Archives for November 2013

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Correcting an Excess Roth IRA Contribution

A reader writes in, asking:

“Way back in January, I maxed out my Roth for the year. Income-wise it turned out to be a better year than I expected and now, barring an immediate layoff, my income for 2013 will be too high to actually be eligible for Roth contributions. I’ve read that it’s a 6% tax if I just leave the money there. That doesn’t sound so bad actually. Thoughts?”

Yes, there is a 6% penalty on (uncorrected) excess IRA contributions. A key point to understand, however, is that it’s a 6% penalty per year for each year in which the excess contribution remains in the account.

So how do you fix the problem? You have a few options.

Option #1: Recharacterize the Contribution (and Earnings)

Often, the best way to deal with the situation is to contact your brokerage firm to ask them to “recharacterize” the contribution (and any associated earnings) as a traditional IRA contribution rather than a Roth IRA contribution. They will then remove the excess contribution and earnings from your Roth IRA and move it to a traditional IRA. If you do this by the due date of your tax return for the year (including extension, if applicable), it will simply be treated as if you made the contribution to the traditional IRA in the first place.

For example, if you contributed $5,500 to your Roth IRA in 2013, but turned out to be ineligible to make a Roth IRA contribution, you have until April 15, 2014 (or October, 15, 2014 if you file for an extension) to recharacterize the contribution by having your brokerage firm move the $5,500 and associated earnings to a traditional IRA.

Some taxpayers will find that, after recharacterizing the contribution as a traditional IRA contribution, they will then want to convert it to a Roth IRA as a part of a “back-door Roth” strategy.

Unfortunately, recharacterization is not a solution in some cases. For example:

  • You have reached age 70.5 and are therefore ineligible to make traditional IRA contributions, or
  • The excess Roth contribution would be an excess contribution even if it was made to a traditional IRA instead (e.g., because you contributed $3,000 at each of two different brokerage firms, thereby exceeding the $5,500 limit or because your contribution was in excess of your compensation for the year).

Option #2: Withdraw the Excess Contribution (and Earnings)

A second way to avoid the 6% penalty is to simply take the excess contribution (and associated earnings) back out of the account. As with a recharacterization, you have until the due date of your return (including extensions) to withdraw the excess contribution in order to avoid the 6% penalty for the year.**

One drawback of this approach is that the earnings that you take out of the account will be taxable as income and (unless you’re over age 59.5 or you meet one of the other exceptions) subject to the 10% penalty for early distributions of earnings from a Roth IRA.

Option #3: Do Nothing

If you are confident that your income next year will be such that you’d be allowed to make a Roth IRA contribution, you can simply leave the amount in the account this year, and under-contribute next year by the appropriate amount.

Example: Samantha contributes $5,500 to her Roth IRA in 2013, but, due to unexpectedly high income, she turned out to be ineligible to make a Roth IRA contribution. In 2014, however, her income is significantly lower, and she is eligible to contribute the full $5,500. If she contributes nothing in 2014, that unused $5,500 contribution limit can count toward rectifying the prior $5,500 excess contribution. As a result, she’ll have to pay the 6% penalty in 2013, but not in 2014.

Drawbacks of this approach are that it results in an avoidable 6% penalty (for the year of the excess contribution), and it sets you up to potentially have to pay the penalty next year as well, if your income once again turns out higher than expected.

**In years after the year in which the excess contribution was originally made, you only have until 12/31 to withdraw the excess contribution in order to avoid the 6% penalty for the year. (For example, if you make an excess contribution in 2013 and do not correct it in 2013, in order to avoid the penalty for 2014, you have to correct the excess contribution by December 31, 2014.)

Should I Roll Over My Roth 401(k)?

A reader writes in, asking:

“I recently changed employers. I’ve read that it’s usually advantageous to roll over a 401K to an IRA. Does the same go for rolling over a Roth 401K?”

In short, yes, as with a traditional (pre-tax) 401(k), most of the time you’ll get access to more (and less expensive) investment options by rolling a Roth 401(k) into a Roth IRA.

And there’s another point in favor of rolling it over: Roth 401(k) accounts are subject to required minimum distribution rules, whereas Roth IRAs are not. So by rolling your Roth 401(k) to a Roth IRA, you can avoid having to deal with RMDs.

Reasons Not to Roll it Over

There are, however, some circumstances in which you might not want to roll over your Roth 401(k):

  1. The investment options in your 401(k) are actually better than they would be in an IRA (because your 401(k) offers access to super cheap “institutional” share classes, for example).
  2. You left your employer in the year in which you turned age 55 (or older) and you want to spend some of the earnings in your Roth 401(k) prior to reaching age 59.5. (The 10% penalty doesn’t apply to 401(k) distributions — whether Roth or traditional — if you separated from service in a year in which you are 55 or older, whereas a pre-age-59.5 distribution of earnings from a Roth IRA could be subject to the 10% penalty.)

With regard to point #2, however, please note that when money comes out of a Roth IRA, it’s first considered to come from contributions (which come out free from tax and penalty) until all of the contributions have been distributed. So this exception to the 10% penalty (which you could have access to by keeping the money in your Roth 401(k) rather than rolling it to a Roth IRA), is only relevant if you expect your Roth distributions prior to age 59.5 to exceed your contributions.

So, to summarize, you might want to keep the Roth 401(k) with your prior employer if you don’t mind being subject to RMDs (or are young enough that RMDs aren’t yet a concern), and either:

  • The investment options in your 401(k) are better than what you would have access to in a Roth IRA, or
  • You separated from service in the year in which you turned 55 (or older) and you want penalty-free access to all of the money prior to age 59.5.

Finally, on a note related to last week’s discussion: As with Roth IRAs, you definitely want to keep track of your Roth 401(k) contribution history (as well as your history of any in-plan traditional-to-Roth conversions that you make), so that you can prove how much of your account balance is the result of contributions or conversions rather than earnings. This will become especially important if you roll a Roth 401(k) over to a Roth IRA, because the new brokerage firm will likely not have records as to the contributions you made with the prior company.

Investing Blog Roundup: Millionaires Next Door (A Room Full of Them)

This was the third year I’ve had the chance to attend the annual Bogleheads reunion/conference. Jim of The White Coat Investor was there this year as well, and this week he explained why he enjoys attending the event. (And for the record, I agree — it’s fun to spend a few days hanging out with a group people who are similarly mindful of their finances.)

Investing Articles

Other Money-Related Articles

Thanks for reading!

Should I Keep My Form 5498?

A reader writes in, asking:

“Each year Vanguard sends me form 5498 showing the amount I contributed to my Roth. Is there any reason to keep these? Since Roth contributions don’t even show up on my return, I wouldn’t think I’d need them in case of an audit.”

It’s true that Roth contributions don’t show up on your tax return (unless you’re claiming the retirement savings contribution credit, that is). But, yes, Form 5498 is still a form you’ll want to hang on to. In fact, depending on your circumstances, you may want to keep your Forms 5498 for a long time — much longer than just the 3-year statute of limitations for IRS audits.

To explain, let’s back up a step and talk about Roth IRAs in general. As you may recall, Roth IRA contributions can be withdrawn at any time, free from tax and penalty. It is only when you are withdrawing earnings (or amounts converted from a traditional IRA or 401k) that you have to jump through various hoops in order to avoid tax and penalty.

So, in the event that you want to take one of these tax-free distributions of Roth IRA contributions, how do you know (and how could you prove to the IRS) how much you’ve contributed to your Roth IRAs over the years? By looking at your Forms 5498.

And depending on how much you’re taking out of the account, you may have to go way back in order to prove sufficient contributions — which is why you’ll generally want to hang on to these forms at least until you’ve a) reached age 59.5 and b) had a Roth IRA for 5 years such that you could take out earnings free from tax and penalty as well.

If you’ve already thrown away your old Forms 5498, your brokerage firm may be willing to send you copies from prior years. (In some cases, even brokerage firms where you used to have an account will be able to send you tax forms upon request.) But, of course, the longer you wait, the less likely it is that they’ll still have the document you’re requesting.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

2014 Tax Brackets, Standard Deduction, and Other Changes

After two announcements last week from the IRS, we now have a good idea of what the 2014 tax year will look like, barring any further legislative changes.

Of course, the biggest change for many people will be the new premium subsidy credit for insurance purchased on the new Affordable Care Act exchanges. But because a) that’s an article all on its own and b) we’ve covered it before, let’s take a look at some of the other changes.

The tax brackets for 2014 are as follows:

Single 2014 Tax Brackets

Taxable Income
Tax Bracket:
$0-$9,075 10%
$9,076-$36,900 15%
$36,901-$89,350 25%
$89,351-$186,350 28%
$186,351-$405,100 33%
$405,101-$406,750 35%
$406,751+ 39.6%

 

Married Filing Jointly 2014 Tax Brackets

Taxable Income
Tax Bracket:
$0-$18,150 10%
$18,151-$73,800 15%
$73,801-$148,850 25%
$148,851-$226,850 28%
$226,851-$405,100 33%
$405,101-$457,600 35%
$457,601+ 39.6%

 

Head of Household 2014 Tax Brackets

Taxable Income
Tax Bracket:
$0-$12,950 10%
$12,951-$49,400 15%
$49,401-$127,550 25%
$127,551-$206,600 28%
$206,601-$405,100 33%
$405,101-$432,200 35%
$432,201+ 39.6%

 

Married Filing Separately 2014 Tax Brackets

Taxable Income
Marginal Tax Rate:
$0-$9,075 10%
$9,076-$36,900 15%
$36,901-$74,425 25%
$74,426-$113,425 28%
$113,426-$202,550 33%
$202,551-$228,800 35%
$228,801+ 39.6%

 

Standard Deduction Amounts

Adjusting the standard deduction amounts for inflation, we get the following for 2014:

  • Standard deduction (single or married filing separately): $6,200
  • Standard deduction (married filing jointly): $12,400
  • Standard deduction (head of household): $9,100

The additional standard deduction for people who have reached age 65 (or who are blind) is $1,200 for married taxpayers or $1,550 for unmarried taxpayers.

Personal Exemption Amount and Phaseout

The personal exemption amount for 2014 is increased to $3,950.

As in 2013, however, the personal exemption is subject to a phaseout. Specifically, the total personal exemptions to which you’re entitled will begin to be reduced as your adjusted gross income (that is, the bottom line of the first page of your Form 1040) exceeds a certain threshold amount (adjusted for inflation for 2014):

  • $254,200 for single taxpayers,
  • $305,050 for married taxpayers filing jointly,
  • $279,650 for taxpayers filing as head of household, and
  • $152,525 for married taxpayers filing separately.

“Pease” Limitation on Itemized Deductions

As in 2013, the amount of itemized deductions which you are allowed to claim is reduced by 3% of the amount by which your adjusted gross income exceeds certain threshold amounts. These threshold amounts are the same as the threshold amounts listed above for the personal exemption phaseout. Two important exceptions to this rule are that:

  1. Your itemized deductions cannot be reduced by more than 80% as a result of this limitation, and
  2. Your itemized deductions for medical expenses, investment interest expense, casualty/theft losses, and gambling losses are not reduced as a result of this limitation.

Non-Changes to Taxes on Investment Income

Because of the permanent changes implemented by the American Taxpayer Relief Act of 2012, qualified dividends and long-term capital gains will be subject to the same 0%, 15%, and 20% tax rates as last year, depending on which tax bracket the income falls into.

In addition, the 3.8% tax on net investment income is unchanged, because the threshold amounts (adjusted gross income of $200,000 if single or $250,000 if married filing jointly) are not indexed for inflation.

IRA and 401(k) Contribution Limits

For 2014, most retirement account contribution limits remain unchanged:

  • $5,500 for Roth and traditional IRAs, with an additional catch-up contribution of $1,000 for people age 50 or older, and
  • $17,500 for 401(k), 403(b), and most 457 plans, with an additional catch-up contribution of $5,500 for people age 50 or older.

The maximum possible contribution for defined contribution plans (e.g., for a self-employed person with a sufficiently high income contributing to a SEP IRA) is increased from $51,000 to $52,000.

AMT Exemption Amount

Finally, because the exemption amount for the Alternative Minimum Tax is now permanently indexed to inflation, we get the following AMT exemptions for 2014:

  • $52,800 for single taxpayers,
  • $82,100 for married taxpayers filing jointly, and
  • $41,050 for married taxpayers filing separately.

For More Information, See My Related Book:

Book6FrontCoverTiltedBlue

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions, exemptions, and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"
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