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Author: TMFPMarti Big funky green star, 20000 posts Home Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121061  
Subject: Re: Roth IRA overcontribution Date: 3/11/2006 5:05 PM
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I think that I understand that one of my options is to recharacterize the overcontribution and associated gains into a non-deductible traditional IRA.

Correct. The deadline for doing this is 10/16/2006.

Everything that I've found online dealing with non-deductible traditional IRA's basically say that they are a complicated tax situation and they don't really discuss them.

You just haven't been to the right place until now.

Since I will have already paid taxes on the non-deductible IRA, how are gains treated and what is the benefit?

Nondeductible contributions to a traditional IRA establish a "basis" for the IRA. When you take distributions, each is a mix of previously-taxed money and untaxed deductible contributions (if any) and earnings. All of this is handled in Part I of Form 8606. If you do decide to recharacterize the 2005 excess, you will need to amend your 2005 return to include the 8606 even though your tax will not change.

The only idea I could come up with is that if you bought and sold stocks frequently and didn't qualify for long term capital gain treatment, you could shield the gains from short term taxes. That still doesn't say anything about how the gains/value of account is taxed when withdrawals are made. Are there any benefits to a non-deductible traditional IRA compared to a taxable account if holdings in the taxable account are held long enough to qualify for long term capital gains treatment?

Deferring taxation of the gains is really the only benefit to the nondeductible IRA. It's a good place for investments that generate ordinary income. IMO long-term buy and hold investments are better off in a regular taxable account, given current tax law. That's because all taxable amounts coming out of a traditional IRA are taxed as ordinary income, even if the income was the result of investments held over a year.

My second question is can I just withdraw the overcontribution and associated gains since it is still before April 15? FWIW, in 2006 we will almost certainly be ineligible to contribute any money to a Roth IRA.

Your last sentence is worth a lot, since leaving the excess alone, paying the 6% penalty, and applying it to your 2006 contribution is the other option. Since you don't think you'll be Roth-eligible in 2006, forget that one.

Yes, you can withdraw the excess and the earnings on it. You will owe the 10% premature distribution penalty on any positive earnings.

Phil
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