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Fools,

At the beginning of 2006 my wife and I both made contributions to our Roth IRAs totaling $8000.

At the time there was no way for me to know that we would end up effectively having zero earned income for the year 2006.

I am certain that I must address this, but do not know how to do so. I have tried the IRS website but did not find any answers.

Any tax savvy fools who know what I need to do to correct this? What are the rules, my options?

Note to self: make sure you have minimum earned income of 8000 in 2007 in order to get the benefit of the Roth.

thanks
Eric

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At the beginning of 2006 my wife and I both made contributions to our Roth IRAs totaling $8000.

At the time there was no way for me to know that we would end up effectively having zero earned income for the year 2006.


You sound like you know what you're talking about, but that word "effectively" bothers me. Did you have earned income or not? Assuming you didn't,

I am certain that I must address this, but do not know how to do so. I have tried the IRS website but did not find any answers.

Any tax savvy fools who know what I need to do to correct this? What are the rules, my options?

Note to self: make sure you have minimum earned income of 8000 in 2007 in order to get the benefit of the Roth.


You have two choices, both covered in IRS Publication 590. You can withdraw the contributions and the earnings on them by the extended due date of your 2006 return. The income is 2006 taxable income and is subject to the 10% early distribution penalty if you're not 59 1/2.

The other option is to leave it alone and pay the 6% excess contribution penalty for 2006. This might be a better option if both of the following are true:

1. Your investments have performed well, and

2. You will definitely have $8,000 in taxable compensation in 2007.

If you go the route of leaving it alone, you cannot make any IRA contributions, traditional or Roth, for 2007.

Phil
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Phil and fools,

Thank you for the reply.

In my ROTH there were gains on the 4000, in the neighborhood of 6.5% over the year. I suppose paying the 6% penalty, $240, makes it a wash, probably better and easier than going through the act of withdrawing funds, declaring the income and paying a penalty. I will have earned income in 2007, so I suppose leaving it alone makes the most sense.

In my wife's account the 4000 bought Johnson and Johnson's which for the year showed a slight loss. At first glance I thought it made sense to withdraw, pay the under 59 penalty and start fresh this year, BUT, $400, the 10% penalty, would be higher than the 6% excess contribution penalty.

Seems I should just leave both alone, make no contributions this year and pony up the $480 (240 for each account) and make some better investment decisions for 2007 ;-)

What do you think?

Thanks,Eric
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In my ROTH there were gains on the 4000, in the neighborhood of 6.5% over the year. I suppose paying the 6% penalty, $240, makes it a wash, probably better and easier than going through the act of withdrawing funds, declaring the income and paying a penalty. I will have earned income in 2007, so I suppose leaving it alone makes the most sense.

I agree. In addition to what you mention, the earnings would add to your taxable income.

In my wife's account the 4000 bought Johnson and Johnson's which for the year showed a slight loss. At first glance I thought it made sense to withdraw, pay the under 59 penalty and start fresh this year, BUT, $400, the 10% penalty, would be higher than the 6% excess contribution penalty.

This one you should withdraw. Remember that the contribution has no effect on your taxes going in, so it has no effect on your taxes coming out. Since the account has decreased in value you actually take out less than $4,000 with zero effect on your taxes.

Note that both these scenarios assume that the 2006 contributions were the only thing in these accounts. The actual method of calculating gains involves the entire account. I think it's explained in Pub 590.

Phil

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In my ROTH there were gains on the 4000, in the neighborhood of 6.5% over the year. I suppose paying the 6% penalty, $240, makes it a wash, probably better and easier than going through the act of withdrawing funds, declaring the income and paying a penalty. I will have earned income in 2007, so I suppose leaving it alone makes the most sense.

Let's calculate those penalties correctly before you go making any decision.

The excess contribution penalty would be 6% of $4000 or $240. But to withdraw the excess contribution and earnings would mean you pay tax and penalty on the earnings only. Since you earned about 6.5%, that would translate into about $260. So you'd pay tax on $260 at, say 25%, or $65. And the penalty would be 10% of $260 or $26. That totals up to $91 of tax and penalty for the withdrawal option.

In my wife's account the 4000 bought Johnson and Johnson's which for the year showed a slight loss. At first glance I thought it made sense to withdraw, pay the under 59 penalty and start fresh this year, BUT, $400, the 10% penalty, would be higher than the 6% excess contribution penalty.

Don't forget to include the dividends in you calculus. And while I'm thinking about it, are there any previous contributions or conversions in these Roth accounts? Or is the only thing in the accounts your 2006 contribution? If there are other funds in the account, you don't get to just look at what you bought with your 2006 contribution. You have to look at the total value of the account to figure up the earnings to withdraw. That could have a big impact on your figuring.

But assuming you have the easier situation of there not being any other funds in your wife's account, she would not have a penalty for withdrawing her excess contribution and earnings. Only the earnings would be penalized. But there are no earnings. So there is no penalty.

Just some food for thought.

--Peter
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Now things are getting interesting.

Both accounts have more than the $4000 in them, mine much more.

Mine will be particularly fun because I converted my regular ira into the roth in 2006.

Seems I better start digging into that IRS publication.

Eric

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Looks like I have this straightened out.

I will be filling out an IRA distribution form provided by my broker, schwab.

There is actually an area on the form where one can declare that the distribution is due to excess contribution.

The 6% penalty applies only to earnings on the excess contribution, if the distribution is taken before April 15th, end of tax year, it is that simple. This distribution is treated by the IRS as an "amount not contributed".

I can either determine the gains myself or have the broker's tax department use an approved IRS formula to determine the gains. This formula takes in the entire gain on the account and then applies a number proportionate to the excess contribution.

My account will see a slight penalty, my wife's account was down overall for the tax year, VLO grrrrr, so hers will be simple to clean up.

Thanks all for the input, great stuff.
eric
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The 6% penalty applies only to earnings on the excess contribution, if the distribution is taken before April 15th, end of tax year, it is that simple.

It's that simple, but the penalty is 10% of the earnings, not 6%.

Phil
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