ROTH IRA Contribution Penalty

[MarinaEA]

Two ineligible $6,000 contributions were made on 9/7/22 and 3/16/21 to Roth IRA. The total account value at the moment is $12,661. The income is over the limit. 

What is the best way to handle this now? To my understanding, need to withdraw both since recharacterization to a traditional IRA makes no sense since there will be penalties anyways for the 3/16/21 contribution. 

Also, the 2021 contribution and penalty are not reflected on 2021 returns. Do we need to amend 2021 return to include a form 5329, or can we just mail a form 5329 without amending the entire return? 

To my understanding, if we withdraw all of it by the year end, then no penalty for 2022 contribution? Would anything need to be reported on 2022 returns? I am suspecting the earnings would need to be reported as income on 2022 returns or on 2023 returns ? 

[qbteachmt]

Are you sure the 2021 contribution isn't for tax year 2020? Form 5498 should show the tax year for each.

You have taxable earnings and excise tax for leaving the money over year(s).

Your removal deadline isn't year end; it's based on the filing due date of the tax return, including extensions. Because there have been so many extended due dates, I would recommend simply using google:

how to correct ineligible roth ira contributions

A lot of great articles exist directed to the consumer, as well as from the IRS, for steps to take.

[MarinaEA]

I am asking her for all the details as no 5498 was provided. Ended up one contribution was not even a  ROTH IRA but a Traditional IRA so don't have to worry about that one.

One was ROTH however. 

I did google search yesterday quite a bit and found many articles, however the main question I can't find any information on is - does one needs to amend the returns just to file 5329 to pay penalties or 5329 can be filed as "stand alone"?!

[sjrcpa · Accepted solution]

5329 can be filed as a stand alone form.

[qbteachmt]

"as no 5498 was provided. Ended up one contribution was not even a ROTH IRA but a Traditional IRA so don't have to worry about that one."

Just because the client doesn't have it, it likely exists. They log into their account provider portal to find it. They call and ask for it. Since the contributions can be made up to the tax filing due date, people don't even realize how late one might be issued for that tax year. There is one for every year there is some activity in that account (contribution, distribution).

[MarinaEA]

Thank you!! I found so much contradicting information about if the form can be filed as stand alone. 

[MarinaEA]

I know that it was provided to her, but she did not provide one to me which is what I meant. I asked for the form a while back, but she said that she did not have and said she was told that it's not required to be filed with the return (true, but I always like to have it to verify information). So I did not worry about it this time, and did not bother her trying to get it, since there were no distributions and Roth IRAs contributions aren't reportable on returns. But now, I am asking for it again, since she apparently has no idea what she did and what IRA even that was. She sent me a screenshot from her IRA account, and that is how I even noticed that one was a Traditional IRA. So, need all documents to verify as seems she has no idea what she is talking about.

[MarinaEA]

@sjrcpa  do you know if 2021 Roth IRA penalties could just be factored into 2022 year’s taxes? Or filing a form 5329 as stand alone for 2021 would have to be done? 

[sjrcpa]

I think it can be done with 2022 return but am not sure.

[qbteachmt]

"2021 Roth IRA penalties could just be factored into 2022 year’s taxes?"

My understanding is you look at the event for Cash Basis.

Missed RMD in prior year(s) and taking it now = current year tax event (no prior year amendment) as there is no tax event in any of those prior years. Only in the year being taken.

But, your tax payer has excise tax and/or penalties, for every year that you realize these scenarios existed. That would = amendment.

[MarinaEA]

We only have to worry about 2021. All ineligible Roth IRA contributions will be withdrawn this year by April 18th. As long as she withdraws it all by April 18th, no penalties for 2022. And her prior contributions were traditional IRAs so don't have to worry about those. 

To my understanding and as someone else mentioned here, a form 5329 can be filed as a stand alone form for 2021 to pay those 2021 penalties, and no need to amend the entire 2021 returns. If that is so, we are trying to see if we could just factor in those 2021 penalties into 2022 returns we will be filing. Maybe, a form 5329 has a place for prior year penalties?! I will have to read the 5329 instructions. 

[qbteachmt]

"as a stand alone form for 2021 to pay those 2021 penalties, and no need to amend the entire 2021 returns"

But it's more than Excess contribution penalty. You have taxable earnings. That's why I'm pretty sure you need to amend 2021. Well, unless the account lost value below basis as of Dec 31, 2021. And 2022 will have earnings (or loss), even if no penalty.

[MarinaEA]

I thought earnings would be taxable and reportable in the year she withdraws them? If she withdraws them this year then this we would report them as taxable income on 2023 returns?  If that is inaccurate, then when she withdraws those contributions and earnings this year, how the plan administrator will report it for 2023 on 1099-R ? 

Are you saying even if she withdraws 2021 contributions and earnings in 2023, it must be reported on 2021 returns?

Now, I am questioning something else as well. Since her 2021 ineligible contribution was not withdrawn by December 2022, does she owe penalties for 2022 as well? What is the deadline to withdraw that 2021 contribution without 2022 penalties - was it December 31, 2022 or April 18, 2023 ( the 2022 tax return due date) ?

Edit: Two tax professionals said - you do NOT amend. When she withdraws this year, she will get a 1099-R for the withdrawal, and then you reconcile it for the 2023 return. 

[qbteachmt]

"Are you saying even if she withdraws 2021 contributions and earnings in 2023, it must be reported on 2021 returns?"

Excess in 2021 means 6% excise tax on the disallowed contribution for each year it remains in the account. That means 2021 and 2022.

There is tax on the attributable earnings.

There is an early withdrawal penalty if the person is under 59 1/2.

For each and every year until the excess is either absorbed (carry forwards can be treated as a contribution for that next year, but your taxpayer still didn't qualify...) or removed. That means the year of removal saves the excise tax.

"Since her 2021 ineligible contribution was not withdrawn by December 2022"

By tax return filing due date, including allowable extensions...

"does she owe penalties for 2022 as well?"

Yes.

"What is the deadline to withdraw that 2021 contribution without 2022 penalties - was it December 31, 2022 or April 18, 2023 ( the 2022 tax return due date) ?"

April filing due date, 2022 (timely filing of tax year 2021 info)

or

October 2022 <== extension, if applied for, creates a later due date

"If you don't remove your excess contribution before the tax deadline, you can file an amended tax return after you've removed the funds, but you must do this by the October tax extension deadline. The government will review this and refund you any penalties it's taken out if necessary."

https://www.fool.com/retirement/plans/roth-ira/excess-contribution/

I also like investopedia articles. All of these are geared toward the consumer trying to figure out their options, so they are easier to read through than the IRS pubs:

https://www.investopedia.com/what-to-do-if-you-contribute-too-much-to-your-roth-ira-4770686

https://www.investopedia.com/articles/retirement/04/042804.asp

"Edit: Two tax professionals said - you do NOT amend. When she withdraws this year, she will get a 1099-R for the withdrawal, and then you reconcile it for the 2023 return."

Did she report the tax and penalty on the 2021 tax return, for the excise and the taxable earnings? I thought you stated no. Here's what you are overlooking:

Each tax year has a Status. that you need to address That is Excess (subject to excise tax because it was left in the account for that tax year) and any taxable earnings (because you are not allowed to benefit  from Roth tax-free rules on disallowed funds).

[qbteachmt]

To confirm:

"Two ineligible $6,000 contributions were made on 9/7/22

For tax year 2022?

"and 3/16/21 to Roth IRA."

For tax year 2021?

Now work on the tax filing due dates, to know which amount falls where. If 3/16/21 was the "make your 2020 contribution by the tax filing due date" then that is a tax year 2020 problem, excise tax and taxable earnings; and that affects 2021 tax year as a carry forward mistake. If not removed by the filing due date for tax year 2020, and not removed by the filing due date for tax year 2021, it affects each year. The excise tax carries on and on, until the contribution and attributable earnings are removed.

[qbteachmt]

Here's another Q&A that is similar to what you need to do:

https://www.irahelp.com/forum-post/62723-multiple-year-excess-roth-ira-contributions-including-curre...

[MarinaEA]

Thank you for all your information. I still have no idea how to go about this as I keep getting contradicting information. To answer your questions.

Roth contribution were made for 2021 and for 2022. I have 5498 and all paperwork and confirmed it with her. As of 12/31/2022, the value of her Roth IRA is $12,089.

So two contributions 6k each plus some earnings/interest. 

[MarinaEA]

"Edit: Two tax professionals said - you do NOT amend. When she withdraws this year, she will get a 1099-R for the withdrawal, and then you reconcile it for the 2023 return."

Did she report the tax and penalty on the 2021 tax return, for the excise and the taxable earnings? I thought you stated no. Here's what you are overlooking:

Each tax year has a Status. that you need to address That is Excess (subject to excise tax because it was left in the account for that tax year) and any taxable earnings (because you are not allowed to benefit  from Roth tax-free rules on disallowed funds)."

Yes, she did not report the tax and the penalty on the 2021 returns, but the two other tax professionals are saying, do not amend, do not file 5329 for 2021 and for 2022. Just reconcile on 2023 because when she withdraws contributions and earning, 1099-R will be issued so you reconcile based on that 1099-R on 2023 taxes

[MarinaEA]

"Excess in 2021 means 6% excise tax on the disallowed contribution for each year it remains in the account. That means 2021 and 2022.

There is tax on the attributable earnings."

So you are saying to file 5329 for 2021 and to file 5329 for 2022 and pay 6% that way. Likely 5329 can be filed as stand alone. Seems, no amendment of the entire return is needed. 

I am confused about the earnings though. Another tax professional is insisting that, "earnings stay in the account and are not reported." This makes no sense to me. Aren't you supposed to withdraw the earnings as well since they are attributable to ineligible contributions or you will be keep paying penalties on that as well each year it stays in the account? And also if you do withdraw, then it must be reported as taxable income, right? 

[qbteachmt]

Are you also including the Form 8606 in your considerations?

https://www.irs.gov/instructions/i8606

Excerpt: "Return of IRA Contributions

If, in 2022, you made traditional IRA contributions or Roth IRA contributions for 2022 and you had those contributions returned to you with any related earnings (or minus any loss) by the due date (including extensions) of your 2022 tax return, the returned contributions are treated as if they were never contributed. Don’t report the contribution or distribution on Form 8606 or take a deduction for the contribution. However, you must include the amount of the distribution of the returned contributions you made in 2022 and any related earnings on your 2022 Form 1040, 1040-SR, or 1040-NR, line 4a. Also include the related earnings on your 2022 Form 1040, 1040-SR, or 1040-NR, line 4b. Attach a statement explaining the distribution. Also, if you were under age 59½ at the time of a distribution with related earnings, you are generally subject to the additional 10% tax on early distributions (see Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, and its instructions).

...

If you made a contribution for 2021 and you had it returned to you in 2022 as described above, don’t report the distribution on your 2022 tax return. Instead, report it on your 2021 original or amended return in the manner described above."

"I am confused about the earnings though. Another tax professional is insisting that, "earnings stay in the account and are not reported.""

There are three considerations: penalties, for things done wrong (10% if early distribution); taxable as income, for things you don't get for free; and 6% excise tax, which is like a punitive tax or penalty for continuing to do something that isn't allowed. Each year is subject to whatever applies. You don't keep paying penalties but you do keep paying excise tax, for instance.

In the retirement and investment strategy world, there are some people that explain how they use their Roth as "emergency savings" where they cover removing your own contributions that qualify to be penalty free. They also propose a strategy that leaves earnings in, because the market does so well, and the offsets a 6% excise tax as a deferred income tax strategy during a period of high growth. Obviously, that isn't going well for these people, right now.

Are you reading the links I provided, where you see how to compute what the earnings are that also would be removed? That's why I provide articles like these. Even the brokerage firms (Wells Fargo, etc) have these articles for reference, for the consumer to be able to follow along and fix their errors.

[MarinaEA]

"Are you also including the Form 8606 in your considerations?"

I do understand about 2022 contribution, and how that would be handled. No need to report it on 8606 if the contribution is withdrawn by the 2022 tax return due date. But need to report earnings on 2022 return if any. 

 "Don’t report the contribution or distribution on Form 8606 or take a deduction for the contribution. However, you must include the amount of the distribution of the returned contributions you made in 2022 and any related earnings on your 2022 Form 1040, 1040-SR, or 1040-NR, line 4a. Also include the related earnings on your 2022 Form 1040, 1040-SR, or 1040-NR, line 4b."

This is a problem. I just tested this in Proseries on 1040 2022. To be able to enter a returned contribution on 2022 line 4a, it wants me to complete a 1099-R. But we do not have a 1099-R and it won't be issued until 2023. 

"If you made a contribution for 2021 and you had it returned to you in 2022 as described above, don’t report the distribution on your 2022 tax return. Instead, report it on your 2021 original or amended return in the manner described above."

I have no idea why there is a need to amend. It would not change the bottom line. Whether we amend or file 5329 as stand alone to pay that 6% excise tax - it would result in the same outcome either way because we were wrong about the earnings for 2021. I read two articles confirming this. There is no need to compute or to withdraw or to report them at all. You do need to report earnings if it's a timely correction ( before tax deadline, would be the 2022 contribution in my case). You do not need to if the correction is untimely (after the tax due date, would be the 2021 contribution in my case). Then you only need to withdraw the excess distribution which will be treated as ordinary or early distribution (depends on the age). Check this out:

https://www.fidelity.com/retirement-ira/excess-ira-contributions

Her 2021 contribution will be untimely correction. So she is liable for the 6% excise tax for 2021 and for 2022 on that contribution. It says that earnings calculation is NOT required for untimely correction. However, what does that mean, the earnings stay in her account ? Even if she closes the account? 🤔 Or this is implying that you do not need to withdraw or to report it, but you can if you want, but then you will pay a 10% early withdrawal penalty on those earning since she is under 59?

And it says: "Tax reporting of untimely corrections : Untimely corrections must be reported as an early or normal withdrawal, depending on your age when you withdraw, using IRS Form 1099-R"

So this will be reported on 2023 1099-R and then we report it as such on 2023 tax returns? ( It will be "early withdrawal" due to her age)

It explains how you don't need to worry about earnings for untimely distribution  (which would be 2021 in my case). Which tells me that no need to amend 2021 returns since the only thing we need to worry about is the 6% excise tax for 2021 which can be paid by filing 5329 as stand alone. I however wonder, if we can just include that 6% excise tax for 2021 and for 2022 on her 2023 returns when a 1099-R arrives. It makes no difference if we pay that 6% excise tax via filing 5329 as stand alone for 2021 or if we include it on 2023 returns.

And here is another good article explaining this. Check out example 5. 

"Example 5: A single, 54-year-old taxpayer is not eligible to contribute to a Roth IRA in 2019 because his modified adjusted gross income exceeds the phaseout limit for those contributions. Nevertheless, the taxpayer mistakenly makes a $7,000 excess contribution in 2019 to a newly formed Roth IRA. The entire excess contribution constitutes after-tax investment in the Roth IRA.

In 2020, after the expiration of the time for making a corrective distribution, the Roth IRA's balance has grown to $7,700. The taxpayer then makes an ordinary distribution of $7,000 that is composed entirely of nontaxable investment and that eliminates the $7,000 excess contribution. The $700 of earnings is retained by the Roth IRA and is allowed to compound tax-free in future years. Unfortunately, the taxpayer must still pay excise tax of $420 for 2019 (6% of the $7,000 excess contribution)."

https://www.thetaxadviser.com/issues/2020/apr/correcting-excess-contributions-iras.html

The article states: “If it is too late to make a corrective distribution, a taxpayer may be able to eliminate an excess contribution simply by making ordinary distributions. For a Roth IRA, the excess contribution is reduced by the entire amount of the distribution. In neither case is there a need to distribute the IRA income earned on the excess contribution.”

Let me know what you think now and what do you think is the easiest way to handle it. Seems, either filing 5329 as stand alone for 2021 or I hope, we can instead factor in that 6% excise tax into 2022 or 2023 returns and reconcile it with a 1099-R? The fidelity article explains that you will be issued a 1099-R reflecting all distributions. 

[qbteachmt]

"But we do not have a 1099-R and it won't be issued until 2023."

That's right, and it will be code P = prior year.

"I have no idea why there is a need to amend. It would not change the bottom line."

Are you still overlooking Taxable Income from the earnings?

"Whether we amend or file 5329 as stand alone to pay that 6% excise tax - it would result in the same outcome either way because we were wrong about the earnings for 2021."

And that is why you would amend.

You seem to think the earnings can be left in the Roth, and left to grow as Roth, which would be tax free, but that's not how this works. Since the basis resulting in the earnings is disallowed, there is no tax free income for those. It's called Net Income Attributable (NIA). If you don't remove it, you report it and pay taxes on it. Every year, until it is removed.

Don't confuse Traditional IRA earnings on a disallowed contribution, and a Roth with earnings on disallowed contribution. We are reviewing Roth, right?

https://www.investopedia.com/net-income-attributable-definition-5223368

"Understanding NIA

When a taxpayer makes an excess IRA contribution, both the allowable contribution and excess contribution generate a gain or sustain a loss. The NIA formula was added to the Internal Revenue Code (IRC) in order to assist taxpayers in assigning a portion of the total gain or loss to the excess contribution. The NIA is added to the excess contribution when the amount is returned to the IRA owner.

If the account gained value during the time the excess contribution was in the account, the NIA calculation is positive. The NIA plus the excess contribution must be withdrawn from the account. If the account lost value during the time the excess contribution was in the account, the NIA calculation is negative. The NIA is subtracted from the excess contribution prior to withdrawing funds from the account."

And: https://www.fool.com/retirement/plans/roth-ira/excess-contribution/

"If you catch your mistake before the tax filing deadline for the year, your best option is to remove the excess before you file your taxes. But hold on, it's not as simple as it sounds. You have to remove your excess contribution and any earnings attributable to that excess contribution."

You would use the 1099-R for 2023 if you missed the withdrawal deadline that allows it to be ignored for 2022:

https://proconnect.intuit.com/support/en-us/help-article/federal-taxes/entering-form-1099-r-proserie...

"Code P advises payees that the earnings are taxable in the year in which the contributions were made. If the Form 1099-R has a distribution code P or code R, the distribution is reported on the tax return for the year immediately preceding the year shown on the Form. Sometimes taxpayers will receive notice from their employers letting them know the transaction and amount in time for it to be reported in the original return, but otherwise, it will have to be amended later."

And they give an example: "If the Form 1099-R  is a year 2022 form, you enter this in 2021."

Maybe it's time to read the IRS Pub:

https://www.irs.gov/publications/p590a#en_US_2021_publink1000231025

"Withdrawal of excess contributions.

For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made."

[MarinaEA]

You said: "And that is why you would amend. You seem to think the earnings can be left in the Roth, and left to grow as Roth, which would be tax free, but that's not how this works. Since the basis resulting in the earnings is disallowed, there is no tax free income for those. It's called Net Income Attributable (NIA). If you don't remove it, you report it and pay taxes on it. Every year, until it is removed. Don't confuse Traditional IRA earnings on a disallowed contribution, and a Roth with earnings on disallowed contribution. We are reviewing Roth, right?"

No, I have it all figured how to report and how to treat it, and I have all that backed by actual IRS instructions and confirmed by the brokerage. 2021 and 2022 contributions are reported and treated differently and separately. You are confusing two contributions that must be reported and treated differently. 2022 will be a timely correction, 2021 will not be a timely correction. I don't seem to think that the earnings can be left in the Roth if the correction is UNTIMELY which would be the case for 2021 contribution. The guidance literally states so. This is not an opinion. 

When I said "we were wrong about the earnings for 2021". I meant YOU and I were wrong assuming that earnings for 2021 must be distributed. That is incorrect. I thought that too originally, and I was wrong and you are too. And I literary posted two sources - from the tax adviser and from Fidelity with the example which literally sates so. From the tax adviser:

"Example 5: A single, 54-year-old taxpayer is not eligible to contribute to a Roth IRA in 2019 because his modified adjusted gross income exceeds the phaseout limit for those contributions. Nevertheless, the taxpayer mistakenly makes a $7,000 excess contribution in 2019 to a newly formed Roth IRA. The entire excess contribution constitutes after-tax investment in the Roth IRA.

In 2020, after the expiration of the time for making a corrective distribution, the Roth IRA's balance has grown to $7,700. The taxpayer then makes an ordinary distribution of $7,000 that is composed entirely of nontaxable investment and that eliminates the $7,000 excess contribution. The $700 of earnings is retained by the Roth IRA and is allowed to compound tax-free in future years. Unfortunately, the taxpayer must still pay excise tax of $420 for 2019 (6% of the $7,000 excess contribution)."

https://www.thetaxadviser.com/issues/2020/apr/correcting-excess-contributions-iras.html

Did you ignore what was posted above? It literally states "The $700 of earnings is retained by the Roth IRA and is allowed to compound tax-free in future years."  This is 100% clear.

I literally posted two sources for you explaining how 2021 earnings do not need to be withdrawn and can grow tax free. If you want to withdraw them, you can, but then you will pay 10% on those earnings if you do as it simply will be treated as early distribution if you are under 59.

The article clarifies and confirms this again by stating: “If it is too late to make a corrective distribution, a taxpayer may be able to eliminate an excess contribution simply by making ordinary distributions. For a Roth IRA, the excess contribution is reduced by the entire amount of the distribution. In neither case is there a need to distribute the IRA income earned on the excess contribution.” 

Again, this literally states: "In neither case is there a need to distribute the IRA income earned on the excess contribution.” This would be applicable to the 2021 contribution.

And Fidelity literally explains this too. It says in the Fidelity article that "earnings calculation is not required for untimely correction". The 2021 would be untimely correction. Per Fidelity: "With untimely corrections, the IRS does not require an earnings calculation―you simply withdraw the amount of the excess contribution. Untimely corrections must be reported as an early or normal withdrawal, depending on your age when you withdraw, using IRS Form 1099-R"

For timely correction, you must calculate and withdraw and report the earnings as well ( that would be applicable to 2022 contribution, not to 2021 contribution). Per Fidelity: "If you are removing an excess contribution using the timely correction method, you are required to remove your original contribution plus earnings. The earnings must be included on your tax return in the year you made the excess contribution." Again, that is applicable to timely corrections, NOT to untimely corrections. 

https://www.fidelity.com/retirement-ira/excess-ira-contributions

No, no need to amend 2021. And no, there is no concept of "earnings" if the removal isn't timely which would be the 2021 contribution. The earnings only must be withdrawn and are taxable if the removal is timely ( 2022 contribution would be). 2021 earnings can either stay in the account and grow tax free as the article explains above, or she can withdraw them and pay 10% tax on those earnings since she is under 59. And that was confirmed by her brokerage as well.

Also, the 5329 instructions explain that there is NO need to amend if you are only filing 5329. It can be filed as stand alone. 

You said: "If you catch your mistake before the tax filing deadline for the year, your best option is to remove the excess before you file your taxes. But hold on, it's not as simple as it sounds. You have to remove your excess contribution and any earnings attributable to that excess contribution."

Yup, that is FOR the 2022 contributions and that is HOW the 2022 contribution is treated. NOT the 2021 contribution which would be AFTER the tax filing deadline. You are confusing two contributions that must be treated and reported differently because  2022 is a timely correction and 2021 is NOT a timely correction. Not a timely correction ( 2021 in this case) is reported and treated as an early or normal withdrawal in the year the withdrawal occurs. There is no concept of "earnings" for untimely corrections. With the untimely correction, the earnings can stay in the account and grow tax free, or you can withdraw it, and it will be treated as an early or normal withdrawal. 

You said: "Withdrawal of excess contributions. For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made."

Yup. Again, this is applicable to timely corrections ( "any contribution that is withdrawn on or before the due date"- that is literally stated in your own reply and the link you provided) which would be applicable to the 2022 contribution. NOT applicable to untimely corrections which would be the 2021 contribution. 

If you actually read the instructions for 5329 and for 8606 forms, it has all the answers. I have all the correct information and how to report it. I will post it in a separate reply for others to see and understand in case someone else faces this issue. 

[qbteachmt]

Can, may, and should, are all treated differently. The taxpayer can pretty much do anything they want to, even if it is subject to penalty and/or excise tax and/or income taxes. I thought I already mentioned that there is a recommended strategy to leave Roth earnings year-over-year, knowing full well it incurs tax and/or penalty, because the person making the recommendations thinks you will easily beat the 6% penalty in the earnings. I would point out if that is true, why not just make that a regular investment?

I suspect the IRS would find a lot of retirement mistakes, if they had the personnel to investigate anything.

[MarinaEA]

"Can, may, and should, are all treated differently. The taxpayer can pretty much do anything they want to, even if it is subject to penalty and/or excise tax and/or income taxes."

Sir, what I stated in my previous reply and sources I provided is how 2021 and 2022 ineligible Roth contributions must be treated and reported according to the guidance in order to stop the 6% penalty from keep accruing each year on excess, and if you want to treat and to report it correctly. No one is saying anything about may or can. The only choice the taxpayer is explained and is considering is to whether they want to leave the 2021 earnings in the Roth IRA or withdraw it. You don't continue accruing 6% penalties on the earnings if you leave only the earnings in the account, because by removing the original contribution, you are removing the excess. If the taxpayer wants to withdraw the earnings associated with the excess contribution as well now or later, then it simply will be treated as an early or normal withdrawal depending on the age. That is it. The earnings do not continue incurring a 6% penalty each year if they remain in the account, or if they are withdrawn later. So I let the taxpayer decide what she wants to do with the 2021 earnings since there is no penalty or tax for letting it stay in the account. Whether she withdraws the 2021 earnings or not, she still has to pay the 6% penalty on the actual excess contribution amount for 2021 and for 2022 either way ( 6k actual contribution in this case) but not on the earnings.

"I thought I already mentioned that there is a recommended strategy to leave Roth earnings year-over-year, knowing full well it incurs tax and/or penalty, because the person making the recommendations thinks you will easily beat the 6% penalty in the earnings."

You will not incur 6% tax or penalty on the earnings by leaving Roth earnings with the untimely correction. And no one is making the recommendations you suggested. The taxpayer discovered this year that she made excess Roth contributions for 2 years, and now we need to resolve this. That is it. The point of my previous reply was to point out that you and I were wrong about the earnings. You kept saying that the 2021 earnings must be withdrawn and or they will be taxable and or need to be reported, since you believe that you are not allowed to have tax free earnings from ineligible contributions. I thought that too originally. But this was incorrect. The IRS does not require calculation of earnings with the untimely correction. And you do not need to withdraw the earnings with the untimely correction. You can leave the earnings and it is allowed to compound tax free. You only need to remove the contribution to stop the 6% penalty, not the earnings. And you will not be paying the 6% penalty on the earnings. You would continue paying a 6% penalty for each year IF you do not remove the original excess contribution. Leaving earnings in the account does not create a 6% penalty on the earnings. By making a distribution of your original contribution, you are eliminating the excess contribution. That is it. 

As per Tax Adviser : .."The taxpayer then makes an ordinary distribution of $7,000 that is composed entirely of nontaxable investment and that eliminates the $7,000 excess contribution. The $700 of earnings is retained by the Roth IRA and is allowed to compound tax-free in future years.”

https://www.thetaxadviser.com/issues/2020/apr/correcting-excess-contributions-iras.html

Tax Adviser always posts very comprehensive, detailed, accurate, information citing the IRS codes as well and with examples. The Fidelity link I posted above also clarifies that.

And here is another source if that's easier to understand. It says:

"If you remove the excess contribution AFTER the tax deadline, you do not have to pay taxes or penalties on the EARNINGS portion because you are not required to distribute the earnings, but you pay a flat 6% penalty per year based on the actual excess contribution amount.

Example:  You contributed $6,000 to your Roth IRA in 2022, your income ended up being too high to allow any Roth IRA contributions in 2022, you discover this error in November 2023.  You will have to withdraw the $6,000 excess contribution, pay the 6% penalty of $360, but you do not have to distribute any of the earnings associated with the excess contribution.

Why does it work this way?  This is only a guess, but since most taxpayers probably try to remove the excess contributions as soon as possible, maybe the 6% IRS penalty represents an assumed wipeout of a modest rate of return generated by those excess contributions while they were in the IRA."

https://www.greenbushfinancial.com/all-blogs/roth-ira-excess-contributions

"I would point out if that is true, why not just make that a regular investment?"

This post is about to handle excess Roth IRA contribution for previous years, sir. Not to ponder the investment options. The taxpayer had no intention to make excess Roth contributions, but did so for 2 years due to the incorrect information given to her by someone else. Now, she asked me for assistance to prepare 2022 returns, and I discovered that her Roth IRA contributions were 100% excess, so we are trying to resolve the issue. Her former tax preparer who prepared her 2021 returns failed to bring it to her attention. The recharacterization of 2021 to a traditional IRA is not an option either because it is too late. Recharacterization of 2022 Roth IRA to traditional is possible, but it makes no sense to do since she can just withdraw it before the 2022 tax return due date thus treating it as the contribution never happened. And she can just open a traditional IRA after if she wants. I already advised the taxpayer of her IRA options with her income. Not relevant to this issue here. This issue took a lot of time, research, etc to figure out, but I have it all figured out now and how to report it on tax returns as well. Instructions on forms 5329 and 8606 make a lot of things very clear as well. 

On another note, that is exactly why this "strategy" has been used lately. This is not my client's situation, but a strategy that has been gaining some popularity as of late surrounds the concept of making excess contributions to a Roth IRA in order to generate additional tax-free returns in the Roth IRA. Since the 6% excise tax only applies to the amount of the Roth IRA excess contribution and no 10% penalty or income tax would apply to the amount of the excess contribution, in addition to the earnings on the excess contribution remaining in the Roth IRA and able to grow tax-free, the idea is that the 6% excise tax on the excess Roth IRA contribution will end up being considerably less than if the investment was made with personal funds subject to the individual income tax rates.

Hence, the excess Roth IRA contribution strategy is based on the notion that paying a 6% tax on excess contributions to a Roth IRA, while gaining the tax advantage of having the earnings from the excess contribution remain in the Roth IRA so it can grow tax-free, is a great deal compared to making the same investment with personal funds and having to pay income tax on the earnings and gains.

[dmvorion]

Hello! I'm in quite a similar situation as you and spent hours doing research.I made accidental excess contributions in 2020, 2022, and 2023 (this tax filing period). I think I arrived at similar conclusions to you. Could you describe your solution process and if it was successfully resolved? It would be super helpful to me! Also I'm wondering if I can use an ordinary distribution to remove all excess (even for the 2023 timely correction) and just leave the net income sitting in Roth? To confirm, the income from prior years can stay and are also not subject to any taxes, right?

[itonewbie]

@dmvorion

You’ve come to an Intuit site that is only open to tax professionals.  You may be looking for support as an individual taxpayer.  Please visit the TurboTax Help site for support instead.

[MarinaEA]

@dmvorion  All I stated in my previous reply was accurate. And yes, we did resolve it. In our case, we had 2021 and 2022 excess contributions. With the timely correction ( 2022 was in my case), you must remove the excess PLUS the earnings. The earnings will be taxable as income at whatever the tax rate is. The earnings have to be added to 1040 as taxable income. With the untimely correction (2021 in my case), you only need to remove the excess to avoid keep accruing the penalty, the earnings can stay in the account. If you do want to withdraw the earnings as well now or later, it will simply be treated as ordinary distributions subject to tax, if any in your case. We paid the 6% penalty on the 2021 contribution, for 2021 and for 2022. No penalty on the 2022 contribution, since the excess and the earnings were timely removed.  Nothing has to be amended. The penalty form 5329 for 2021 was filed as stand alone. And the penalty form for 2022 was filed with the 2022 returns and the earnings from the 2022 contribution were reported on 2022 return. 

Note, this is how this is treated on the federal level. Depending on the state, it can be treated differently on the state level. Some states do not conform to some federal laws. In my case, I had to research how CA would treat this, and if they conform. 

And @itonewbie is correct. I believe you are in the wrong forum, since this is for tax professionals. If you are not a tax professional, I would strongly suggest to have this handled by one, since this can be complicated. 

[dmvorion]

I'm so sorry, I didn't realize this was a restricted forum. I really appreciate your response nonetheless! Of course your don't have to reply further.

An interesting observation: I assume in your situation, the 2021 excess was subject to the 6% penalty for both years 2021 and 2022 (rather than just 2021 exclusively) because there were no Roth distributions to eliminate the 2021 excess in 2022?

Also, you stated that 5329 was filed as standalone, but line 25 for 5329 indicates that the value needs to propagate to Schedule 2 of 1040. Also, the 5329 instructions state, "If you don’t have any other changes AND [sic] haven’t previously filed a federal income tax return for the prior year, file the prior year's version of Form 5329 by itself." So I assume a 2021 income tax return was not filed? However, instructions immediately after state, "If you have other changes, file Form 5329 for the prior year with Form 1040-X, Amended U.S. Individual Income Tax Return." To me this implies 1040-X is needed only if there are other changes. It's a bit ambiguous to me. 

[qbteachmt]

It's not so much a restricted forum. If you read at the top, you see it's for using a specific Tax Prep program for your clients. This is a ProSeries tax prep user forum.

You seem to be lost on the internet.

You’ve come to a Peer User community for Intuit Income Tax Preparation products supporting tax preparation professionals using ProSeries, Proconnect and Lacerte Tax Preparation programs, and you may be looking for support as an individual taxpayer using TurboTax. Please visit the TurboTax Help site for support.

And try this screen, for the various topics (subforums): https://ttlc.intuit.com/community/discussions/discussion/03/302

Your sign in user info here is the same one you can use over at the TurboTax forum.

Thanks.