Deliberate Excess Contributions

[Guest rgeary]

After reading through IRS publication 590, it appears that there is nothing illegal about deliberately over-contributing to an IRA or Roth IRA account. This raises the following question: what is there to stop me from opening a Roth IRA account with an initial deposit of, say, $10,000, if I am willing to pay a $480 penalty each year for the rest of my life on the $8,000 excess contribution? The way I see it, $40 per month is a small price to pay for a ~3 year jump start on untaxed growth using Mechanical monthly investing, as I use (or practically anything that at the very least matches the market).

(btw, the example on p31 of

http://ftp.fedworld.gov/pub/irs-pdf/p590.pdf

makes it clear that it's the excess contribution itself, excluding any capital gains or interest that it might generate, that gets the 6% tax each year, even though it requires the withdrawal of the excess plus the earnings in order to stop the annual tax)

On a related note, does anyone know about excess contribution taxes that individual states might impose in addition to the 6% federal tax?

Thanks,

Robbie Geary

[BPickerCPA]

I hear this question often. Here are the issues.

The first issue is that the plan is not permitted to take the $10K contribution. The plan document itself must limit contributions to $2K per year.

The main issue is that the net income attributable to an excess contribution can NEVER be a qualified distribution, meaning it will NEVER be tax free. So you have accomplished nothing.

As a side note, the IRS would have the right to declare the entire account invalid as a Roth, by virtue of the fact that it was not treated in accordance with the law. All in all, it's not worth it.

Barry

[Guest mcdonnell]

Another problem with a contribution that exceeds the $2,000 limit is that the excess is also subject to income tax when withdrawn after the tax return due date.

[BPickerCPA]

[[Another problem with a contribution that exceeds the $2,000 limit is that the excess is also subject to income tax when withdrawn after the tax return due date.]]

I'm not sure that's true with Roth money. Why do you think it is?

Barry

[Guest mcdonnell]

Barry, I think it is for the following reasons:

- Roth IRAs are treated like traditional IRAs except where the IRC specifies different treatment (Sec. 408A(a)).

- Sec. 4973(f) regarding the excise tax on Roths includes the same section (408(d)(4))applicable to traditional IRAs on corrective distributions before the due date to avoid the tax. No reference is made to distributions after the due date.

- Distributions after the due date from traditional IRAs of excess contributions where the excess is due to a contribution greater than $2,000 (the Sec. 219(B)(1)(A) amount) shall be included in gross income (Sec. 408(d)(5) and Conference Committee Explanation P.L. 93-406). If the same treatment applies to Roths as indicated under

Sec. 408A(a), then distributions are taxable.

- Form 5329 instructions for line 23 state that Roth excess contributions will not be taxed as distributions ONLY IF the contributions and attributable earnings are withdrawn by the due date. Implying that distributions that do not meet these requirements are taxable.

- If the assumption is made that distributions of excess contributions after the due date are not taxable, then unlimited contributions could be made by those willing to pay the 6% tax each year in exchange for higher investment returns (presumably much higher) that compound on a tax-deferred or tax-free basis.

- The issue of an IRA plan not accepting more than $2,000 could be avoided by opening separate IRAs at multiple institutions and contributing $2,000 to each account.

However, confusion is created by the IRA Trustee reporting instructions for 1099Rs. These instructions state that $0 should be entered in the Taxable Amount Box (2a) for distributions from traditional IRAs of excesses after the due date and specifically reference section 408(d)(5).

Bill

[BPickerCPA]

Bill,

Thanks for the analysis.

Barry

[Guest kurt johansen]

I am dealing with this issue for a client who made a Roth conversion in 1998 when he wasn't elegible due to his AGI. The money is still in the Roth today and I am supposed to figure out the tax consequences. This is my first crack at the Code and Regulations on the issue and so far I have found them to be an impenetrable fog. A hypertechnical reading of the statute often leaves me with a conclusion not supported by the regulations or common sense.

Based on the regulations, I believe that the Service treats the Roth conversion as a taxable distribution from the traditional IRA in 1998 and a corresponding excess contribution to the Roth IRA in 1998. This shoud mean that my client will need to pay income tax and the 10% excise for early withdrawal in 1998. Also, an excise tax of 6% for 1998, 1999, and 2000 in the amount of the contribution but not on the earnings. A distribution of the entire account in 2001 should lead to income and excise tax on the earnings only. I base this treatment mainly on Q&A 4&5 of Reg. 1.408A-6. Q&A 4 states that a distribution from a Roth IRA that is not a qualified distribution is subject to income tax to the extent that the distribution exceeds the sum of all contributions to the plan. Therefore, only the earnings should be subject to income tax. Q&A 5 states that the excise tax under 72(t) only applies if the distribution is subject to income tax. Thus, only the earnings should be subject to the 10% excise tax on early withdrawals.

Where I depart from Bill's analysis is that I don't think that 408A(a)'s incorporation of the rules for regular IRAs means that you can look to the legislative history of the earlier act for guidance. Furthermore, having read 408(d)(5) about twelve times I still don't understand what it does but it appears to be inapplicable to any contribution that is larger than $2,000. That puts us back to the general rule under 408(d)(1) which says that the distribution is taxed under 72. I do not pretend to have a firm grasp of the statutory language under Code section 72 but I believe that it contains rules to determine which part of a distribution is deemed to be a return of contributions and which part is taxable. Therefore, under Code section 72 only the earnings would be subject to income tax.

I would love to hear someone else's opinion on the issue.

Kurt

[BPickerCPA]

Kurt,

Your analysis is correct.

I have successfully obtained permission from the IRS for a late recharacterization. This is done via a request for a private letter ruling.

According to the people at the IRS, your chances for the relief decreases significantly if they come to you before you come to them.

[Guest AFRICA6796]

Barry,

Can you cite a reference regarding the fact that a distribution of excess contribution to a Roth IRA is taxable because it cannot be deemed qualified?

The Final regs state "In response to concerns raised in the comments regarding potential double taxation, the final regulations clarify that a nonqualified distribution from a Roth IRA is taxed only to the extent that the amount of the distribution, when added to all previous distributions (whether or not they were qualified distributions) and reduced by the taxable amount of such previous distributions, exceed the owner's contributions to all his or her Roth IRAs. "

This seems to contradict your response.

[Guest AFRICA6796]

mcdonnell,

Your statement "However, confusion is created by the IRA Trustee reporting instructions for 1099Rs. These instructions state that $0 should be entered in the Taxable Amount Box (2a) for distributions from traditional IRAs of excesses after the due date and specifically reference section 408(d)(5). " is incorrect.

The instructions for filing IRA Form 1099-R states that any distribution of an excess contribution that is in excess of $2,000 must be reported as a taxable distribution- which sometime results in double taxation for traditional IRA owners.

[Guest mcdonnell]

Page R-6 (under Box 2a section) of the 2000 Instructions for Form 1099R states "For a distribution of contributions without earnings after the due date of the individual's return, under section 408(d)(5), enter 0 (zero).

[Appleby]

If I may jump in here. Africa's intrepretation of the reg. is correct. However, I must make a qualification.

mcdonnell, you are right in stating what the instructions say. However, instructions, like most other IRS documents, need to be crossed referenced with the regulations , if one needs in-depth explanations.

According to 408(d)(), a return of excess contribution after the due date is not taxable "to the extent that such distribution of any contribution exceeds the amount allowable as a deduction under section 219..."

The refereced amount under 219 is $2,000. Ergo, any return of excess contribution in excess of $2,000 will be subjected to ordinary income taxes and an additional 10% premature penalty is the participant is under the age of 59 1/2.

[Guest mcdonnell]

The taxability issue I addressed in my 9/22/00 analysis. In that analysis, I merely included the point that the 1099R instructions added confusion to the intrepretation of the code.

[Appleby]

I understand. This was not meant to be a criticism, just a mere attempt to clarify the issue, for those that may read and misconstrue the instructions. From my experience with my clients, most lay-people do. Therefore, it helps to state clearly, what the IRS implies.

You are apparently very knowledgable on the subject.I would love to see a copy of your 9/22 analysis. Could you attach the link (url) in a response?

Thanks

Appleby

[BPickerCPA]

Africa,

With reference to the taxability of earnings on an excess contribution, the return of the excess contribution should not be taxable, but the earnings on the excess contribution will be taxable.

To restate it, if one makes an excess contribution and does not remove it, there will not be tax free distributions of income until the excess contributions AND THE RELATED INCOME is removed from the account. The income will be taxable.

[Guest Art E]

Robbi

You asked what keeps people from overcontributing to their IRA. The biggest reason for not overcontributing to an IRA, regardless of the legality issues, is simply because it's a dumb thing to do. It ranks right up there with having munis in an IRA account.

Overcontribution is a very bad investment approach for most people compared to most other options. Investing the overcontribution amount in about any normal taxable account investment vehicle, excepting perhaps bonds, CDs or high dividend paying stocks with high annual taxable incomes, and holding these investments for even a few years is far better than overcontributing to either a tax-free or tax-deferred IRA.

AE

[Guest mcdonnell]

My analysis is on this board.