Calculating Earnings on Excess Contributions

[Guest Randy Ehle]

A client made an excess contribution to his IRA in October 1999. That contribution was invested in a money market fund, while the rest of the account was invested primarily in equities. The whole account is valued at over a million dollars.

UPI's guide basically says to pro-rate the earnings on the whole account for the entire calendar year. In the scenario above, because the whole account is large and invested in equities, the earnings on the account were large (15-20%) for the whole year. However, the contribution was made late in the year and invested in a money market fund yielding roughly 4.5%.

The difference in calculations is significant; one shows earnings of $700 on a $2,000 contribution. The other shows earnings of about $20. Since the client will pay taxes and may be penalized on the excess amount, that is a very important difference.

Any input from law (as opposed to just what one firm does versus another firm)?

[BPickerCPA]

The computation of earnings on excess contributions is governed by law and is stated in code sec 408, I believe subsection (d). So there shouldn't be a range of answers to the question. There should just be one answer.

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Barry Picker, CPA/PFS, CFP

New York, NY

[John G]

BPicker, a question for you. Who makes the calculation? The custodian or the taxpayer/tax preparer? I had the impression that the custodian wants to do the math because of fiduciary responsibilities.

[BPickerCPA]

John,

I've never seen a custodian willing to do it. I wouldn't trust them anyway.

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Barry Picker, CPA/PFS, CFP

New York, NY

[Guest John W]

There have been a couple of mentions of a method of calculating earnings on an excess contribution but I can't find the formula. Can someone point me in the right direction?

[BPickerCPA]

From memory, check in code sec 408(d) or the regs under that section.

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Barry Picker, CPA/PFS, CFP

New York, NY

[Guest PeteD]

What IS the earned income threshhold for contributing to an IRA. Does the max decrease as the income increases?

[John G]

There are multiple income issues involving IRAs and the answers depend upon your marital status and the type of IRA you have in mind.

For example, you need earned income to qualify for either Roth or regular IRA. It can be your earned income or the earned income of your spouse. When thinking of earned income, think paychecks, commissions, bonuses etc that show up on your W2. Capital gains, dividends, and interest do not count as "earned". The contribution to an IRA can not exceed earned income. For example, a teenager making $1500 this summer is maxed out at that amount, rather then the theoretical $2000 (assuming no spouse!).

Sounds simple? Well, there is a second income issue. If you have too much income (what a thought!) then you may be prohibited from contributing to an IRA. For Roth IRAs, married couples with incomes in the 150-160K range have a phaseout of eligibility. Just to make things a little more complex, this is based upon your total income, so capital gains, dividends, interest, as well as payroll income are all included.

You said "Does the max decrease as the income increases?" I don't know what this means. The requirement for earned income is a totally separate issue from the issue of maximum income that effects eligibility.

Read the IRS publications on IRAs very carefully, or visit the www.rothira.com site to read articles there, and of course talk with your tax preparer.

[Guest PeteD]

I am interested in a Roth IRA. I have one but have not funded it yet.

Sounds simple? Well, there is a second income issue. If you have too much income (what a thought!) then you may be prohibited from contributing to an IRA. For Roth IRAs, married couples with incomes in the 150-160K range have a phaseout of eligibility. Just to make things a little more complex, this is based upon your total income, so capital gains, dividends, interest, as well as payroll income are all included.

My wife and I (filing joint) are slightly below that 150-160K range right now. I anticipate being above that range by year's end (raises, new job, etc.). Do I need to manage my monthly contribution to ensure I am not over-contributing? What are the penalties for over-contributing?

You said "Does the max decrease as the income increases?" I don't know what this means.

I guess I mean the "phaseout of eligibility" you mentioned above. What is that?

Thanks for the quick reply.

[John G]

"My wife and I (filing joint) are slightly below that 150-160K range right now. I anticipate being above that range by year's end (raises, new job, etc.). Do I need to manage my monthly contribution to ensure I am not over-contributing? What are the penalties for over-contributing?"

The phase out issue is discussed in detail with examples at www.rothira.com and I suggest you look at the the Gary Lesser article, page 152 example. The maximum Roth contribution drops from 2,000 to zero as married filing jointly income goes from 150k to 160k.

Sounds like you may have no problem qualifying for 1999. In 2000, you might be able to have an employer shift any bonus to the following year.

At your income level, you clearly should seek the assistance of an accountant or tax preparer. The rules are complex and you are likely to have other options for shifting income.

The qualification for a Roth is done based upon the entire calender year income. You don't qualify on a month to month basis.

Since this is a transition year, you may want to wait until early 2001 to see what you final income will be for this year. You may have surprises such as moving expenses, former employer cash outs, vacation pay and other events that may make planning difficult.

[Guest Condorcet]

quote:

---

Originally posted by John G:

BPicker, a question for you. Who makes the calculation? The custodian or the taxpayer/tax preparer? I had the impression that the custodian wants to do the math because of fiduciary responsibilities.

---

The partial recharacterization rules (unless they have been revised since the 1999 CFR quoted below) appear to assume the custodian will compute the income allocable to the amount being transferred; otherwise they would be impossible to comply with.

The basic rule in 1.408-5 seems to be:

(a) An individual makes the

election described in this section by

notifying, on or before the date of the

transfer, both the trustee of the FIRST

IRA and the trustee of the SECOND

IRA, that the individual has elected to

treat the contribution as having been

made to the SECOND IRA, instead of

the FIRST IRA, for Federal tax purposes.

The notification of the election

must include the following information:

the type and amount of the contribution

to the FIRST IRA that is to

be recharacterized [note - not the amount of income attributable; it would be odd to lump that in as "any additional information" below -- Condorcet];

the date on which the contribution was made to the FIRST IRA and the year for which it

was made; a direction to the trustee of

the FIRST IRA to transfer, in a trustee-

to-trustee transfer, the amount of

the contribution and net income allocable

to the contribution to the trustee

of the SECOND IRA; and the name of

the trustee of the FIRST IRA and the

trustee of the SECOND IRA and any

additional information needed to make

the transfer.

***

© If paragraph (B) of this A–2 does

not apply, then the net income attributable

to the amount of a contribution

is calculated in the manner prescribed

by §1.408–4©(2)(ii) (disregarding the

parenthetical clause in §1.408–

4©(2)(iii)).

Section 1.408 ©(2) provides:

(ii) The amount of net income attributable

to the excess contributions is an

amount which bears the same ratio to

the net income earned by the account

during the computation period as the

excess contribution bears to the sum of

the balance of the account as of the

first day of the taxable year in which

the excess contribution is made and

the total contribution made for such

taxable year. For purposes of this paragraph,

the term ‘‘computation period’’

means the period beginning on the first

day of the taxable year in which the

excess contribution is made and ending

on the date of the distribution from the

account.

(iii) For purposes of paragraph

©(2)(ii), the net income earned by the

account during the computation period

is the fair market value of the balance

of the account immediately after the

distribution increased by the amount

of distributions from the account during

the computation period, and reduced

(but not below zero) by the sum

of: (A) the fair market value of the

balance of the account as of the first

day of the taxable year in which the

excess contribution is made and (B) the

contributions to the account made during

the computation period.

***

Assuming the date of the "distribution" is the date of the recharacterization transfer, there is no way for the taxpayer to know the proper amount of earnings to transfer. IMHO, the IRS regulations suffer throughout from a fundamental defect, in that they assume the taxpayer is in control of the timing of events, rather than at the mercy of an incompetent and indifferent custodian. In practice, what does one do? If the taxpayer is forced to specify the amount, and errs on the high side, may he then simply treat a sufficient portion of the phantom "earnings" as a greater amount of recharacterized contribution? That is, if one needs to recharacterize $100 because the custodian misreported a 1998 amount on a 1999 form 1099R (just to use a random example), and one estimates $50 of earnings and therefore orders $150 transferred, but it turns out the earnings were only $40 on $100 as of the transfer date, then may (should) he treat it as a recharacterization of $107.14 and earnings of $42.86? If so, must he send some kind of revised notice to the custodian(s)? (and what does he do when the first custodian again will not report correctly to the IRS?). Is there reason to believe the IRS will live with a calculation that is accurate as of the close of business the day before the transfer instructions are mailed, or delivered, to the custodian?

Editorial comment: IMHO, Senator Roth and his pandering colleagues who created the nightmarish complexity of the IRA provisions of the Code are responsible for many billions of dollars in deadweight loss to the national economy, namely the value of resources and time expended on creating, interpreting, and trying to comply with arbitrary rules; the fees spent on setting up (and transfering from unsatisfactory custodians) millions of unnecessary additional accounts; the trees destroyed to print all the reports, etc. – all for a supposed incentive to private savings that is so inefficient it would be laughable were it not for the enormous waste of resources involved (most contributions to IRAs come from funds that would have been saved without a tax gimmick, reinvestments within an IRA may be offset by a higher marginal propensity to consume income outside the IRA, and of course the loss of revenue contributes to public dissaving).

-- Condorcet

[Guest gastultz]

No one has answered the original question. Are earnings computed based on the earnings of the entire account for the year (weighted by that year's contribution) or on the earnings of that year's contribution? It may become ambiguous as to what piece of the IRA is for a given year so I would think the answer is to base earnings on the entire IRA?

[Guest Condorcet]

Gastultz,

The answer to the original question may have changed since my last post, for contribution years after 1999. See Notice 2000-39 at http://www.benefitslink.com/IRS/notice2000-39.shtml

which describes a (temporarily) optional new computation method. Whether there has been still later guidance, you should investigate before acting. May the "net loss" part of the notice have no application to your account!

-- Condorcet