Archives for November 2013

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 cases in which the excess Roth contribution would be an excess contribution even if it was made to a traditional IRA instead (e.g., because you contributed $4,000 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.)

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.