Best way to handle Excess Roth IRA Contributions

[samury]

Hello, I read a lot of other posts on this topic, but couldn't find one that matched up nicely with my situation.  

I am married filing jointly, but have not filed our 2021 taxes yet.  I am running into an issue regarding Roth IRA contributions in excess of the limit for 2021.  We are both 35 years old.  I contributed $6,000 to my Roth IRA with Merrill Edge for the 2021 year on February 4, 2021.  My wife contributed $6,000 to her Roth IRA with Fidelity for the 2021 year on September 24, 2021.  I contributed $6,000 to my same Roth IRA with Merrill Edge for the 2022 year on January 21, 2022.  We have contributed $0 to traditional IRAs for years 2021 and 2022.  

We made a good amount in capital gains (much more than I had anticipated), but unfortunately it put us over the income limit for making any contributions to our Roth IRAs, so each of us is $6,000 over our allowed contribution of $0.  

I am reading about the different options regarding how to fix this before filing taxes.  My understanding is that the traditional way of doing this would involve removing the excess contribution and any earnings on that contribution, following the formula  Net income = Excess contribution x (Adjusted closing balance-Adjusted opening balance)/Adjusted opening balance.  Would the Adjusted Opening Balance be the exact balance of the accounts the very day before the contribution was made?  Would the Adjusted Closing Balance be the exact balance of the accounts the very day we remove the contribution?  Would we have to ask Merrill Edge and Fidelity to provide us with the exact account balances for the Adjusted Opening Balance?  Since we're 35 we'd also be charged a 10% early withdrawal penalty, correct?  

I also read about other potential ways to fix the situation by recharacterizing the excess contributions and any attributable earnings from the Roth IRAs to traditional IRAs, or by applying the excess contributions to the next year (I already contributed $6,000 to my Roth IRA for the 2022 year, but my wife has not made any contribution yet), or by withdrawing the excess in 2022 (after October 15, but before December 31).  I haven't done the calculations using the net income formula above, but I would estimate that the $6,000 contributions have appreciated nicely.  Would one of these options be applicable and better to pursue?  Thank you

From many of the threads, I noticed that @dmertz has provided savvy advice.  Any thoughts you might be able to offer are much appreciated.  

[dmertz · Accepted solution]

The answers to many of your questions are in CFR 1.408-11:

https://www.law.cornell.edu/cfr/text/26/1.408-11

"Would the Adjusted Opening Balance be the exact balance of the accounts the very day before the contribution was made?"

It would be the account value immediately prior to depositing the $6,000 contribution.

"Would the Adjusted Closing Balance be the exact balance of the accounts the very day we remove the contribution?"

It would be the account value immediately prior the the distribution of the return of contribution.

"Would we have to ask Merrill Edge and Fidelity to provide us with the exact account balances for the Adjusted Opening Balance?"

Yes.  Merrill Edge and Fidelity should do the calculation for you, but you should obtain the relevant account balances so that you can perform the calculations yourself to verify what Merrill Edge and Fidelity calculate.

"Since we're 35 we'd also be charged a 10% early withdrawal penalty, correct?"

Only on the taxable earnings.

Regarding which option to pursue (return of contribution, recharacterization or keeping the excess and applying it as a 2022 contribution) depends on a number of factors.  Recharacterization allows you to keep a contribution for 2021 but will be nondeductible if either of you is covered by a workplace retirement plan.  Keeping the excess contribution, paying the 6% and resolving the excess in 2022 with either a regular distribution after October 15, 2022 or using the excess as part of your 2022 contribution depends on how much investment gains you have as you approach the October 15 deadline to do a recharacterization or return of contribution and how much you'll end up being eligible to contribute for 2022.  I usually use a 30% gain as the threshold for keeping the excess in and resolving the following year, but that's just a rule of thumb.

[samury]

Thank you very much, @dmertz .  The rule of thumb is very helpful.  Since I already contributed $6,000 to my 2022 contribution limit, I think I will withdraw my $6,000 contribution between October 15 and December 31.  Since my wife has not yet done a 2022 contribution, I'll see if it makes sense to use that towards her 2022 contribution and fill out Form 5329.  

For me specifically, is this plan correct?  I will pay the 6% ($360) excess contribution penalty with my 2021 tax return, and then after October 15, 2022 but before December 31, 2022 obtain a regular distribution to my non-retirement investment account of exactly $6,000 with no adjustment for gain, eliminating the excess for 2022 and beyond.  This would avoid the tax and penalty on the gains and let them grow tax-free.  I would still have to pay ordinary income tax on the $6,000 distribution, and a 10% early withdrawal penalty on it for 2022 taxes, correct?  Do I need to complete any extra forms for this plan?  

[dmertz]

Regarding your plan, the $6,000 distribution after the extended due date of your 2021 tax return is a nontaxable distribution of Roth IRA contribution basis.  Since it's nontaxable, it's also not subject to penalty.  The distribution will be reported on 2022 Form 8606 Part III calculating that the taxable amount is zero.  This distribution will also appear on 2022 Form 5329 Part IV to eliminate the excess.

[samury]

That is great news to hear.  Thank you so much for the timely, expert  guidance!  I'm going to finalize and file my taxes later today, and then set a reminder for October 15 to do the distribution.  

[samury]

I apologize for the extra follow-up, but I went ahead and did the $6,000 distribution from my Roth IRA account and my wife's in early December 2022 to correct the $6,000 of excess contributions we each made in 2021.  I received a 1099-R from my brokerage.  For each of us, box 1 notes the gross distribution of $6,000, blank for box 2a taxable amount, box 2b taxable amount not determined is checked, box 7 distribution code is J, and the rest is blank except for payer and recipient identification.  Is box 7 distribution code J the correct code?  

When I add the 1099-Rs, it adds a tax and penalty amount around $1,900 for each.  When I look at Form 8606 part III, line 19 shows $6,00 as nonqualified distributions from Roth IRAs in 2022, and further on it shows the taxable amount as $6,000 with an additional $600 tax.  Any thoughts you have are much appreciated.  Thank you @dmertz 

[dmertz]

Code J is correct.  You must make sure that you click the Continue button on the page that lists the Forms 1099-R that you have entered and make sure that TurboTax shows the correct amount of contribution basis for each of you, including the $6,000 of contribution basis from the excess contributions.  For each of you, TurboTax will include the distribution on Form 8606 Part III and apply the contribution basis to get the result that the distribution is nontaxable.  TurboTax will also include the distribution on line 20 of each of your Forms 5329 to be subtracted from the excess shown on line 18.

[samury]

You continue to impress me!  Thank you very much for the fast and expert guidance.