Roth conversion

My thanks for Natalie Choate for analyzing and pointing out the following information.  Ms. Choate is truly a rock star in the world of IRA law, and much gratitude is owed to her by those of us in the financial community for her thorough analysis and commentary that she provides on such matters as this.

If you live long enough, you’re liable to see just about anything… the following is an example of the most extreme example I’ve ever heard of for using the tax law to your own advantage, deliberately flaunting the law for purposes of evading tax.

The Facts

If you intentionally over-fund your Roth IRA, above the amount that you’re allowed to contribute for the tax year.  The tax law allows you to remove the excess contribution by October 15 of the year following the year of contribution.  If you do not remove the excess contribution (and the gains associated with it) by that point, you will be subject to a 6% excise tax on the excess contribution until the situation is rectified.

The situation can be rectified by either crediting the excess contribution to a future years’ contribution, or by withdrawing the excess amount prior to the deadline for the following year.  Each year that you do not rectify the over-contribution you will be subject to the excise tax.

The Anomaly

If you do not remove the excess contribution and the growth associated with it by October 15 of the year following the year of contribution, once you’ve been assessed the excise tax, your rectification is only required to the extent of the excess contribution – not the growth associated with it.  The growth is no longer considered (under present tax law).  In other words, you can rectify the excess contribution at that point by simply removing the excess, but the growth doesn’t have to be removed.

If you’re following the way this is working, you’ve probably figured out the gist of the “idea” we’re talking about here.

The Terrible, Terrible Idea

Here’s an example of the bad idea in play:

Let’s say you have no Roth IRA at all, but you have $20,000 that you’d like to invest.  Furthermore, you don’t have compensation that would make you eligible to contribute anything to a Roth in the first place.  Ignoring all convention, you open an IRA and contribute the $20,000, investing it in the latest hot stock.  October 15 the following year rolls around, and your hot stock has doubled in value.  (It should be noted that if your hot stock didn’t do so well, such as losing money, you could pull it out now and walk away with no consequence.)

Under the normal conventions, you could withdraw the entire $40,000 (your contribution plus your gain), but you’d have to pay ordinary income tax on the gain of $20,000.  Doing this, you’d avoid the excess contribution 6% excise tax, $1,200.

However, in this terrible, terrible idea, you decide to wait until after October 15, and pay the excise tax on the over-contribution.  Now you have three choices:

• If you’re otherwise eligible for contributions to the Roth in the current year, part of the excess contribution can be used (credited) as a regular contribution.  You would then be subject to the excess contribution tax on the remainder of the over-contribution until it’s been used up by future credits (this is one of the right things you could do).
• If you’re not eligible for the contributions, you could withdraw the excess contribution at this point, along with the growth in the account, paying ordinary income tax on the growth.  This is the other right thing you could do.
• If you’re up for a challenge (and possibly jail time), you could withdraw only the excess contribution and leave the growth in the account to grow tax free for the rest of your life.  It probably won’t do you a lot of good in Alcatraz, though.

The Reason This is a Terrible Idea

The IRS is never in favor of kooky tricks like this that don’t work as the law intended.  So what might happen?  Well, the IRS could review your IRA account and disqualify it completely, on the basis that the custodian should never have allowed the excess contributions in the first place.  In this manner, you’d be subject to tax on the growth in the account and the whole account would be null and void.  Your IRA custodian is likely to be in hot water as well, as this would be a violation of the basic rules of IRAs.

Since the entire concept of the ability to withdraw the excess contribution is designed to help taxpayers resolve an honest mistake, abusing this provision is likely to be soundly disallowed.  If the facts were known, (which they would be discovered eventually), the IRA is likely to be disallowed completely, and the abuse is likely to carry with it severe penalties.

The IRS doesn’t presently have remedy for the situation – and in the case where you honestly make a mistake and elect to leave the funds in the account (crediting against the current year, as in the first bullet point above) – it wouldn’t be too much of a leap for the IRS to disqualify distributions from the gains.  This would become especially so if the activity I’ve described becomes a rampant abuse.

It’s best to follow the rules as intended and leave well enough alone.

Photo by CarbonNYC

Even with our “best laid plans”, sometimes we make mistakes.  Perhaps you underestimated your income for the year and contributed more to your IRA than could be deductible; maybe you rolled over an amount that was not eligible for rollover; or maybe you made a contribution to an IRA that you were not eligible to contribute to, such as an inherited IRA.  Whatever the case, you’ve over-contributed money into an IRA and need to take action, otherwise you can be setting yourself up for some penalties and other un-wanted taxation.

Actions for Dealing With an Over-Contribution

You have three options for dealing with the over-contribution situation:  you can pull the over-contribution out; you could also re-characterize the contribution; or you could do nothing.

Pull the over-contribution out. This is known as a corrective distribution.  Essentially this is exactly as it sounds:  you pull out the money that represents the over-contribution, plus (here’s the wrinkle) any growth or income attributed to the over-contribution.  You need to do this by the due date (including extensions) of the tax return for the year of the contribution… In this case “due date” has a special meaning:  if you filed your return on time (including extensions) this means October 15 of the year following the year of the contribution, even if you did not use an extension; however, if you did not file your return on time, the deadline is (was) April 15 of the year following the contribution year.

So if you contributed a total of $1,000 more than you were eligible for to your IRA, and there was growth and income of $200 attributable to the over-contribution, you need to withdraw $1,200 before October 15 of the year after your contribution year.  And, you’ll need to pay ordinary income tax on the $200 of earnings – plus 10% in early distributions penalty.  Of course if you didn’t file your tax return on time, (actually if you plan to not file your tax return on time) you need to pull out your over-contribution by April 15.

Recharacterize. This method resolves an over-contribution to a Roth IRA, by changing the character of the contribution to a traditional IRA instead of a Roth IRA.  This can only be done if you’re eligible to make a contribution (either deductible or non-deductible) to a traditional IRA (you meet the income, other plan coverage, and age limits).  To do this you submit Form 8606 to the IRS indicating a change to the over-contribution amount, plus or minus any earnings or losses that have occurred attributed to the over-contribution, from Roth to traditional.  This has the same deadlines mentioned above for the corrective distribution.

Do nothing. In essence you’re not exactly doing nothing – you’re accepting the fact that the over-contribution occurred, and you’ve chosen to accept the consequences.  The consequences are that for any amount you’ve over-contributed, you are subject to a 6% penalty for excess contribution.  This may be the best course of action if the over-contribution can be absorbed as a contribution in the following year.

As an example, maybe you made a contribution to your Roth IRA of $5,000 for the year, and it turns out that your income level only allows a contribution of $4,800 – something you didn’t discover until it was too late.  The consequence is that you’ll owe a penalty of 6% – $12 total – on the over-contribution of $200.  As long as you are eligible to contribute at least $200 to your Roth IRA in the following year (and you don’t over-contribute again), you can pay the penalty and leave the money where it is.

Unfortunately, if the over-contribution amount in question is large, this method doesn’t really help much.  This can be the case if you’ve mistakenly rolled over an inherited IRA into your own IRA instead of an inherited IRA – and you’re a nonspouse beneficiary.  If you don’t catch it in time, you will be subject to the 6% penalty for the year of the rollover and every subsequent year thereafter until you distribute the IRA.  When you finally catch the mistake (or rather, the IRS catches your mistake, more than likely), you’ll be subject to ordinary income tax (and retroactive penalties and interest) on the entire distribution as well, since you effectively treated the IRA as your own money from the very start.

Photo by Darwin Bell

… or better yet, what will they Roth in the future? You’re right, terrible attempt at a pun.

In case you aren’t a retirement and financial planning geek like myself, there has been a proposal put forth by the current administration to require all employers to automatically enroll employees in a retirement plan.  I find it interesting that the choice for a “default” retirement plan for the proposed system is a Roth IRA.

The reason this is so interesting is because a Roth IRA doesn’t provide the participant with an immediate benefit – there is no tax deductibility, no employer match, etc..  Granted, any sort of retirement savings is a good idea, but this type of plan will be a hard sell for those folks who haven’t already bought into the concept of saving strictly for the benefit of saving on their own.

In addition, there’s the current push (in 2010) for lots and lots of Roth conversions.  This one is even better – there’s not only no adverse tax revenue consequence, there’s a great tax revenue advantage if lots of IRA money is converted and taxed. This push has been referred to as a “mortgaging of the future” – since we’ll get lots of tax revenues from the conversions today at the expense of future revenues on the growth in the accounts. It wouldn’t be hard to imagine a future administration pointing to 2010 as the first domino that caused the soon-to-be current circumstances.

Is there more to it?

Perhaps there is more to it – obviously, a dramatic increase in participation in deductible IRAs could have a significant negative impact on tax revenues, hence the Roth being recommended as the default.  But what if Congress decides at some point down the line that this Roth deal looks too good for the taxpayer??  What if the idea of completely tax-free distributions starts to cause extreme anxiety among our legislators (as un-taxed benefits often do)?

It’s quite possible that the reason the Roth IRA account has been deemed the plan of choice is primarily because of the non-existent tax impact in the short run.  And the longer-run consequence (the mortgage of the future) of potentially locked up funds that will bring no tax revenues can be dealt with by future administrations – when such tough decisions can be confronted far distant from the decision-makers who helped us to get into the position in the first place.

Another thing that’s pretty interesting is the fact that many of the online Roth Conversion calculators are reportedly over-stating the benefits of Roth Conversion – putting far more emphasis on the potential for future higher tax rates and the benefits of no RMDs than is warranted.  It’s not hard to guess why asset-gathering companies might suggest that it would be in your best interest to convert assets to Roth IRAs; conveniently under the management of the company who recommends conversion.

Imagine the case in 20+ years when a great amount of the wealth in this country is locked up in Roth IRA accounts – with no tax ever to be paid on it (under current law), and no Required Minimum Distributions (RMDs) of the funds.  I can imagine that there might be an “emergency needs-based” change to the law – perhaps something simple like a requiring RMDs, with maybe a value-added tax, along with possibly inclusion of Roth IRAs as taxable assets in your estate.  That would pretty much knock all these conversion schemes on their collective ears, don’t you think?

Your Defense

It is for these reasons that I believe most folks are best served by not putting too many eggs in one tax treatment basket – you should not only have traditional IRA or 401(k) assets along with Roth IRA or 401(k) assets – you should also have taxable savings, such as a standard brokerage account and/or savings account.  By diversifying your savings across multiple tax treatments you can hedge your bets against whatever adverse changes there may be for the future.

In addition, cast a wary eye toward any recommendation for conversion to a Roth IRA – make sure that this makes complete sense to you, both from a tax payout standpoint today, and from the point of view of what you know and expect about future tax rates and laws.  Most importantly, don’t take advice strictly from someone who stands to benefit from the very advice he’s giving.  Don’t take this to mean that Roth IRA conversion isn’t ever beneficial: for many people there are compelling reasons to convert at least some assets to Roth.  It just makes good sense to proceed with caution and make no swift, dramatic changes.

And pay attention, because these things have a tendency to happen so subtly that you might even think it’s a good idea…

Photo by Rennett Stowe