Roth IRA excess question

[camel207]

I have a tricky Roth IRA question. I have 2 Roth IRA accounts. I used backdoor IRA to contribute my personal Roth (Vanguard) and use mega backdoor IRA to convert after tax 401k to Roth IRA (Schwab). I have maxed out both accounts on both years 2021 and 2022.

Recently my company added 2021 401k matching $5k and over contributed. Schwab told me to remove excess on Schwab Roth IRA $5k. Since this is 2021 year money and it passed 10/15/2022 deadline, they will issue me 1099-R and that will be contributed to my income 2022. Here are my questions :

1. I read online and some articles saying the penalty for withdrawing excess from Roth IRA after 10/15 only needs to pay 6%, nothing else. But some article saying I need to pay 6%, and 5k considered as ordinary come (double taxation). I am very confused which one is correct ?

2. How to avoid double taxation ?

3. Some article saying I can leave the 2021 excess to carry over to 2022 IRA contribution. Since I already maxed out 2022 IRA, does it mean I should do the following :

a) move vanguard Roth IRA to Vanguard brokeage account including gain to clear 2022 quota b) Request Schwab Roth IRA sending the excess money to Vanguard Traditional IRA account (since I am not eligible to deposit to Roth IRA directly) c) After money comes in Vanguard traditional account, then do Roth conversion to convert money from Traditional IRA to Roth IRA

My main goal is to not get "double taxation". Please share your thoughts !

[Anonymous_]

@dmertz ?

[dmertz]

Already answered in response to an earlier post by @camel207 .

https://ttlc.intuit.com/community/retirement/discussion/re-how-do-i-report-on-excess-roth-ira-contri... 

[camel207]

Thanks for your information dmertz.

My understanding from your post is that Roth IRA excess is non taxable and the easiest solution for my case is to request a check $5k  (excess distribution) from Schwab Roth IRA account,  and pay 6% penalty and be done with it.  No double taxation on the excess distribution.  

Could you please confirm my understanding is correct ? 

[dmertz · Accepted solution]

If the excess Roth IRA contribution was made for 2021 or earlier, that's right.  Make sure that the Roth IRA contribution basis carried in from 2021 includes the excess Roth IRA contribution made for 2021 or earlier so that TurboTax places the correct amount on 2022 Form 8606 line 22 to reduce the taxable amount to zero.   The 2022 Form 5329 will show this same distribution on line 20, added to line 19 and that total subtracted from line 18.

You'll also need to make sure that you've filed 2021 Form 5329 to pay the 6% excess contribution penalty for 2021.

[camel207]

Thanks for your information.

I was reading Schwab letter about $5k excess contribution and they mentioned they will issue 1099-R with tax code E (Distribution under Employee Plans Compliance Resolution System).

Does it mean this excess is considered employee plans excess and due for double taxation ?

Is there anyway recommendation to avoid double taxation ?

[dmertz]

Code E indicates that you have an excess contribution in a designated Roth account in an employer plan like a 401(k), not in a Roth IRA.  Code E is never used for distributions from a Roth IRA.

Box 2a of the Form 1099-R issued by Schwab will indicate the taxable amount.  There is no option not to receive the distribution so you are stuck with whatever taxable amount is shown on the Form 1099-R; there is nothing you can do to change it, so your only concern is that you have tax withholding or have made estimated tax payments sufficient to avoid any tax underpayment penalty.

[Mike9241]

since this is a Roth 401(k) you never got a deduction for the amount contributed that's being returned so that will be tax-free.  only the income earned on the excess that is being returned, if any, will be taxable. that's what should show up in box 2a. 

[dmertz]

If the cause of the excess Roth 401(k) contribution was an excess employer contribution rather than the distribution being required because of the plan failing ADP (Actual Deferral Percentage) or ACP (Actual Contribution Percentage) testing, the distribution is subject to double taxation when the corrective distribution is made after April 1 of the year following the year for which the excess contribution was made.

[camel207]

From @Mike9241  I thought he meant contribution is tax free and I only need to pay tax on earnings.

From @dmertz  Since excess is coming from employer contribution, I need to pay tax on both contribution and earning.  

Sorry I am getting confused. 

I was also reading Publication 525 on "Excess Annual Addition" session.  (this shows code E)

A corrective payment of excess annual additions consisting of elective deferrals or earnings from your after-tax contributions is fully taxable in the year paid. A corrective payment consisting of your after-tax contributions isn't taxable.

My understanding from IRS rule : This is saying the contribution is not taxable.  only earning is.   Could you please help me understand this ?

Thank you

[Mike9241]

Distributions Under Employee Plans
Compliance Resolution System (EPCRS)
The procedure for correcting excess annual additions under
section 415 is explained in the latest EPCRS revenue
procedure in section 6.06 of Rev. Proc. 2021-30, 2021-31
I.R.B. 172, available at IRS.gov/irb/2021-31_IRB#REVPROC-
2021-30.
Distributions to correct a section 415 failure are not
eligible rollover distributions although they are subject to
federal income tax withholding under section 3405. They are
not subject to social security, Medicare, or Federal
Unemployment Tax Act (FUTA) taxes. In addition, such
distributions are not subject to the 10% early distribution tax
under section 72(t).
You may report the distribution of elective deferrals (other
than designated Roth contributions) and employee
contributions (and earnings attributable to such elective
deferrals and employee contributions) on the same Form
1099-R. However, if you made other distributions during the
year, report them on a separate Form 1099-R. Because the
distribution of elective deferrals (other than designated Roth
contributions) is fully taxable in the year distributed (no part of
the distribution is a return of the investment in the contract),
report the total amount of the distribution in boxes 1 and 2a.
Leave box 5 blank, and enter Code E in box 7. For a return of
employee contributions (or designated Roth contributions)
plus earnings, enter the gross distribution in box 1, the
earnings attributable to the employee contributions (or
designated Roth contributions) being returned in box 2a, and
the employee contributions (or designated Roth
contributions) being returned in box 5. Enter Code E in box 7.
For more information, see Rev. Proc. 92-93, 1992-2 C.B.
505.
Similar rules apply to other corrective distributions under
EPCRS. Also, special Form 1099-R reporting is available for
certain plan loan failures. See section 6.07 of Rev. Proc.
2021-30 for details.

section 6.06 of Rev. Proc. 2021-30, 2021-31
I.R.B. 172

A distribution of an Excess Amount is generally treated in the manner described in section 3 of Rev. Proc. 92-93, 1992-2 C.B. 505 (relating to the corrective disbursement of elective deferrals). The distribution must be reported on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the year of distribution with respect to each participant or beneficiary receiving such a distribution. Except as otherwise provided in section 6.02(5)(c) with respect to recovery of small Overpayments, where an Excess Amount has been or is being distributed, the Plan Sponsor must notify the recipient that (a) an Excess Amount has been or will be distributed and (b) an Excess Amount is not eligible for favorable tax treatment accorded to distributions from an eligible retirement plan, as defined in § 402(c)(8)(B) (and, specifically, is not eligible for rollover).

as I understand it, since employer contributions, if made, are always the same percentage for every employee. when the anti-discrimination tests are failed what is returned is employee contributions. if i'm wrong and part or all of what's being returned includes employer contributions, such an amount would taxable since it would represent additional compensation that was tax-free when the employer made their contribution.  

but the simplest thing to do is to clarify the situation is with your company's human resource/personnel department.

[dmertz]

@Mike9241 is right.  I had not considered that code E being used to report the correction of an excess employee contribution to the designated Roth account implies that the excess contribution should not have been allowed by the plan in the first place, an error made by the plan.  If the excess contribution was instead the result of contributing to plans of more than one employer where neither employer plan on it's own allowed an excess contribution, the distribution of the excess, including earnings, after the due date of the tax return would be reported as a regular distribution with code B and would show the entire distribution as being taxable.