Form 5498 Excess contribution to 2020 Tax Year ROTH

[pipeclamp]

I contributed $7000 for the tax year 2020, to a 2 year old personal ROTH IRA, opened and also maxed out in the tax year 2019.  This contribution has grown in value.  Our MAGI will exclude the entire 2020 contribution.   

Can I simply recharacterize my ROTH contribution made for the tax year 2020, to the tax year 2021, where better planning will avoid the recurrence of the MAGI disqualification. 

If so, how will the growth on the 2020 tax year contribution of $7000, made between July 1, 2020 and December 31,2020, be addressed?   

[DanaB27]

Yes, you can request with your bank to remove the excess contributions and earnings and apply the contributions to next year (this is not recharacterization). The earning will be taxable on your 2020 tax return.

Or as another option: If your MAGI disqualifies you from contributing to the Roth IRA then you can recharacterize the Roth contribution as a traditional IRA contribution for 2020 and choose to make it nondeductible. Then you are able to convert the funds from the Traditional IRA to the Roth IRA. This is called backdoor Roth conversion. The conversion part will be on your 2021 tax return if you decide to do this.

You will need to request a recharacterization with your bank by the due date of your return. They will move the contribution and earnings into a traditional IRA.  There is no tax or penalty on the earnings since the earning will be simply switched into the recharacterized account. 

You will enter the recharacterization when you enter the contribution to the Roth IRA

1. Click on the Search box on the top and type “IRA contributions”
2. Click on “Jump to IRA contributions"
3. Select “Roth IRA”
4. Answer “No” to “Is This a Repayment of a Retirement Distribution
5. Enter the Roth contribution amount 
6. Answer “Yes” to the recharacterized question on the “Did You Change Your Mind?” screen and amount (no earnings or losses)
7. TurboTax will ask for an explanation statement where it should be stated that the original $xxx.xx plus $xxx.xx earnings (or loss) were recharacterized.
8. On the screen "Choose Not to Deduct IRA Contributions" answer "Yes"

Then on your 2021 tax return if you decide to convert you follow these steps:

1. Click on the Search box on the top and type “1099-R”
2. Click on “Jump to 1099-R" and enter the information from your 1099-R
3. Answer questions until you get to “What Did You Do With The Money” and choose “I moved it to another retirement account”
4. Then choose “I did a combination of rolling over, converting, or cashing out money.” and enter the amount next to "Amount converted to a Roth IRA account"
5. On the "Your 1099-R Entries" screen click "continue"
6. Answer "yes" to "Any nondeductible Contribution to your IRA?"
7. Answer the questions about the basis

[dmertz]

However, what DanaB27 describes is not a "recharacterization."  A recharacterization would make the contribution be a traditional IRA contribution for 2020 rather than removing the excess Roth IRA contribution and leaving you with no contribution for 2020.

You also have the option to leave the Roth IRA contribution for 2020 as is, pay the 6% excess-contribution penalty for 2020, then apply the excess as your 2021 contribution.  You would consider doing this if the investments in this Roth IRA appreciated appreciably, say, something like 30% or more, after you made the excess contribution.  This would allow the nontaxable gains to remain in the Roth IRA and eventually more than make up for the 6% penalty.  If you consider doing this, just be sure that you will be able to apply the excess as a 2021 Roth IRA contribution so that you do not incur additional penalties on this excess.

[pipeclamp]

I have been doing a lot of digging trying to fully understand my best options and what I have learned is you seem to be putting me on the right track.  The specific circumstance is that I was buying Ford stock as it was collapsing due to Covid, so my starting balance, in MAY20, is artificially low, then in June I contributed more for the tax year 2020 and I continued buying Ford stock.   It has rebounded, creating the hypothetical you qualified in your response.

Here it is in a nutshell by definition of a formula I found;

My adjusted opening balance, the ROTH IRA balance on 31MAY20 plus the $7,000.00 equates to  $12,950.66.  I contributed in two segments over the course of tax year 2020 , $5,029.00 in JUN 2020 and $1,971.00 on 31DEC20. 

My theoretical adjusted closing balance, I am using the closing balance on 31JAN21, is $17,694.36.   (This balance was up almost $2,000 by mid-February. I have not decided how to handle this yet, but your comment looks like the winner.) 

IRS Formula for net income calculation:   

Excess Contribution * (adjusted closing balance - adjusted opening balance) / adjusted opening balance

$7,000 * ($17,894.36 - $12,950.66) / $12,950.66  = $2,564.03

I cannot contribute to the ROTH due to our MAGI, we are in the 24% tax bracket this year so, IRS formula for Net Income yields - ($2,564.03 * .24) (24% Federal Income Tax on ordinary income) = $615.367 TAX

plus I haven't taken into consideration the State of MI 4.35% income tax.

In this instance it appears that standing pat, leaving the gains in place while "carrying forward" the contribution for the tax year 2021 and paying the excess contribution federal penalty of ($420), makes the most sense?  Would you agree with that?  

[dmertz]

You meant to type:

$7,000 * ($17,694.36 - $12,950.66) / $12,950.66  = $2,564.03

That means that the net income attributable based on the January 31, 2021 balance is simply  $2,564.03.  Your marginal tax rate or tax bracket has nothing to do with it unless you choose to obtain a return of contribution (nowhere was a return of contribution previously mentioned), in which case of the $9,564.03 distributed to you, $7,000 would be nontaxable basis in Roth IRA contributions and $2,564.03 would be taxable as ordinary income.

On the other hand, a recharacterization is nontaxable.  The $2,564.03 of gains would simply become tax deferred gains in the traditional IRA.

Yes, it would seem to make sense that because the gains are now something like 50%, leaving the excess in, paying the $420 penalty, then after October 15, 2021 but before the end of 2021 obtaining a regular distribution of $7,000 with no adjustment for earnings (or being able to apply the $7,000 as your contribution for 2021, if eligible) to eliminate the excess for 2021 and beyond.

[pipeclamp]

"On the other hand, a recharacterization is nontaxable.  The $2,564.03 of gains would simply become tax deferred gains in the traditional IRA."

I presume you to mean I should reconsider "carrying forward" the $7,000 ROTH IRA contribution and instead look to re-characterize the $7,000 ROTH contribution, to non-deductible IRA contribution status, for the 2020 tax year.   This would defer paying ordinary income tax on the net increase, now; I would also avoid paying the $420 penalty, as the non-deductible IRA is allowed for MAGI at $208,000 and above?  Do I have that correct. 

The trade off to consider is the potential tax free growth on the 2020 ROTH IRA contribution and it's net increase, going into the future, for the cost of $420 today?  Do I have those two perspectives correct?

[dmertz]

I'm not recommending any particular option, I'm just explaining the options and their consequences.

You are correct, a recharacterization would eliminate the 6% excess contribution penalty and the attributable  gains that are now in the Roth IRA would become tax deferred gains in the traditional IRA.

(I'm assuming that the Roth IRA contribution is an excess contribution only due to MAGI and not because you had insufficient compensation to support an IRA contribution.)

[pipeclamp]

"then after October 15, 2021 but before the end of 2021 obtaining a regular distribution of $7,000 with no adjustment for earnings (or being able to apply the $7,000 as your contribution for 2021, if eligible) to eliminate the excess for 2021 "

This is my last time back at you, but I feel it necessary to make sure I fully understand what it is you are saying. The action you describe to take after 15OCT21 but before the end of 2021, is a required action on my part as the payment of the 6%, $420.00 penalty just allows the  overcontribution to remain in the account, for the above stated time period.  Therefore, it still needs to be corrected by seeking a ROTH IRA principal distribution, correcting the overfunding of tax year 2020, then simply redepositing the principle distribution back into the account under tax year 2021.  I would presume then that a principle distribution has to be taken from a cash position, so between now and 15OCT2021 I would have to select the proper point to get $7000 to cash so I could take it out, to subsequently redeposit it? 

That seems to make sense to me and it seems to make sense on what I have read in Fidelity's request to correct excess contribution document.  That is what you are saying and the logic behind it? 

[dmertz]

Correct.  If you know for sure that you will be able to contribute a full $7,000 for 2021, you could also just leave the excess in and apply it as your 2021 contribution.  However, it's safest to make the regular distribution between October 15, 2021 and December 31, 2021, determine your MAGI for 2021 in early 2022, then make a new contribution for 2021 if permitted.  That way, if you ultimately find yourself ineligible to contribute for 2021 because your MAGI ends up being too high, you will not have missed the opportunity to avoid the 6% penalty for 2021.

[pipeclamp]

You have been extremely generous with your time.  Both contributor's observations coupled with a bit more digging of my own helped me gain an understanding I lacked.  Your input taught me the best way to address the excess contribution.  I consider that to be outside the spirit of this "turbo tax software forum". 

So for that, I am very grateful. 

[atalle]

Hey got a follow-up question to this. 

My situation is my wife and I got married in 2020 and at the end of the year, I realized our new combined income was just a few thousand over the limit to contribute to a Roth IRA.  For our 2020 taxes, I paid the 6% penalty on the $3,000  in ineligible contributions I had made before we got married.  

By the end of 2021, our income will be less since I was unemployed for a few months, making me eligible to contribute the full $6,000 again to my Roth IRA.  Are you saying I can apply the $3,000 excess from 2020 to 2021 and be free of having ineligible money in my Roth? Thus I could invest only $3,000 for this year since I would be using $3,000 from 2020. 

That is how I'm reading IRS Form 5329 Part IV.