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I know there is a 6% penalty on excess contributions to a Roth IRA, but do you also have to withdraw the money? I ask because in the long run it may make sense to make that contribution, pay the penalty, and then get the tax-free growth and withdrawals.

Any thoughts?
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I know there is a 6% penalty on excess contributions to a Roth IRA, but do you also have to withdraw the money? I ask because in the long run it may make sense to make that contribution, pay the penalty, and then get the tax-free growth and withdrawals.

Interesting that you should ask this -- I was having a similar thought yesterday.

But, I basically figured out that this probably doesn't work to your advantage.

The tax is 6% of the amount above your allowable contributions EACH YEAR, meaning that if you plunked an extra $10K into your account this year, it would mean 5 years of paying on the excess, 6% of $8K in the first year, 6% of $6K in the second year, etc.

That's as best I've figured out, perhaps Phil and Roy could be of more help here.

For very large amounts of money, ignoring the write-down of $2K you could make each year on the excess, you'd essentially be paying 6% of your total each year, which, for most folks would mean earning upwards of 14 or 15% on the money in the IRA to make it worthwhile (because 6/15 would be 40%, which is close to what many people pay in income taxes, total). This might be possible, but with the market averaging less than that over the long term (what is it, 11 or 12%?), it's a risky proposition. You'd have to beat the market for a long stretch to make it work to your advantage.

I considered putting ALL my assets into the IRA and doing just this, but realized that it probably doesn't work out to your advantage -- if they ever lower the excise tax on the overage amount to something less than 6% though, I'd do it immediately.
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<< <<I know there is a 6% penalty on excess contributions to a Roth IRA, but do you also have to withdraw the money? I ask because in the long run it may make sense to make that contribution, pay the penalty, and then get the tax-free growth and withdrawals. >>

Interesting that you should ask this -- I was having a similar thought yesterday.

But, I basically figured out that this probably doesn't work to your advantage.

The tax is 6% of the amount above your allowable contributions EACH YEAR, meaning that if you plunked an extra $10K into your account this year, it would mean 5 years of paying on the excess, 6% of $8K in the first year, 6% of $6K in the second year, etc. >>

It doesn't work that way. An excess contribution remains an excess contribution in full until it's withdrawn. IOW, you can't call $2,000 of a 1999 excess distribution your 2000 contribution. In the example you gave, you would pay a 6% annual penalty on the full $10,000 until you removed it.

Phil Marti
Tax Preparer
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<< I know there is a 6% penalty on excess contributions to a Roth IRA, but do you also have to withdraw the money? I ask because in the long run it may make sense to make that contribution, pay the penalty, and then get the tax-free growth and withdrawals. >>

As is noted in another response, the 6% penalty applies every year until you get the money out of there. There's no excess contribution penalty if you remove the excess by the due date of your return. (You also have to remove the earnings on the excess contribution, and there's a 10% premature distribution penalty on the earnings only, unless you meet an exception.)

Phil Marti
Tax Preparer
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It doesn't work that way. An excess contribution remains an excess contribution in full until it's withdrawn. IOW, you can't call $2,000 of a 1999 excess distribution your 2000 contribution. In the example you gave, you would pay a 6% annual penalty on the full $10,000 until you removed it.

Yes, but if you continue to contribute $2K each year, it effectively drops the percentage of the total assets that are an "excess contribution". Maybe not in the same proportion as I originally posted. In any case, when you have a very small amount in the IRA and you add a very, very large amount as "excess", it makes almost no difference.

But, Phil, I must ask, does the rest of what I said make sense?

Could you do this and not have the IRS take a severely dim view of it?

It might make sense for certain individuals.

And, do I have the rest right? If I can earn 15% annually on that money, and I'm paying 6% annually in the form of tax, do I get the rest tax free? If I earn more than 15% on the assets, and I'm in the highest tax bracket, this would easily work to my advantage. It would allow one to shelter short term gains and not pay as much tax as one would pay if they were in a taxable account.

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<< If I can earn 15% annually on that money, and I'm paying 6% annually in the form of tax, do I get the rest tax free? If I earn more than 15% on the assets, and I'm in the highest tax bracket, this would easily work to my advantage. It would allow one to shelter short term gains and not pay as much tax as one would pay if they were in a taxable account. >>

Your math is ok to a point. Some problems I see:

1. I'm old enough to remember when the S&P didn't go up 35% and the NSADAQ 80% per year. I'm even old enough to remember when there wasn't a NASDAQ.

2. The money isn't tax-free forever. When it's withdrawn you pay tax as ordinary income. (The penalty for failing to take a required distribution is 50% of the required amount.) I'm not sure off the top of my head whether the excess contribution penalty also applies to the earnings on the excess.

3. If this turns out to be a good investment strategy, Congress will nix it. It's clear that they didn't want people piling more money in there. One of the ways we wind up with complex tax law is Congress, I'll be charitable, fine-tuning the Code to deal with schemes that people have come up with.

Phil Marti
Tax Preparer
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Your math is ok to a point. Some problems I see:

1. I'm old enough to remember when the S&P didn't go up 35% and the NSADAQ 80% per year. I'm even old enough to remember when there wasn't a NASDAQ.


Yes, I'm very aware of that and I don't expect to get anything more than about 10 or 11% a year, over the long term, which is why I haven't actually persued this.

2. The money isn't tax-free forever. When it's withdrawn you pay tax as ordinary income. (The penalty for failing to take a required distribution is 50% of the required amount.) I'm not sure off the top of my head whether the excess contribution penalty also applies to the earnings on the excess.

Yes, in a traditional, but in a Roth? All of the excess would be post-tax dollars, so there'd be no sense in sticking it into a traditional IRA if the Roth were an option...

3. If this turns out to be a good investment strategy, Congress will nix it. It's clear that they didn't want people piling more money in there. One of the ways we wind up with complex tax law is Congress, I'll be charitable, fine-tuning the Code to deal with schemes that people have come up with.

Yes. I really wish Congress would simplify the tax code. It's unfortunate, because I really think the code is complex just because folks of means spend a lot of time (and money on tax attorneys!) trying to circumvent paying taxes, and each time the update the code, they plug a few more holes... only, there's a huge cost to everyone because the code just gets more complex and it becomes more and more time-consuming to get it done properly!

Thanks again!
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<<<< If I can earn 15% annually on that money, and I'm paying 6% annually in the form of tax, do I get the rest tax free? If I earn more than 15% on the assets, and I'm in the highest tax bracket, this would easily work to my advantage. It would allow one to shelter short term gains and not pay as much tax as one would pay if they were in a taxable account. >>


One other point on this issue...if you try it, you're running a BIG risk. An overcontribution is always an overcontribution. And if IRS finds out about it, they can FORCE you to remove the funds and associated earnings...thereby causing you some big tax and penalty problems.

And, not only that, unless your IRA administrator is a complete dummy, they won't let you make...say...a $50,000 contribution to your IRA...when the annual limit is $2k. You could lie to them, of course, and say that it was a rollover. But because of the paperwork required (and reports required to be filed with the IRS by the administrator), it could tip the IRS off to your little plan. And, since there is not "statute of limitations" to requiring the removal of the overcontribution, Uncle Sammy wouldn't necessarily be in any hurry to check you out.

Don't do it. Please.

TMF Taxes
Roy
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Don't do it. Please.

I wouldn't, if I knew for sure that the Congress didn't ever want an IRS to be used in this manner. The problem is, from a reading of the IRS publications, it's simply impossible to know!

I can't tell from 509 if they thought of this and were trying to communicate "You shouldn't do this!" or if they actually were trying to communicate "We hope you'll sock as much as possible into your IRA! Yes, we have to tax you, but as long as you pay the tax, we're happy to have you do it!"

I really couldn't.

Most other issues that I've researched vis-a-vis the IRS publications, I've come away with a pretty clear understanding of.
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<<I wouldn't, if I knew for sure that the Congress didn't ever want an IRS to be used in this manner. The problem is, from a reading of the IRS publications, it's simply impossible to know!>>

Any time Uncle Sammy places a penalty on an issue, you can be sure that they don't want you to do it. I've given you my best advice. Don't do it.

Now you're on your own. Free will and all that...

TMF Taxes
Roy
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I was thinking more of contributing the 2K, despite the fact that I may be phased out now that I am married to someone whose income is significantly more than mine was.
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