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Author: djruiz Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 122859  
Subject: roth ira contribution question Date: 1/14/2000 11:55 PM
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I just finished reading the article Roth IRA - Part 1 by Roy Lewis. I have just a couple questions, both having to do with earned income. The first involves severance pay and the second bonuses paid after severance.

Hypothetical situation. Employee is offered a voluntary severance package late in 1999. He accepts the package and elects to take severance pay in a lump sum the following January 2000. Also, since he worked the majority of 1999, he will be eligible to recieve any performance bonuses paid out in April 2000 for performance during the 1999 work year. He then decides to take some time off and travel. He does not intend to work again until the year 2001.

Question. Will he be eligbile to contribute anything to a Roth IRA in the year 2000? Although he will not be working, he will recieve income 2 times in the year 2000. The article did not specifically mention anything about severance pay, but I'm guessing a big fat NO on that one. Still, it would be nice to be sure. The article does specifically mention bonuses and goes on to state that it is considered earned income, but I'm not sure that the author meant it to apply to this situation (the situation being that the individual will not be working at all during the year the contribution is made). Again, it would be nice to be sure.

A great big THANK YOU to anyone who could help. An even BIGGER THANK YOU to anyone who could point me to some type of official documentation that could confirm one way or the other. Lastly, an average size thank you for even reading this far. I tend to be long winded sometimes. Sorry.

Dan.
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Author: pmarti Big funky green star, 20000 posts Home Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25088 of 122859
Subject: Re: roth ira contribution question Date: 1/15/2000 4:31 AM
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<< Although he will not be working, he will recieve income 2 times in the year 2000. The article did not specifically mention anything about severance pay, but I'm guessing a big fat NO on that one. Still, it would be nice to be sure. The article does specifically mention bonuses and goes on to state that it is considered earned income, but I'm not sure that the author meant it to apply to this situation (the situation being that the individual will not be working at all during the year the contribution is made). Again, it would be nice to be sure. >>

It's earned income if it's reported as wages, which I think will apply to both severance and bonuses. The law doesn't care whether you were sweating while you earned it. IOW, if it goes on line 7 of your 1040, it qualifies as earned income for IRA contributions.

IRS has issued a lot of guidance on this, but I couldn't point you to a specific. I'd first try IRS Publication 590, available at http://www.irs.gov.

Phil Marti
Tax Preparer

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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25146 of 122859
Subject: Re: roth ira contribution question Date: 1/15/2000 8:32 PM
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<<I just finished reading the article Roth IRA - Part 1 by Roy Lewis. I have just a couple questions, both having to do with earned income. The first involves severance pay and the second bonuses paid after severance.>>

OK, Dan...let me see what I can do.

<<Hypothetical situation.>>

I prefer real live situations. Hypos can be annoying, since they don't necessarily have any basis in reality. But let's move forward.

<< Employee is offered a voluntary severance package late in 1999. He accepts the package and elects to take severance pay in a lump sum the following January 2000. Also, since he worked the majority of 1999, he will be eligible to recieve any performance bonuses paid out in April 2000 for performance during the 1999 work year. He then decides to take some time off and travel. He does not intend to work again until the year 2001.>>

OK...

<<Question. Will he be eligbile to contribute anything to a Roth IRA in the year 2000?>>

In your example above, you didn't say when the bonuses were actually PAID. Compensation in the form of payroll (such as you describe above) is reported to you on your W-2 form in the year PAID...not in the year "earned". So the answer to your question will depend on when the payments are actually made to the employee.

<< Although he will not be working, he will recieve income 2 times in the year 2000. The article did not specifically mention anything about severance pay, but I'm guessing a big fat NO on that one. Still, it would be nice to be sure.>>

Again...wages are reported in the year paid...not when "earned". So the payment date will control the AGI for contribution purposes.

<< The article does specifically mention bonuses and goes on to state that it is considered earned income, but I'm not sure that the author meant it to apply to this situation (the situation being that the individual will not be working at all during the year the contribution is made). Again, it would be nice to be sure.>>

Again, I assumed that everybody knew that compensation was reported in the year paid...and not when earned. But, obviously, it was wrong to make that assumption since many people might have the same questions that you have. So I apologize for not making this clear in the original article.

<<A great big THANK YOU to anyone who could help. An even BIGGER THANK YOU to anyone who could point me to some type of official documentation that could confirm one way or the other. Lastly, an average size thank you for even reading this far. I tend to be long winded sometimes. Sorry.>>

If you want to check when income is earned, you can go to the IRS web site and check out code section 451 and regulations 1.451

Hope this helps...
TMF Taxes
Roy



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Author: djruiz Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25164 of 122859
Subject: Re: roth ira contribution question Date: 1/16/2000 2:03 AM
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Ok, I'll come clean. It's not a hypothetical situation. It's my situation. Just felt a little strange saying so.

I was severed from the company I worked for in October of last year (1999). I am now in Mexico and do not intend to return to the states for at least a year.

I thought that I did make it clear in the last post that both the severance payout and bonus were to occur this year, in January 2000 and April 2000 respectively.

I asked this same question of a financial planner brought in by my x-employer during the exit process. I was told by them that severance was NOT considered earned income for the purposes of contributing to a ROTH IRA. I did not ask if the same was true for the bonus because I did not know that I would be recieving one at the time. Since then, many people have been telling me that both are earned income for 2000, which inspired my original post.

Lastly, I'm not even sure how my income for this year will be reported come tax time or how my W2 will look. I understand how strange this sounds and how ignorant that makes me look, but the truth is that this is the first time I've ever been severed from a company, as of October 31, 1999 I am no longer on the payroll of any company (I no longer have an employer), the check I recieved for severance pay this month did not include all the boxes at the bottom that reported W2 taxable income (although they did withhold a truckload of taxes), and the only people I can really call to consult on the issue (the HR folks from my previous company) have either told me that they didn't know either or (in the case of the Financial Planner that they hired) that the severance money was a lump sum paid out to help the process of finding new employment and was not considered earned income. Perhaps I should just ignore everyone else and let it rest there. Not particularly foolish, but then again, residing currently in a foreign country makes it more difficult to follow up on (and expensive when I have to make phone calls) and I'm not particularly tax savvy.


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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25295 of 122859
Subject: Re: roth ira contribution question Date: 1/17/2000 6:30 PM
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<<I thought that I did make it clear in the last post that both the severance payout and bonus were to occur this year, in January 2000 and April 2000 respectively. >>

Sorry...you did make that clear. After going back and re-reading your original question, it was very clear. I must have just missed it. My apologies.

<<I asked this same question of a financial planner brought in by my x-employer during the exit process. I was told by them that severance was NOT considered earned income for the purposes of contributing to a ROTH IRA. >>

Balderdash!!! W-2 income is considered "earned" for Roth IRA purposes...and for all other purposes. So the financial planner just didn't know his or her stuff.

<<I did not ask if the same was true for the bonus because I did not know that I would be recieving one at the time. Since then, many people have been telling me that both are earned income for 2000, which inspired my original post.>>

And it sounds like your friends are better versed in this issue than the financial planner. Sad but true...at least in this case.

<<Lastly, I'm not even sure how my income for this year will be reported come tax time or how my W2 will look.>>

Well...all I can tell you is that it's very likely that your severence and bonus will be paid via W-2. And if that is the case, then it's earned income in the year that you receive the income...and not in the year it was necessarily earned.

<< I understand how strange this sounds and how ignorant that makes me look, but the truth is that this is the first time I've ever been severed from a company, as of October 31, 1999 I am no longer on the payroll of any company (I no longer have an employer), the check I recieved for severance pay this month did not include all the boxes at the bottom that reported W2 taxable income (although they did withhold a truckload of taxes), and the only people I can really call to consult on the issue (the HR folks from my previous company) have either told me that they didn't know either or (in the case of the Financial Planner that they hired) that the severance money was a lump sum paid out to help the process of finding new employment and was not considered earned income.>>

Sounds goofy to me, and pretty unusual. But I certainly can't refute what you are being told without some additional documentation. But I have never seen severence pay made without a W-2 form. Perhaps others have. If so, please enlighten me. It's very possible that I'm the one that is ignorant on this issue.

<< Perhaps I should just ignore everyone else and let it rest there. Not particularly foolish, but then again, residing currently in a foreign country makes it more difficult to follow up on (and expensive when I have to make phone calls) and I'm not particularly tax savvy.>>

As you say, all you can do is depend on pros who are suppose to know this stuff. But there MUST be a way to get your hands on the information. Heck, somebody with experience in this issue can look at your "pay" stub and see what taxes were withheld. That'll give you a clue. If there were deductions for FICA and/or Medicare, this income will certainly be considered "earned"...regardless if any federal or state withholding was removed or not.

TMF Taxes
Roy


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Author: pmarti Big funky green star, 20000 posts Home Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25319 of 122859
Subject: Re: roth ira contribution question Date: 1/17/2000 7:53 PM
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<< Sounds goofy to me, and pretty unusual. But I certainly can't refute what you are being told without some additional documentation. But I have never seen severence pay made without a W-2 form. Perhaps others have. If so, please enlighten me. It's very possible that I'm the one that is ignorant on this issue. >>

I've always seen severence treated as wages also. I do recall, a couple of years ago, that a group of (IBM?) employees (in upstate NY?) were challenging this in court in an effort to avoid FICA and Medicare, but I don't recall what, if anything, came of it.

Phil Marti

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Author: djruiz Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25334 of 122859
Subject: Re: roth ira contribution question Date: 1/18/2000 1:36 AM
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Roy and Marti,

There were indeed FICA and Medicare taxes withheld from the check. Based on what you say, it sounds promising.

I did search through the IRS website. Found nothing specific. They did have a Tax Law questions by email function so I submitted the question to them.

I did develop another concern based on something that I encountered on the IRS website. I took the following quote from an article entitled Employee Compensation.

If you are an employee, you should receive a Form W-2 from your employer showing the pay you received for your services. Include your pay on line 7 of Form 1040 or Form 1040A, or on line 1 of Form 1040EZ, even if you do not receive a Form W-2.

If you are not an employee, you generally will not receive a Form W-2. Nonemployee compensation is generally reported on Form 1099-MISC, Miscellaneous Income. For information on reporting nonemployee compensation, see the instructions on the back of Form 1099-MISC

Based on this excerpt and the fact that my employment terminated in October of last year, do you think that it is possible that my severance income will be reported on this 1099-MISC instead of the W-2? I did not know enough to ask this question of my employer before I left and I don't particularly feel excited about spending another $15 to be put on hold and then told that they don't know again.

Another thought is, if I put the $2000 in, and then early next year find out that I wasn't supposed to, is it possible to take it back out as if I never put it in in the first place. Somebody mentioned that this might be possible and something I should consider.

Lastly, thanks for all your help. You guys are great.

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Author: RooCat Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25337 of 122859
Subject: Re: roth ira contribution question Date: 1/18/2000 2:27 AM
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do you think that it is possible that my severance income will be reported on this 1099-MISC instead of the W-2?

Possible but not probable. IRS frowns on Employers giving 1099s to W-2 employees. You were given the severence pay while still an employee. Additionally, the fact that SS & MC were withhold indicates this will be on a W-2 form.

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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25364 of 122859
Subject: Re: roth ira contribution question Date: 1/18/2000 1:16 PM
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<<I've always seen severence treated as wages also. I do recall, a couple of years ago, that a group of (IBM?) employees (in upstate NY?) were challenging this in court in an effort to avoid FICA and Medicare, but I don't recall what, if anything, came of it.>>

Right...they were actually trying to make the severance pay non-taxable due to damages paid on behalf of an age discrimination suit. Last I hear the employees lost on all counts...but I haven't followed it that closely.

TMF Taxes
Roy



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Author: TMFTaxes Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25371 of 122859
Subject: Re: roth ira contribution question Date: 1/18/2000 1:28 PM
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<<There were indeed FICA and Medicare taxes withheld from the check. Based on what you say, it sounds promising. >>

Don't know about promising...but it sure sounds like "earned" income.

<<I did search through the IRS website. Found nothing specific. They did have a Tax Law questions by email function so I submitted the question to them. >>

Good luck...

<<I did develop another concern based on something that I encountered on the IRS website. I took the following quote from an article entitled Employee Compensation.>>

OK...

<<If you are an employee, you should receive a Form W-2 from your employer showing the pay you received for your services. Include your pay on line 7 of Form 1040 or Form 1040A, or on line 1 of Form 1040EZ, even if you do not receive a Form W-2.>>

Right...

<<If you are not an employee, you generally will not receive a Form W-2. Nonemployee compensation is generally reported on Form 1099-MISC, Miscellaneous Income. For information on reporting nonemployee compensation, see the instructions on the back of Form 1099-MISC>>

OK again...

<<Based on this excerpt and the fact that my employment terminated in October of last year, do you think that it is possible that my severance income will be reported on this 1099-MISC instead of the W-2?>>

Anything's possible, but I would be very, very surprised. 1099 forms are for non-employee compensation, with no withholding for FICA or FWT. It would be a real twist of logic to give you a 1099 while at the same time withholding FICA. It just wouldn't make any sense.

<< I did not know enough to ask this question of my employer before I left and I don't particularly feel excited about spending another $15 to be put on hold and then told that they don't know again.>>

Can't blame you...

<<Another thought is, if I put the $2000 in, and then early next year find out that I wasn't supposed to, is it possible to take it back out as if I never put it in in the first place. Somebody mentioned that this might be possible and something I should consider.>>

Sure...you can recharacterize the Roth IRA back to a traditional IRA (including the contributions and the earnings). The deductibility of the IRA will be based upon a new set of rules (as noted in the Taxes FAQ area). But the worst that would happen is that you would have a non-deductible traditional IRA.

You could certainly remove the contribution (tax and penalty free), but any earnings that are removed would be subject to both tax and penalties.

So the choice is yours...but a recharacterization would likely be in your best interest. This is also discussed in the Taxes FAQ area.

TMF Taxes
Roy


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Author: BladeXrunners One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25423 of 122859
Subject: Re: roth ira contribution question Date: 1/18/2000 5:51 PM
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djruiz wrotes:

<<Another thought is, if I put the $2000 in, and then early next year find out that I wasn't supposed to, is it possible to take it back out as if I never put it in in the first place. Somebody mentioned that this might be possible and something I should consider.>>

Roy wrotes:

Sure...you can recharacterize the Roth IRA back to a traditional IRA (including the contributions and the earnings). The deductibility of the IRA will be based upon a new set of rules (as noted in the Taxes FAQ area). But the worst that would happen is that you would have a non-deductible traditional IRA.

If it turn out that Dan can't contribute to his Roth IRA because he received no compensation, then he won't be able to recharacterize to the traditional IRA because he still wouldn't have any compensation to be eligible to contribute to a traditional IRA.

So, his is only option is really to withdraw his contribution and its earning. No penalty. But he'll have to pay tax on his earning.

But I don't think Dan have anything to worry about because I agree with everyone that severance pay=termination pay=payment for services rendered=compensation. Likewise for bonuses. (Sorry, no definitive quote, but Pub 17 Your Federal Income Tax & Pub 15 Circular E, Employer's Tax Guide give very strong indication--I'm trying to read the tax code, but those suckers are confusing.)

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Author: BladeXrunners One star, 50 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25429 of 122859
Subject: Re: roth ira contribution question Date: 1/18/2000 7:14 PM
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Oops. Typo in my post.

The earning on the excess contribution are subject to 10% penalty.

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Author: djruiz Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25445 of 122859
Subject: Re: roth ira contribution question Date: 1/18/2000 11:54 PM
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Ok everyone, I'm sold. I think I actually feel comfortable enough to go ahead and make the contribution.

One last question though (I promise this time). If it turns out that next year come tax time I have to withdraw the contribution and its earnings, how is it possible to determine which earnings were from the $2000 contribution this year as opposed to earnings from contributions from previous years?

I realize and agree that the likelyhood of having to withdraw the contribution is minimal. I'm still curious to know how that would work though.

Thanks again for all the help everyone.

Dan.

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Author: ptheland Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 25479 of 122859
Subject: Re: roth ira contribution question Date: 1/19/2000 12:36 PM
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Ok everyone, I'm sold. I think I actually feel comfortable enough to go ahead and make the contribution.

I'm glad you got the reassurance you needed.

One last question though (I promise this time). If it turns out that next year come tax time I have to withdraw the contribution and its earnings, how is it possible to determine which earnings were from the $2000 contribution this year as opposed to earnings from contributions from previous years?

I realize and agree that the likelyhood of having to withdraw the contribution is minimal. I'm still curious to know how that would work though.


The easiest way (by far) would be to open a separate account with this year's contribution. Then the balance in the account is easily seen as the contribution and earnings. You might look at Roy's article on how many Roth's you need. It's in the FAQ - the link is at the top of this page.

The next best choice (if you make the contribution to an existing account) is to ask your custodian to figure the amount for you. I understand that should you need to withdraw or recharacterize an excess contribution many custodians will insist on calculating the earnings for you. (I should note that I haven't seen this myself - I'm only relating what I've heard from others.)

I would give this a sanity check by doing the following: find the FMV of the account on the date the contribution was made, and then find the proportion of the contribution to the FMV. Say the FMV of the IRA on the date you made the contribution was $10,000 (including the new contribution of $2,000) then the contribution would be 2000/10000 or 1/5 of the account. On the date you withdrew the excess contribution and earnings, I'd take out 1/5 of the account. The excess of this over $2,000 (or the shortage under - it could go down!) would be the earnings on the contribution.

This makes the most sense for an IRA invested in a mutual fund, or one with fairly active trading. If you can trace the contribution to a specific security, you could argue that the security is the contribution and look only at it's earnings and change in value.

BIG WARNING!!!
I don't know if either of these are a correct way (in the IRS's eyes) of doing the earnings calculation. I only present them as a sanity check on your custodian's calc of the numbers. I'm pretty sure, however, that the separate account way is perfectly acceptable to our big uncle.

--Peter

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