th to avoid penalty this year.

[Opus 17]

You are experiencing one of the negative tax consequences of filing separately to get better IBR terms.  You need to really think about whether this is a valid long term strategy.  (Something else a lot of people don't know -- if you ultimately qualify for loan forgiveness after 10 or 20 or 25 years depending on the program, the forgiven loan principle is taxable income in the year the loan is forgiven.  You could owe tens of thousands of dollars, especially if you have unpaid interest that gets capitalized and increases the loan balance.)

Anyway, when married filing separately, she is not allowed to contribute to a Roth if her income is more than $10,000.  The penalty for unqualified contributions is 6% per year for as long as the contributions remain in the account and unqualified.

One way to fix this is to file jointly.  If you file jointly, her contribution limit is $5500.  Since it seems she made a $2400 contribution this year, you can apply the remaining $3100 of limit to qualify $3100 of the original (older) contributions.  Then for 2017 if she contributes zero new dollars, you can apply her $5500 limit to qualify an additional $5500 of prior contributions.  And so on.  Whatever the balance of unqualified contributions is will be subject to the 6% penalty.

Your only other alternative is to withdraw some or all of the money.  You can withdraw all of the non-qualified contributions, plus their earnings, before April 18, and pay no penalty.  Unless she made qualified contributions in 2011 or earlier, it sounds like you would have to remove the entire balance from the Roth.  The earnings get added to your taxable income (since she was not allowed to use a Roth to get tax-free earnings when filing separately).  Whatever you don't withdraw before April 18 will be subject to the 6% penalty this year.

You can't roll the money over into another retirement instrument because it will still be non-qualified money.  However, you can certainly invest the money in some kind of investment instrument after you withdraw it from the Roth.

Because she is filing separately, she can contribute up to $5500 to a traditional IRA but only if you are not covered by a retirement plan where you work.  Note that this is not a rollover.  She withdraws the unqualified contributions from the Roth and separately makes a contribution to a traditional IRA.

If you are covered by a retirement plan at your work, she can't make any IRA contributions -- Roth or traditional. You would have to look for investments that are not part of a tax-advantaged scheme (or file jointly). 

[meaty_matt]

Thanks for your comment. My loan will be forgiven in 3 years. I am aware that the forgiven amount will be taxable. If I file jointly my payment increases $6000 per year.

Regarding the IRA only if I don't have a retirement account. I though we could contribute but it would not be deductable.

I guess she will have to withdraw all contributions after 2012 and pay the early withdraw penalty. I was hoping to just convert to traditional IRA yo avoid that.

[Opus 17]

She can't make any contribution to a *Roth* IRA when filing separately.

She can contribute up to $5500 per year to a *traditional* IRA **if you are not covered** by a retirement plan at your job.

Withdrawing the unqualified contributions to the Roth is not the same as withdrawing money to spend.  It is not subject to the 20% early withdrawal (before retirement) penalty.  But, while the point of a Roth IRA is that the earnings are tax free, if you withdraw the non-qualified contributions and earnings, those earnings are taxable.  If you decide to withdraw the non-qualified contributions and earnings, make sure you tell the IRA trustee that is what you want to do, so they don't code it wrong on your statement.

If she withdraws the non-qualified contributions and earnings from the Roth IRA, she could contribute up to $5500 of that money into a traditional IRA, if you are not covered by a retirement plan at your work.

[meaty_matt]

Thanks again. I do have a retirement plan. So she can't cintribute to traditional IRA. Can I?

[meaty_matt]

<a rel="nofollow" target="_blank" href="https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-iras-contributions">https://www...> says we can contribute, but can't deduct.

[Opus 17]

With married filing separately and one spouse covered by a retirement plan, neither spouse can contribute to a deductible IRA or a Roth IRA.

As far as contributing non-deductible money to a traditional IRA, you're going to need to see a tax or investment advisor.  Contributing non-deductible money to a traditional IRA is, IMHO, unwise.  At best, it is basically the same as investing in a mutual fund through a stockbroker, except with more rules and paperwork and higher taxes on withdrawals.  The only advantage might be access to funds with lower commissions and cost ratios.

Now, I am not an expert, but for most middle class taxpayers it looks something like this

Deductible IRA: Tax-free deposits (saves 25% or more on income tax), withdrawals taxed at 25% (or less depending on your tax bracket in retirement), 10% early withdrawal penalty if you need the money early.

Roth IRA: fully taxed on deposit, withdrawals are tax-free. 10% penalty on early withdrawals of the gains but no penalty on withdrawing the principle.

Mutual fund (not a tax instrument): fully taxed on deposit, interest at 25% tax, gains at 15% tax, no penalties for early withdrawals.

Non-deductible traditional IRA: fully taxed on deposit, 25% tax on withdrawals (least savings/most tax), 10% penalty for early withdrawals.

In short, making non-deductible contributions to a traditional IRA makes your future tax returns more complicated, and ties up your money with the early withdrawal penalty without any offsetting benefits of tax savings either going in or coming out.  

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If you are eligible for a 401(k) or a 403(b), you should make the maximum contribution you can.  My first recommendation is to close the Roth and pay income tax on the gains -- if you close it by April 18 you won't owe the 6% penalty this year.  Put the money in your checking account and then go to your HR department and maximize your 401(k) or 403(b).  Thats about $18,000 per year or $1500 per month.  Since that is pre-tax, your actual reduction of take-home pay will be around $1000-$1300 depending on your bracket and state taxes.  Make up the difference in take-home pay using the Roth money you put in the checking account.  If you have $12,000, that will be about 10 months.  Then go back to HR and drop your retirement contribution to what it was before.  The net effect will be to move the Roth money to your 403(b) or 401(k).   That's the only way I can see to get your money out of the Roth, stop paying the 6% penalty, and get the money into another tax-deferred retirement account.  (This will also lower your effective income for the next few months which may lower your other tax rates and lower your IBR next year.) (It will require discipline not to spend that lovely $12,000 on something unwise.)

If you don't like that idea, I would close the Roth, and put the $12,000 into a regular mutual fund.  You will owe some income tax each year on the dividends and capital gains, but it will be less than your current marginal rate (because the cap gains are taxed lower), and you will have access to the money any time instead of being tied up in a retirement account, and when you retire, you will only pay capital gains tax on the gains you pull from the mutual fund, with principle you pull being tax free since it was already taxed before being put in the fund.

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@dmertz @TaxGuyBill am I wrong here?

[meaty_matt]

Thanks!

[meaty_matt]

Last question. Which Avenue of reinvesting will I not get charged the early withdrawal fee?

[Opus 17]

Every tax-deferred retirement plan has a 10% penalty for withdrawing the money before retirement age. That would include a 401(k) or 403(b) plan at work, as well as a Roth and traditional IRAs.  However, your money is tax deductible and grows tax-free until withdrawal.

Investing money in stocks and bonds through a broker (or online broker, etc) does not have any penalties for withdrawing money.  You will likely pay more income tax over your working life, but that means you pay less tax whenever you withdraw the money.

(The "withdrawal of excess contributions" from your current Roth does not have a 10% penalty because the money never belonged there in the first place.)

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One more illustration.  Not to blow your mind, but because there really are lots of different options that have different pluses and minuses.


Let's say you withdraw $12,000 from the Roth and decide to invest it in a mutual fund.  That's $12,000 on deposit. Simple.

On the other hand, let's say you withdraw $12,000 from the Roth and decide to maximize your 401(k) or 403(b) contribution for 11 months.  Assume you are in the 25% tax bracket and a state with moderate taxes (5% or so).
You will put in $1500 x 11 = $16,500 on deposit in the retirement account.  But that only drops your take home pay by $1050, which you make up from the Roth money for those 11 months ($1050 x 11 = $11,550).

So with the mutual fund, you start with $12,000 on deposit, but with the retirement plan at work, you start with $16,500 on deposit.

Assuming you leave the money alone for 30 years and have an average rate of return of 6%,

$12,000 turns into $69,000
$16,500 turns into $95,000.

The trade off for the tax savings and potential for larger gains is the 10% penalty for early withdrawals.

[meaty_matt]

You're a smart guy. Thanks.

[meaty_matt]

Opus, so I withdrew $12000 (2400 for 5 years, 2012-2016) for my wife plus $1029 in gains. I withdrew $5500 for me for 2016 plus $805 in gains. How do I enter this? Do i need to report the excess since I withdrew it all plus the gains?

[Lego-Rebel]

I searched for this answer because I'm in the same boat!  Together, my husband and I will owe taxes.  Separately, I would owe around $500 but get a few thousand back in state.  So it seems worth it to me.  But I put in $1500 to my Roth and I'm getting the same penalty warning the OP did.  But what if we filed jointly next year?  That would remove the penalty, correct?  Thanks for your thoughts- you are brilliant.

[dmertz]

Filing a joint 2023 tax return has no bearing on determining eligibility to make a 2022 Roth IRA contribution.  If you file separately in 2022, the $10,000 MAGI limitation applies.

If you choose not to obtain returns of the excess Roth IRA contributions made for 2022 before the due date of your 2022 tax return, including extensions, you would owe the 6% excess contribution penalty for 2022.  Resolving this excess contribution to avoid another 6% penalty on this same excess for 2023 would require either being able to apply the excess as a 2023 Roth IRA contribution (requiring that you qualify to make a 2023 Roth IRA contribution) or obtaining a regular distribution of an amount equal to the excess, with no adjustment for investment gain or loss, after the due date of your 2022 tax return, including extensions.