Qualification for Roth IRA contribution

[Guest indcontractor]

I finished attending school last summer. My first job out of school was a temp job, and I was asked to work as an 'independent contractor.'

because my income for last year was very low (less than $2000), I thought contributing to Roth IRA makes much sense. So I contributed the exact amount that I made into Roth IRA (after I got a 'real' job this year but before 4/15.)

I understand that to be eligible for contributing to Roth IRA, you need to have 'earned income'. Since my income is 'earned', I thought I can contribute to Roth IRA. Was I right? or Was I only eligible for Self Employment Plan (SEP) IRA?

If I was not eligible, I need to transfer the money into this year's Roth IRA -- Would there be a penalty for doing so since it's past tax deadline? My bank where I set my Roth IRA account is not reliable when it comes to this type of questions, please help.

[Guest Nighthawk]

You were eligible to contribute up to $2000 or your earned income in this case for a 2001 Roth Ira providing it was done before 4/15/2002.

Milan

[Guest indcontractor]

Thanks Milan,

So 'Earned income' CAN be income from self employment, right?

[Guest Nighthawk]

Yes, if you have taxable income from being self employed it is considered earned income.

Milan

[Guest indcontractor]

Thank you so much for your prompt response. I have some additional questions as I keep finding new information about Roth IRA and tax filing.

I thought that the maximum amount that I can contribute to Roth IRA was my ‘net income’ in case I made less than $2000, but I just found out that the maximum contributable amount was my ‘gross income’... Is this right? If so I will need to pay pricey penalty charge and sales charge for withdrawal from my Roth IRA brokerage account.

I found out that if I hadn’t claimed any deduction for Self Employment expenses (health insurance, travel expenses, etc.), I would have been able to minimize the 6% penalty cost (plus sales charge associated with withdrawing money out of my Roth IRA brokerage account) to a few dollars. Additional tax that I would owe by not claiming deductions would still cost me less than paying full penalty and sales charges for correcting my overcontribution mistake. Therefore, I am considering filing 1040X to amend my tax return and get rid of all the deductions that I originally claimed.

Would this procedure be legal? – I was told that taking deductions is something entirely up to me, and I can choose NOT to take self-employment related deductions even if I AM qualified to do so. I am simply trying to avoid any additional cost, and I wouldn’t want to do this if this will cause another penalty. I am also not sure if I can simply leave this alone as my tax return was already processed and I haven't heard anything from IRS that I need to pay the penalty. (this is off the record.) But it seems like IRS can audit old returns too, so I feel like I should do something to correct my honest mistake.

Also, my gross income includes interest earned from interest earned from my savings account. Will I need to subtract the interest amount from the gross income to figure out my true ‘earned income’ or is ‘earned income’ = ‘gross income’?

[papogi]

The maximum you could contribute in 2001 to a Roth IRA was the lesser of $2000 or your taxable compensation. For purposes of IRA’s, compensation includes wages and salaries from box 1 on your W-2 (this is a gross amount), commissions, and net self-employment earnings. Interest/dividends are not compensation. There is no line on your 1040 for the compensation for IRA purposes. It is not the total income line, and it is not the adjusted gross income line. The deductions you take for half of your SE tax don’t come into play. Compensation for IRA purposes is something you have to calculate separately. If you previously thought that the upper limit was your net compensation, this is lower than gross compensation. Remember that you do use net amounts for self-employment, but gross amounts for wages and salaries. It sounds like you only have self-employment income. Since you made less than $2000, the most you could contribute in 2001 to your Roth is your NET self-employment compensation. You will find that on your SE form, whether you filed the long or short SE form. There is a line for net self-employment income. Based on your previous posts, I think you’re fine.

[Guest indcontractor]

Thank you for your assistance!

To make a long story short, I found out that I definitely made some excess contribution due to some miscellaneous calculations that I haven't mentioned in this board.

I have some questions regarding 6% penalty for the excess contribution.

Citibank IRA enrollment kit states that in order to avoid tax penalty on excess contribution after tax filing deadline, "You could contribute less than the maximum contribution in later years. For example, if you are eligible for a full contribution and you had a $300 excess contribution for tax year #1 and the maximum contribution you could make in tax year #2 is $1200, you could avoid reapplication of the penalty by contributing only $900 in tax year #2 ($1200-$300). Note that you could make a $1200 contribution for tax year #2 as long as you did not contribute the excess in tax year #1."

From the above, it is my understanding that there is no way to avoid the 6% penalty for the over-contributed year (year #1). If so, will there be any problem if the taxpayer pays the penalty but does NOT withdraw the excess contribution (as long as s/he does contribute less than maximum amount into the following year’s IRA)? OR does the excess amount have to be withdrawn under any circumstances?

OR is there still a way to avoid the 6% penalty for the over-contributed year? On Page 52, chapter 2 of Form 590 states, “If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year.” Does this mean that as long as excess contribution is applied to a later year, there is no 6% penalty at all?

I appreciate your help and guidance.

[papogi]

You have to pay the 6% penalty at least once. If your excess contribution was in 2001, then your taxes filed in April should have reflected this on Form 5329, Part IV. Since you did not apparently deal with this, first you should file an amended return for 2001. This will result in your owing 6% of the excess contribution. It is an additional tax to pay (line 55 on 1040), and does not affect your income.

Once this is rectified, you need to be sure to put an amount into your Roth IRA in 2002 that is lowered by the excess contribution from 2001. You will need to file Form 5329 in April 2003 for the 2002 tax year. In Part IV, you will then show the IRS that the excess from 2001 is cancelled out by the lowered amount from 2002. There will be no penalty for the 2002 tax year, but the form still needs to be completed. For the 2003 tax year, there will be no reporting requirement for this situation.

[Guest indcontractor]

Thank you so much for your guidance.

Now I understand that I owe 6% penalty no matter what. However, do I need to 'withdraw' excess contribution or can I keep it there as long as I pay the penalty? (If possible, I want to avoid paying deferred sales charge for withdrawing excess amount since my IRA is mutual fund.)

[papogi]

You don't need to withdraw the money. Following the steps in my previous post will get you free and clear by the 2003 tax year.

[Guest indcontractor]

"You will need to file Form 5329 in April 2003 for the 2002 tax year. In Part IV, you will then show the IRS that the excess from 2001 is cancelled out by the lowered amount from 2002. There will be no penalty for the 2002 tax year, but the form still needs to be completed. "

What if I do not contribute any money into 2002 IRA?

Is there a deadline for filing ammended 2001 return?

Also, apparently IRS processed my 2001 return without finding any problems -- but they can still catch me for the mistake in the future, right? (What I am afraid is the accumulated 6% reapplication penalty if IRS checks everything in details possibly when I take out money in 30+years.)

[papogi]

You don't have to contribute in 2002. For 2002 line 19 (Form 5329) will be $3000 in that case, and line 24 will be zero. An amended return generally must be filed within 3 years of the date you originally filed for that year. Definitely do it this year. Each year you wait adds another 6% penalty to pay. Incidentally, I'm not at all surprised that the IRS did not see anything wrong with your return off the bat. I would be worried, however, since your IRA custodian submitted this information directly to the IRS, and they very well may see it in the future. 6% of an overage probably is not a great amount of money to pay in order to be certain that everything is kosher.