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As my title indicated my wife and myself both contributed $4000 to our Roth IRA's this year. As a result of me selling some mutual funds (to the tune of $12000 profit) that pushed our adjusted gross income to $159k. Apparently there is a $156k limit on Roth IRA contributions and it turns out we can only contribute $2660 each to our Roth IRAs. It seems I have several options and I'm not sure which is the best:

1. I can pay a 6% penalty ($80 each) this year and put the extra $1340 towards next years Roth. I assume we will be below the limit next year since I don't plan on selling off any funds this year so we should be back below.


2. I can recharacterize $1340 of Roth IRA money into a traditional IRA. I wouldn't have to pay a penalty, but I'm not sure what the benifits of this would be. I know I can later recharacterize that back into a Roth, however since I am above the income limit for deducting IRA contributions wouldn't I pay a double tax? Tax I've I've already paid on the original money put into the Roth and then tax again when I recharacterize the ira money back to a roth (if I decide to do that of course)

Some clarifications here. If you choose option 2 the effect on your 2007 taxes is zero. Assuming that the amount you recharacterize as traditional IRA contributions is nondeductible, you will report that amount on Form 8606, Part I, establishing an after-tax "basis" in your traditional IRA. That money, taxed on your 2007 return, will not be taxed again. See IRS Publication 590 and the instructions for Form 8606.

Should you later want to move that money to a Roth, it would be a conversion, not a recharacterization. Under current law you cannot do that if your Modified AGI exceeds $100,000. Also under current law, the income cap is eliminated in 2010, but that could change.

3. I can get a return of the excess portion ($1360 each) that it seems like I can automaticlly have applied again my '08 contribution instead of getting a check. I have an account with Fidelity and they have a form for this. I'm not sure if the entire 1360 gets applied or how gains/losses are applied and what implications this might have.

This option involves a calculation of earnings, which must also be withdrawn, by a prescribed formula, which you can find in Pub 590. If the earnings are positive you will have a 10% premature distribution penalty on the earnings, regardless of what you do with the distribution (take it in cash or designate it as a 2008 contribution).

4. I think it's also possible for me to change how my cost basis is calculated for the mutual funds that I sold. I sold 5 funds. 2 of which I sold my entire stake in, but 3 of which I sold just a portion of. I used avg. cost basis for my basis. Is it possible for me to select specific shares I wish to sell, which would change my basis a bit, but I think the lowest I could get my AGI would be in the 157k range, which is still above the 156k limit.

This will reduce, but not eliminate, your problem.

Option 2 is the only approach that leaves you with zero effect on your 2007 return, other than reporting any nondeductible traditional IRA contribution. Your penalty for leaving things as they are and reducing your 2008 contributions by the 2007 excess is easily calculated. To figure out what the cost of withdrawing the excess and positive earnings, complete Worksheet 1-3 on page 31 of Pub 590, replacing "recharacterized" with "withdrawn." The penalty would be 10% of the earnings.

Find out what fees your custodian would charge for what actions, and you'll have all the numbers you need as input for your decision.

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