Dear Rick:
I have a question on my 2016 tax return. In April I filed for an extension and I’ve just started to work on my return. In 2016, I got married in October. However, prior to getting married, I contributed $5,500 to a Roth IRA. When I made the contribution I was eligible for a Roth IRA contribution. However, when I started doing my 2016 return, when I factored in my wife’s income along with a bonus that she received, our income is over $200,000 for last year, and as a result, I am not eligible for a Roth IRA contribution. My first question is that since I contributed to a Roth when I was eligible, before I got married, does that change the situation and allow me to contribute to a Roth? Is there a special form that I need to complete? My second question is, if I could not contribute into a Roth, what should I do with regards to the money that’s still in the Roth IRA?
Thank you,
Jose
Dear Jose:
The first issue is whether the fact that you made your Roth IRA contribution when you qualified, versus when the return was done, makes a difference. Unfortunately, the answer is no. For tax purposes, someone’s marital status is determined as of December 31st. It doesn’t matter if you were married January 1st or December 31st. For tax purposes your marital status for the entire year is set on December 31st. Therefore, since in the case at hand you were married as of December 31, 2016, you are considered to be married for the entire year. Thus, because of your joint income you’re not eligible to contribute into a Roth.
When someone contributes into a Roth IRA when they are not eligible the penalties are severe. The IRS accesses an excess contribution penalty of six percent of the amount you contributed. For example, if you had contributed $4,000 into a Roth IRA your excess contribution penalty would be $240.
What people are unaware of is, the excess contribution penalty isn’t just for the year you made the excess contribution; rather, it is for every year that you don’t correct the excess contribution. Therefore, it is important that you withdraw the contribution and the earnings from the Roth IRA. If you don’t, you could be subject to the same penalty a year from now.
When you withdraw your contribution from the Roth IRA you also have to withdraw any earnings that the contribution has earned. For example, if you contributed $4,000 into a Roth and that money grew to $5,000, you have to withdraw the full $5,000 from the account. In addition, the income that you withdraw is taxed to you at your ordinary income level. Furthermore, unless you are over 59½, permanently disabled or have other significant medical expenses, you are also liable for the 10 percent early withdrawal penalty on the earnings.
Of course, you may be asking yourself what happens if you had a loss on the money you invested into the Roth. Unfortunately, you cannot deduct that loss for tax purposes. In addition, if you contributed $4,000 and today it’s worth $3,500 it is the $3,500 you have to withdraw from the Roth, not the $4,000.
Because you have not filed your 2016 tax return and you’re still within the tax deadline, and because you filed for an extension, you can avoid the six percent penalty on excess contributions if you withdraw the money before your return is due. This doesn’t avoid the tax and potentially any penalty on the income that you earned; however, it would avoid the excess contribution penalty.
For those of you who filed for an extension in April, you still have time to do your 2016 tax return. My advice is that you start as soon as you can so you’re not rushing at the end. As I’ve always said, one sure way to guarantee higher scrutiny is to file an inaccurate or sloppy return. Therefore, if you have filed for an extension, now is a good time to start working on your 2016 tax return.
Good luck!
If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com