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unqualified Roth IRA contributions


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#1 swamp100

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Posted 03 April 2006 - 12:13 PM

My wife and I made $4k 2006 Roth IRA contributions in Januay,2006. However, due to an unexpected income last month, our 2006 AGI will exceed $160k. What are our options?

Thanks in advance!

#2 txdd

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Posted 05 April 2006 - 10:13 AM

1) Leave them there and pay 6% penalty each year until you are eligible for contributions again.

2) Withdraw contributions plus earnings by 10/15/07. Positive earnings subject to tax and possible 10% penalty in 2006 taxes.

3) Recharacterize contributions plus earnings to traditional IRA by 10/15/07. No tax or penalty. Contributions deductible in 2006 if neither of you covered by employer retirement plan.

#3 swamp100

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Posted 06 April 2006 - 09:25 AM

1) Leave them there and pay 6% penalty each year until you are eligible for contributions again.

2) Withdraw contributions plus earnings by 10/15/07. Positive earnings subject to tax and possible 10% penalty in 2006 taxes.

3) Recharacterize contributions plus earnings to traditional IRA by 10/15/07. No tax or penalty. Contributions deductible in 2006 if neither of you covered by employer retirement plan.


Thanks for your reply!

Regarding to option3, I have a question about how it will be taxed after we reach 59.5 years old. I am covered by 401(k), so the contribution is the after tax money. When we get distribution from this recharacterized traditional IRA, will all the money (orignal contribution + gain) be taxed as income, or only the gain will be taxed?

Thanks!

#4 txdd

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Posted 07 April 2006 - 09:04 AM

In a nutshell ...

When an individual makes non-deductible contributions to a traditional IRA, he/she reports them on Form 8606 and establishes a "basis" in that individual's IRA accounts. Subsequent withdrawals from any regular IRA (not Roths) are then partially tax-free according to the ratio of the total basis in all regular IRA's for that individual to the total balance in those IRA's. The remaining basis is reduced by the tax-free amount. You also file Form 8606 to report partially taxable withdrawals. Note that an IRA created by rolling over your 401k would be included in the calculation.

See IRS Pub 590 and Form 8606 for details.

#5 swamp100

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Posted 18 April 2006 - 03:39 PM

Thanks txdd for your reply!

If I choose to recharacterize to traditional IRA, the gain will be taxed as income. The tax rate will be higher than long term capital gain rate. I think I am going to option #2, and put the money into a taxable account.

In your first reply, you mentioned the positive earning is subject to POSSIBLE 10% penalty. Could you elaborate under which circumstance I have to pay the penalty? Actually, I called Vanguard custome service about this question, the told me the IRS rules is not clear about it, I need to cousult with a tax advisor about it ...

#6 txdd

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Posted 19 April 2006 - 09:14 AM

IRS rules for distributions from Roth IRA's are clear but also complicated. Probably too complicated for phone reps or this board to explain.

Since you are less than 59.5, you are PROBABLY subject to the 10% penalty (only on the amount in excess of your contribution). There are exceptions. Get IRS Pub 590 and read the paragraphs under "Are Distributions Taxable?" in the Roth IRA section.

You can judge whether it makes sense to pay for advice based on the amount of the potential penalty. If you don't think you meet any of the listed exceptions, you are likely better off just paying up.