Dear Tax Talk,
I am a U.S. citizen working for a U.N. agency in Thailand for the last two years and qualify for the foreign earned income exclusion. I had made several contributions to a Roth IRA in 2009, but I am learning all of a sudden that I cannot do this if claiming the foreign earned income exclusion.

I am using a tax program and at the end of the program I am being instructed that I owe money and will continue to do so each and every year.

This is very confusing and any advice would be very much appreciated. Thank you very much.

— Ross

Dear Ross,
A Roth IRA is an individual retirement plan that is pretty much subject to the same rules that apply to a traditional IRA. Unlike a traditional IRA, you cannot deduct contributions to a Roth IRA. But, if you satisfy the requirements, qualified distributions are tax-free. You can make annual contributions to a Roth IRA, or you can convert a traditional IRA to a Roth IRA by paying tax on the converted funds. I’m not a proponent of paying tax now for a conversion and in hindsight, many people that did pay tax on conversions now find that their IRA has declined in value. In other words, they paid tax on an inflated value and in effect lost twice.

In order to contribute to a Roth, your adjusted gross income, or AGI, with certain modifications has to be below a threshold that changes annually for inflation. In 2009, you can contribute to a Roth IRA if you have taxable compensation and your modified AGI is less than:

  • $176,000 for married filing jointly or qualifying widow(er).
  • $120,000 for single, head of household or married filing separately and you did not live with your spouse at any time during the year.
  • $10,000 for married filing separately and you lived with your spouse at any time during the year.

There is no rule that says you cannot make the contribution if you claim the foreign earned income exclusion. However, your foreign earned income, or FEI, exclusion is added back in determining if your modified AGI is below the threshold.

You can make contributions to a Roth IRA at anytime during the tax year and up to April 15 of the following year. Since you may have contributed and later discovered that you are not eligible due to MAGI limitations, you can redesignate or withdraw your contributions without penalty up to the due date of your tax return, including extensions. If you do not act by then, your overcontribution is subject to an excise tax penalty of 6 percent for each year you do not withdraw the excess contribution.

That is why the program says you will continue to owe each and every year. You need to advise the IRA custodian of your problem and decide what is best as far as applying the contribution to the 2010 tax year or withdrawing the funds. Any earnings on the Roth should be included in your 2009 income tax return.

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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