Tax treatment of Roth IRA gains involving excess contributions

[Guest uneek]

I know that gains from an excess contribution are taxable, but I think this scenario might be a bit different than usual.

I have a cash account at a brokerage designated as a Roth IRA. I use this account to buy and sell stock.

Since this is a cash account (and adding margin privileges would void the IRA), Regulation T compliance is especially important. My question is, how are gains on the sale of securities taxed when there is an excess contribution made in order to comply with Regulation T (where the contributions are subsequently withdrawn on the settlement date)?

In other words, are the gains 'attached' to the excess contribution (and thus required to be withdrawn and taxed) or are they attached to the (unsettled) proceeds from the original sale?

My opinion is that since Reg. T's Free Rider stipulation concerns the amount of time that banks are permitted to settle the proceeds from a sale of securities, any excess contribution made to cover a purchase does not produce the gain from the 2nd sale, but the contribution is made in order to cover a position in case the funds from the original sale are not *available* to make the 2nd purchase.

Seems to me that the excess contribution is an insurance policy against the possibility of funds not clearing in time, but that the gains from the transaction are the result of a sale that uses albeit unsettled funds.

If I were to make an excess contribution in order to avoid a free ride, could I then withdraw this contribution without the gains from the sale being taxable?

Failing this, can the gains be pro-rated in some way between the unsettled funds and the (excess contribution) extra contributed funds involved in the purchase? Perhaps at the time-value attached to the extra contribution in lieu of the bank marking up the unsettled funds to settle at the speed of the transaction rather than the 3 day period (or perhaps this isn't possible under regulation T, that 3 days is 3 days, period)?

[Slider]

This looks more like a loan to the Roth IRA rather than an excess contribution, thus possibly creating a prohibited transaction. Unless this comes within an exemption to the prohibited transaction rules (I doubt that PTCE 80-26 applies, even though it has the "three day rule"), the Roth IRA potentially could be disqualified (i.e., lose it's tax exemption).

Althought Section 408A does not refer specifically to prohibited transactions, following the reference in 408A to 7701(a)(37) back to 408(a) and (b), would seem to incorporate the prohibited transaction rules by reference. The DOL has takenthat position in a number of advisory opinions and PTEs.

[Guest uneek]

Thank you

[John G]

I am not sure I understand the details of your problem. Is this a theoretical issue, or a problem you custodian has confronted you about. Are you daytrading and have overlaping transactions? Are you buying/selling obscure stocks like microcaps or international stocks? The "solution" of putting in extra funds and then extracting it out could cause you a lot more problems than just slowing down the trade fequency, or segmenting the assets into subaccounts that are never traded on the same three day cycle.

I am curious which custodian (if any) is suggesting this complicate scheme of adding fund and then taking the extra out.

With normal excess contributions, custodians must calculate the earnings on the excess amount. I find it hard to believe that a custodian would want to take on this extra task on any frequent basis. You are correct that you can't have a margin account and incorporate any type of borrowings on a Roth or IRA.

As this issue is way out of the mainstream, you may want to consider hiring legal/tax advice from professionals.

[Guest uneek]

Hi,

No, this is purely theoretical.

I do overlap trades, typically the scenario is that I will sell a stock, and then rebuy it later that day or the next day. So I am unable to sell for 2 or 3 days and a lot can happen in that time.

No one has suggested anything to me about excess contributions, this is purely my own speculation.

I do own an international stock - how'd you guess? I own shares that trade on the AMEX but there are also shares on the TSX.

[John G]

Irregularities on NYSE and NAZDAQ are very rare. Some foreign exchange transactions get a little sticky.

I suggest you talk with your custodian about what restrictions they may impose. They can hold you to a higher standard then the IRS would impose. Not all custodians will treat unusual trading the same way. When you call, ask for the back office IRA desk. The average telephone or front desk clerk will not know enough.