taxes

Roth IRA mistake costs plenty

George Saenzq_v2.gifDear Tax Talk,
On April 13, 2007, I contributed $4,000 to my 2006 Roth IRA. The same year, I contributed $4,000 to my 2007 Roth IRA.

My adjusted gross income for 2006 was over the $110,000 income limit. My adjusted gross income for 2007 was under the $114,000 income limit.

I've already intermingled the money to buy and sell stocks. Overall, my Roth IRA account has a negative balance currently.

What should I do? Sell the stocks and take a hit? Can I take out the 2006 contribution without consequence?
-- Phillip

a_v2.gifDear Phillip,
When you say your Roth has a negative balance, I assume you mean that you have less than the $8,000 you invested in the account.

Of course, this is contrary to the benefits of a Roth IRA. The advantage of a Roth is that its growth always is tax-free when withdrawn. Without any growth, the existence of the Roth IRA has little significance.

In order to be eligible to contribute to a Roth IRA, a taxpayer's modified adjusted gross income has to be below a certain threshold, which is adjusted annually for inflation. In 2006, you were ineligible to make the contribution, but in 2007 you were eligible.

Ineligible amounts contributed to an IRA are considered excess contributions. You should never have made the $4,000 contribution April 13, 2007, knowing that you were ineligible.

Excess contributions are penalized at 6 percent annually if they are not withdrawn by the due date of the tax return. The penalty is computed on Form 5329. If you did not compute the penalty on your original return, the IRS will generally bill you for it based on information it receives from the IRA custodian on Form 5498.

You owe the penalty for 2006 through 2008, which really hurts since the account hasn't earned anything.

Because there are no earnings, you need to remove the lesser of the $4,000 excess contribution or the remaining balance of the account (obviously, you can't remove more than there is).

If you do end up taking out the full Roth IRA and it is your only Roth IRA, you can claim a loss for the difference between the $8,000 contributed and the balance returned to you. The loss is a miscellaneous itemized deduction on Schedule A, subject to reduction by the 2 percent floor. The excess contribution penalty is not deductible. Because there are no earnings, the $4,000 withdrawal has no further tax implications.

Read more Tax Talk columns.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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