Excess Contribution to Roth - ideas

[Strongsilence-CPA]

Taxpayer used an off-the-shelf tax software product from 2016 to 2020. Made excess Roth contributions each year.  (He claims the software didn't provide a notification or diagnostic.)

The rule is that an excess deferral may only be corrected by a distribution of the excess amount, plus allocable earnings. Are there strategies that would meet the rule but reduce the 6% penalty?

The 6% Penalty will likely be 8K.

1. I haven't read any rule that mandates that the withdrawal of the contribution and the earnings has to occur when discovery of the error is made.   This implies timing, either within a year or to a future year.   Although risky, it might be worth it to wait for a market downturn.  There are almost 5 months left in the year and so there could be time for a downturn.

2.  Could the IRA custodian somehow lower the balance prior to the distribution? The goal would be to reduce the closing balance below the balance of the Roth "immediately before" the contribution. Shooting yourself in the foot perhaps. If there are winners to offset losers, then it makes a bit more sense.

Then I read a bit about dollar-limited distributions, making ordinary distributions, and something called "absorption" and thought about asking a wealth-advisor referral to take this case. 

Finally: Who computes the income/earnings allocable to the distribution?  Does the custodian or must the taxpayer do it?

Thanks for your thoughts.

[qbteachmt]

This is a bit complicated when it is Roth. I knew there was a recent discussion for such a past-due event, and I found it here:

https://proconnect.intuit.com/community/tax-talk/discussion/reporting-earnings-on-excess-roth-contri...

I put some reference links in there, which should be helpful. There is a known strategy to suck up the 6% penalty when the other Roth rules might make it advantageous not to make the corrective distribution, just because someone found it.

Have fun reading. It's a lot of details. Take it one year at a time, and that might be easier to work through.

[TaxGuyBill]

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@Strongsilence-CPA wrote:

it might be worth it to wait for a market downturn. 

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No, no and no.

Besides the fact that the market could also increase and that you should NOT be advising your client when to sell investments, if you expect it to downturn it would be crazy to wait for that.  It is a bit more complex than this, but here is a simplified example:

Let's say the excess IRA value is $10,000.  A 6% penalty would be $600.  Therefore your net value is $9,400.

If you expect the market to decrease, let's say the excess value would then be $9,500.  Then the 6% penalty would be $570, and your net value would be $8930.

You would not want to intentionally wait/hope for a market decrease, as your net value in this example would be $470 less than if you sold it right away.