Q. We are a fairly young married couple, and we understand the importance of starting to save early for retirement and have contributed to our Roth IRAs for the past six years. We funded our Roth IRAs for 2013, invested the contributions and have made money on the investments. Now a friend told us that if all of our income was earned while overseas, we may not be able to make a contribution. Do you know if this is correct? If so, what do we do about the contribution we’ve already made?
A. Your friend is probably correct, and if so, your timing of asking the question is good, but you will have to act sooner rather than later. A consultation with a tax/financial professional is suggested since your particular situation may allow for a contribution, but I’ll explain the general rules and what to do if you think your 2013 contribution was made in error.
To contribute to a Roth or a Traditional IRA you must have taxable compensation. Taxable compensation is what you earn from working, such as wages, salaries, commissions, tips, bonuses and taxable alimony. If you are working overseas and have foreign earned income and/or housing allowances, the IRS will not recognize these as taxable income for purposes of allowing a contribution to an IRA. If you have some income from work performed in the United States not deemed as foreign earned income, that income may count as taxable compensation and allow you to make a contribution. Also, if after taking the Foreign Earned Income and Foreign Housing Exclusions you have additional foreign income, the excess may count as taxable compensation. Compensation to an employee of the federal government working overseas is also counted as taxable compensation for this purpose. As a married couple, your 2013 modified adjusted gross income must also be less than $178,000 to make the maximum contribution of $5,500 ($6,500 if age 50 or over).
If you determine that you should not have made a contribution, you have what is called an “excess contribution.” There is a 6 percent excise tax on excess contributions to either traditional or Roth IRAs. If you both made the maximum contribution of $5,500, that’s a $660 penalty, so much for trying to do the right thing and save for retirement! It gets worse if you leave the contribution in the account, because the 6 percent excise tax is applied for each year the contribution remains in the account.
Here is why the timing of your question is good. If you withdraw the excess contribution and any earnings prior to the due date (plus any extensions) for the tax return of the year the excess contribution was made, you can avoid the 6 percent excise tax. Any income earned on the contribution will need to be included as taxable income and taxed as a premature distribution if you are under age 59-1/2. Since you have gains on your contribution, you may want to ask your investment adviser, broker or brokerage if you can reverse the trade via their “error account.” This will eliminate the gain and convert your contribution back to cash. If they won’t do this, you will want to sell the investment plus the gains as soon as possible. Once the cash is in the account, complete an IRA distribution form and indicate that the distribution is a removal of excess contribution plus net income attributable before a tax filing deadline including extensions. You’ll need the date of the contribution, tax year for which the contribution was made, amount of excess contribution, amount of earnings and or loss.
If you don’t withdraw the excess contribution plus earnings by the due date (plus extensions) for the tax year of the year the excess contribution was made, you have other options, but the tax ramifications are more severe, and a consultation with a tax/financial professional is even more important.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624