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Okay - so I looked at Pub 590. The 6% penalty and the application of excess funds to the following year is clearly discussed. However, it is not clear about a requirement to withdraw funds -- only that you can avoid the excise tax by withdrawing any excess.

Hypothetically, let's say someone intentionally contributes $3000 to a Roth in tax year 2000, knowing that they are only technically qualified to contribute $2000. Let's assume the individual does the same for year 2001.

1) Pub 590 discussion implies that there is only a 6% excess tax. For the 1st year the excess can be carried to year 2001. Then year 2001 would have an excess of $2000 which presumably could be carried over to year 2002. So, each year he pays just 6% on the excess?? For example $60 the first year then $120 the second year. Nothing the 3rd year if no other deposits are made that year? Any earnings from the excess funds are not taxed at all. Is this correct?

2) Conversely, Pub 590 (Chap 4) distinguishes that excess (employer) contributions to a SEP are subject to an ANNUAL excise tax of 6% --until the excess funds are withdrawn. I guess this is because, unlike the privelidges of a Roth, excess SEP contributions are not technically allowed to be "carried over" to the next year (?'cause they are viewed as deferred income?). Is this correct?

3) So, from the way I'm interpretting this could the following scenario occur? Joe has confidience in the long-term market. He opens and deposits $20K into a Roth in year 2000 and plans to make no additional deposits until year 2010. He qualifies for the full $2K contribution each year between 2000-2010. The 1st tax year he pays $1080 for the 6% excise tax on the excess $18,000 and carries over the excess to next tax year. 2nd year pays only $960 on the remaining $16K excess, .... and so on until year 2009 where he pays no excise tax because the remaining $2K excess qualifies for that year. In total, he pays $5,400 in cumulative excess taxes of 6% of the excess any given year through 2008. Meanwhile, the initial $20,000 earns an annual average return of 10% and has grown compounding to about $52K. In 2010, he withdraws the initial $20K contribution, but lets the $32K in earnings sit in the Roth, where they continue to earn only 8% annual average return for the next 10 years, growing to a value of about $69K. In year 2020 Joe is 60 years old and he withdraws the entire $69K from his Roth -- tax free. In effect, Joe has paid just under 8% in taxes on his $69K earnings (5400/69000) -- or has a net gain of about $63,600 tax free. If Joe had contributed only $2K/yr for those first 10 years, under the same conditions he would only have about $26,000 in earnings by year 2020. Obviously, Joe is better off making excess contributions and paying the measley 6% excise tax. Does the tax law really permit this scenairo?

Welcoming any additional thoughts before I move all my funds into my Roth!!!

Making Trax
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