Ask the Dollar Diva By Dorothy Rosen • Bankrate.com

Avoiding the Roth IRA 'excess contribution' tax

Dear Dollar Diva,
I normally make my Roth IRA contribution early in the year, but this year I have a dilemma: I may exceed the income limit. What happens to my contribution and the respective earnings if I do?
Greg

Dear Greg,
Making IRA contributions as early as possible is an excellent investment strategy. It not only gives your IRA more time to make its magic, but it keeps those important retirement funds out of temptation's way.

If you contribute now, and are lucky enough to exceed the income limits, (see chart below) there are ways to fix it so you won't get hit with the 6 percent "excess" contribution tax.

The "excess" contribution tax
If you make an IRA contribution that you shouldn't have because your income exceeded the limits, and you don't fix the mistake, you will be hit with a 6 percent "excess" contribution tax. This tax will be assessed to the contribution, year after year, until you make things right.

The Diva offers the following suggestions for staying on the right side of the IRS should your high income disqualify the Roth contribution you made earlier in the year.

Withdraw the Roth contribution
You can withdraw the Roth contribution, plus any income and excluding any losses, before you file your tax return for the year you made the contribution. It's the easiest way to fix the problem.

You'll have to pay tax on any income earned in the year the "excess" contribution was made, but you will not have to pay the "excess" contribution tax, and you will not have to fill out any extra forms.

Withdrawing the funds may be the easiest solution, but it's not necessarily the best. Read on.

Morph the Roth into a nondeductible traditional IRA
If you exceed the income limits for a Roth IRA, you can have your Roth contribution and any earnings (or losses) morphed into a nondeductible traditional IRA. The IRS calls this "recharacterization;" the contribution (not the income) gets reported as a nondeductible contribution to a traditional IRA on Part I of Form 8606,  Nondeductible IRAs and Coverdale ESAs.

With the "recharacterization," it's as if the Roth contribution never existed.

There is no income ceiling for a nondeductible traditional IRA; as long as you earn $3,000 in 2002, you can make a $3,000 contribution, even if your modified adjusted gross income is a million dollars.  

For more information on this option, go to IRS Publication 590, Individual Retirement Arrangements (IRAs).   

Pay the "excess" tax and carry contribution over
If you were lucky enough to get a huge return on your Roth IRA investment, you could leave the money in the Roth, pay the 6 percent "excess" contribution tax for one year, and let your contribution and the related income grow tax-free in the future. Here's what it would take to make it work: 

• This year's large income was atypical and you expect next year's income to be low enough to allow you to make a Roth contribution.
• Your Roth IRA earned enough to justify paying the 6 percent excise tax for one year.
• You pay the 6 percent tax on the contribution (the income is not subject to the tax) the year it was made. Use Part IV of Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, to report the "excess" contribution and compute the tax.
• You carry forward the "excess" contribution to the following year.

For more information, go to IRS Publication 590, Individual Retirement Arrangements (IRAs).

-- Posted: Feb. 21, 2002

DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting, from the Kellogg Graduate School at Northwestern University in Evanston, Ill. Rosen has more than 15 years of experience in the financial arena, serving in Illinois and Florida as a certified public accountant, financial consultant, expert witness and educator. She is owner of Dorothy Rosen, CPA, a public accounting firm that serves individuals and small businesses.