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I made contributions to a Roth IRA for 2006, but now Turbo Tax is saying that my "modified adjusted gross income" is too high. Are capital gains considered in this calculation?

Yes. See IRS Publication 590.

Our combined salaries is less than 160,000 but we had a large capital gains that would put us over that limit. I read in an IRS publication under the heading "What Is Not Compensation?" and it listed "Earnings and profits from property, such as rental income, interest income, and dividend income." So I thought that capital gains were not included.

With props to TMFTaxes, you're mixing apples and hand grenades. Capital gains are not "compensation," but they are part of AGI, which is the starting point for calculating Modified AGI. They do not get backed out of MAGI, as you will note in the MAGI calculation worksheet in Pub 590.

Also as I was entering the Roth contributions, Turbo Tax decreased the amount of my calculated refund. Why would contributing to a Roth make my tax liability go up?

If you look at line 60 of the 1040 you'll see that you're being charged 6% of the Roth contribution because it's an excess contribution.

Now let's fix the problem.

If you will be eligible to make 2007 Roth contributions you can leave things as they are, pay the penalty for 2006, and "apply" the 2006 excess to your 2007 contribution. This means that you would reduce your allowable 2007 contribution by the amount of the 2006 excess.

To avoid the penalty you have two choices with respect to the contribution and the earnings on it. In both the contribution and earnings travel together. You can either withdraw it or recharacterize it as a traditional IRA contribution. You can read up about these options in Pub 590.

If you don't leave things as they are, once you've decided what you're going to do you must abandon the interview mode in TurboTax and deal with forms if you want a prayer of getting it right. Let's just leave things where they are until you decide your course of action. Then start a new thread and we can help you with how to deal with it on your return.

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