Roth IRA excess contribution

[Guest kapil]

Hi,

In 2005 I added 4000$ to my existing roth IRA in scottrade. My existing roth IRA has 8K all invested in mutual funds. I didn't do anything with the 4K and it just sat there, not earning anything. Now when filing the taxes I realized I can't contribute due to exceeding income limits. I requested withdrawal of the excess of 4K. Scottrade sent me a check for 4666 666 being the earnings. They said during the time the account had grown from 12K to 14K due to gains in mutual funds. So 2K*4/12 = 666 is the earnings on 4K.

I don't think this is right. The 8K would have earned 2K whether or not I had put in the 4K. The 4K didn't earn anything, so shouldnt I just be getting 4K?

I spoke to IRS on their phone line and they agreed, but scottrade is not convinced. What should I do? Who is right?

The kicker here is overall I am still at a loss of $100 in my IRA, so don't want to pay taxes on 666$ and accumulate 766$ loss in my IRA! I am thinking of just withdrawing everything so that I dont have to pay any taxes, but somehow think maybe thats not such a good idea, there has to be a better way. Such a huge penalty for being a dedicated investor setting aside a small amount for roth ira?

thanks

[John G]

Your both right. Scottrade is using a method they think is defensible, by their general scheme, your incremental 4K became part of a portfolio that had a gain. Their snapshot should be account value when contribution was made vs value when they exited. That makes lots of sense an answer you would get from many custodians.

The IRS supported your position which, while weaker, has some credibility. You can argue that you placed the funds into the account and kept them in cash waiting to see if you qualified for a 4K contribution. If you made not other transactions after the contribution date, you have an alternative scenario. As money market assets, those funds increased only a tiny amount. Sounds reasonable and looks like it is supported by the facts.

You may want to get your accountant or tax preparer to send Scottrade a letter, which you could also include in your tax return. The problem comes in trying to get your custodian to change their conclusion as they will say this is too chaotic and introduce "exceptions". But, try again and perhaps ask for the main office retirement dept. The key is to get them to refund a check for 4K plus money market interest. You can try to file your return including a letter of explaination to the IRS that you spoke with their office and how you handled the arrangement.

Close all Roths? Even if you can't get Scottrade to accept your position, I would not do this. You have not given us all the facts such as your age or your retirement account history. Those imbedded losses could look like a small splinter many decades from now when you account is large. The tax on $660 could be about $200 and frankly is less than what your time and your accountants fee for resolving this problem. As much as you might hate this answer, the best option might be to pay it and move on.

If you are going to consistently exceed the income limits for Roths, you need to investigate other tax shelters like Keoghs, 401k, pension/profit sharing, etc. that will allow you build a bigger nest egg. You accountant can point out which programs best fit your circumstances.