Options to avoid on-going penalty - Excess Roth IRA contributions - Amended 2021 return in 2023

[coolcarn1sam]

Greetings -   A new Roth IRA was funded in April 2022  for prior year 2021. 

Unfortunately the deadline to process a 2021 Return of Excess Contribution was October 17th, 2022.

What alternative distribution options are available to me to avoid ongoing penalty for 2022, 2023 and later ?

Background :

As I was preparing to file on April 15th Turbo Tax warned of excess contribution so I requested extension of had subsequently requested the trustee to execute a refund of the excess amount.  Subsequently I filed the return before Oct 2022 without any penalties.

Unfortunately,  On Dec 30th 2022,  I received a W2C - with some additional income due to employers error. I filed a 2021 Amendment this year Jan 2023.  Turbo Tax reported an excess contribution due to this minor increase in income that was subject to 6% penalty for 2021 and also generated the form 5329.

As of Jan 26, 2023 I have not yet received the 1099-R for the excess 2021 Roth contribution refund taken out in 2022.

Thank you !

Thank you !

[ThomasM125 · Accepted solution]

To avoid a penalty going forward you need to withdraw the excess contribution. You can do this by taking a distribution from the pension plan for the amount of the excess contribution, or you can simply not make allowable contributions in the current or future years up to the amount of the excess contribution. For instance, if your excess contribution is $7,000 and you are allowed to make $7,000 in contributions for 2022, you can simply not make those contributions and you will have paid back your excess.

[coolcarn1sam]

Thanks @ThomasM125  -  

As Unfortunately allowable contributions this year are too less.

I will have to take the distribution of the 2021 carry forward excess contribution as  "Early Distribution - No Exceptions - I'm under the age of 591/2 with no known exceptions"   - Correct ?    

Besides this years 6% penalty on form 5329 on 2022 return - Will the 10% penalty on the withdrawn amount be payable on 2023 return ?  

Besides filing 5329 with 2022 return what else needs to be done to avoid having to amend 2022 return in future ?

Regards

[MichaelG81]

 What the other expert explained is what's called an "absorption" where you if you put less this year, it'll absorb your excess up to your maximum contribution rate this year from last year excess. But if any excess remains after the absorption for the year and your maximum, you will still be charged a 6% penalty on the excess for next year, a lower amount do to the absorption. Here's some information about reporting requirements from a previous answer, answered last year; but same concept. A code of P and J might apply to this withdrawal on your 1099-R.

It depends, if no known exception applies, you will be taxed 10% early withdrawal. Here's information from the IRS website about additional taxes on contributions and exceptions to the 10% tax. If you withdrew in 2023, you will receive a form in early 2024, for 2023 tax return.

Just report what you've done for your 2022 year. Also, with this withdrawal you have 2 options:

• You can wait until you receive the 1099-R  2023 in 2024 and amend your 2022 return or
• You can report it now in your 2022 return and ignore the 1099-R when it comes unless there is Box 4 Federal Tax withholding and/or Box 14 State withholding. Then you must enter the 2023 1099-R into the 2023 tax return since the withholding is reported in the year that the tax was withheld. The 2023 code P will not do anything in 2022 tax return but the withholding will be applied to 2023.

@coolcarn1sam 

[fanfare]

Since it is past the time including extensions to file for the year of the contribution,

all you have to do is have the custodian take out NNN dollars from your Roth where NNN is the amount of your excess contribution (or your entire Roth, whichever is less). It is not taxable. The penalty stops when you file a 5329 showing the distribution on Line 20. 

@coolcarn1sam 

[coolcarn1sam]

@MichaelG81  Thanks for your reply. I will request the custodian to remove the remaining excess 2021 amount in the Roth IRA that can not be "absorbed" in 2022 and withhold 10% tax.

So do I have to manually fill in the 1099-R in the 2022 return for this amount after I request the regular withdrawal from the custodian ?  Will this will generate the line 20 in the 5329  so the penalty will be 0 for 2022 ?  Or I will still have to pay the 2022 6% penalty ?

I want to follow the second option you indicated - I do not want to amend the 2022 return in 2024. So when the custodian will give the 1099-R I will report the 10% withholding when I file the 2023 return in 2024.

By the way in Feb 2023 I have also received the 1099-R for 2022 with P and J distribution code checked in box 7  from the custodian for the removal of the 2021 (part) excess without penalty before Oct 2022.  This has been imported in the TurboTax but is not part of the filing documents as withholding was 0.

Regards

[MichaelG81]

It depends, the Roth contribution is already included in your taxable compensation for the year of contribution and taxes paid on your Roth contribution, so taxes are already being withheld. If you withdraw, there is no additional federal income taxes, unless the early withdrawal penalty of 10% applies with possible exceptions (before 59 1/2) mentioned in link above from IRS.

Or if you leave the excess in, a 6% penalty for what does not "absorb" or is taken out will apply. Remember, Roth contributions are made with after tax money, however pulling out early will trigger the 10% tax penalty, unless an exception applies.

You can manually enter if you take that option; but remember if taxes are withheld next year on the form you must report for tax purposes.

@coolcarn1sam 

[EDITED 03/06/2023 | 12:07 PM PST]

Keep in mind you only have until generally April 15, 2022 to withdrawal the excess in 2021 to avoid penalty for that year, and what's not absorbed for 2023 needs to be taken out or a penalty will apply again on excess contributions.

[coolcarn1sam]

Hi @fanfare  Thanks for your thoughts and appreciate the time. 

Are you are suggesting I request the excess from 2021 to be withdrawn now in 2023 as a regular distribution AND to indicate to the custodian that they should not withhold the 10% ?

The line 20 of the 5329 says it is "2022 distributions from your Roth IRAs (see instructions)" and not 2023.

[fanfare]

it is now 2023 so yes you will show the distribution on your 2023 tax return.

what 10%?, there is no tax.

there is 6% penalty on your 2022 tax return for leaving the excess in throughout 2022,

@coolcarn1sam 

[MichaelG81]

If it's an excess not taken out by 2022 April 15, 2022, it is considered an early withdraw if taken out in 2023, unless there is still a limited absorption amount to take some of that off from 2021.

[fanfare]

There is no notion of "early withdrawal" for contributions. You can always take back your contributions to a Roth IRA.

[MichaelG81]

The 5 year rule applies if opened in 2022.
[EDITED 03/06/2023 | 01:09 pm PST]

-For earnings

[fanfare · Accepted solution]

the 5-year rule applies to earnings. 

in this situation, it is contributions that are being removed.

[coolcarn1sam]

@fanfare @MichaelG81  Thanks again for your inputs that 5 year rule does not apply as this is Roth IRA .

I will go ahead and take out the excess Roth contributions.  I suppose I can request custodian for 0% withholding. 

In any case in this case there are no earnings in this period due to market downturn. 

As required I have already paid the 2021 and will pay the 2022 6% penalty. 

I blame it on the employer who sent me the 2021 W2C so late in 2022 causing this excess !