Withdrawing Excess Contributions

[Guest ntrainer]

My basic question is how to calculate "earnings on contributions" when I'm withdrawing excess contributions placed in a Roth IRA. My husband just received a bonus that will probably place us in the middle of the "Modified AGI" limits for contributing to a Roth IRA. Let's say, hypothetically, that our "Modified AGI" will be $152,000 for 2006. We have each already contributed $4,000 to our Roth IRAs since we didn't anticipate the bonus. According to my calculations (and based on the IRS' instructions), this means that the maximum each of us should be able to contribute to a Roth IRA is $3,200.

I understand that, according to IRS Publication 590, I can avoid paying a 6% excise tax that would otherwise be due for excess contributions to my Roth IRA. But in order to do so, I must not only withdraw our excess contributions of $800 apiece, I must also withdraw "earnings on the contributions."

How do I figure out how much of my earnings to allocate to the excess contribution? Each of our IRAs has approximately $18,800 in it at the moment. Each of the IRAs (invested in Vanguard mutual funds) received approximately $150 in dividends during the year. One way to calculate the relevant amount would be to assume that if the principal of $18,800 had been reduced by the excess contributions of $800, then we'd have earned about 4% fewer dividends (since $800/$18,800 = 4%). Thus we should withdraw excess earnings of 4% x $150, or $6.38, in addition to withdrawing $800 apiece.

Vanguard hasn't offered me any help in performing these calculations. I'm hoping I'm on the right track or someone here can point me toward the right track.

I'm also hoping there's nothing wrong with simply transferring our excess contributions (and excess earnings) into our Traditional IRAs, also with Vanguard. We're way beyond the point at which our IRA contributions would be deductible, but I'd still rather put that money toward retirement. Please let me know if that would pose any tax-related problems.

[Appleby]

There is nothing wrong with transferring the excess Roth IRA contribution to your traditional IRA, providing your aggregate contribution (for both your traditional and Roth IRAs, ) do not exceed $4,000 ( $5,000 if you reach age 50 by year-end).

This transfer is referred to as a recharacterization. For recharacterizations, the earnings must be recharacterized among with the contribution being recharacterized. The formula for determining these earnings is the same as the formula used to determine earnings on amounts removed as a ‘return of excess’ contribution.

Bear in mind that your recharacterization can be done ‘in-kind’, which means you need not liquidate your mutual funds to complete the recharacterization.

The formula is available in TD 9056 available at http://www.irs.gov/pub/irs-regs/td9056.pdf

[Guest ntrainer]

If I'm reading the document you cited correctly, the relevant figures for computing "net income attributable to the contribution" are the amount(s) that our Roth IRAs were worth on two dates: (1) the amount the fund was worth BEFORE the first excess contribution was made, and (2) the amount the fund is worth when I make my request to Vanguard to recharacterize our funds.

Thus, for these purposes, the IRS doesn't separate "earnings" from capital appreciation, really... any increases in the total value of my fund between those two dates needs to be allocated between (a) non-taxable amounts and (b) amounts that need to be recharacterized in order to avoid taxes.

This makes sense to me. I'm hoping that it's simple to determine the two relevant dates. The excess contribution is, in reality, unlikely to be a round figure, but we've been investing regularly in our Roth IRAs (every month) since January. If I'm reading this document correctly, and our excess contribution is $672, I would be able to say that $400 of that excess contribution came from our October 1 contribution and $272 came from our September 1 contribution and the relevant "opening balance" date is September 1.

I also hope the relevant "closing balance" date is the date I REQUEST Vanguard's help with this matter, and not the date Vanguard ACTUALLY recharacterizes the IRA, since the value of the fund on the ACTUAL recharacterization date will not be clear to me when I'm making these calculations.

Am I correct in all of this or have I read TD 9056 wrong?