I'm a grad student living off of fellowship stipends. In CY 2014, I saved up a little and started contributing to a traditional IRA. I kept this up into CY 2016. Then, when I took my 2015 taxes to H&R Block a few days ago, I learned that since the university doesn't give me a W-2, I'm not actually eligible to contribute to any sort of IRA. This is a little-known fact that my 2014 return preparer apparently missed - though thankfully she knew I wasn't allowed to deduct the contributions.
From the IRS site, it's looking like I have a few options now.
First, I could clear out the account by April 18. I would have to pay income tax on the interest I earned, but since my contributions were never deducted, it seems to me I won't have to pay double income tax on the contributions. I'd also have to pay a 2 x 6% =12% tax on the 2014 contributions that I kept in for CY 2014 and 2015. It's not clear to me if I'd have to pay the 10% early distribution tax on interest and/or contributions.
Second, I could leave the contributions there and not contribute for the first 3 years that I'm actually eligible to do so. I'd pay the 6% tax every year the contributions stay in until they're cancelled out, but as far as I know, that's all. It could be 5-7 years before I have a job that gives me a W-2.
This is my question. Nearly all the sources I'm seeing talk as if pulling the contributions out is a no-brainer. But when I run some numbers, it looks to me that in the long run, leaving the contributions in is a better bet. This is because the 6% penalty is on the contributions, and so it's a constant proportion. If I never put any more in, I pay $12,000 (current contribution total) x 0.06 = $720, every year until I get a job with a W-2 and can cancel out the excess by not contributing for a time. But the interest continues to grow tax-free, and that's an exponential growth. The cumulative interest earned quickly overtakes the cumulative yearly $720's paid. My cash flow takes a hit from the penalty every year, but my wealth in the IRA increases faster and causes a net benefit in the long run.
If I cleared the account, I'd likely be putting it into a brokerage account growing at the same rate as the IRA would have. This is because I'm not eligible for any form of retirement savings and can't think of anywhere better to put it. Then I don't pay the $720 every year, but I do pay income tax on the interest earned. And since the interest grows exponentially, the tax does too. The growth in tax in the brokerage scenario quickly overtakes the tax in the ineligible IRA scenario.
It seems to me that I will pay less tax over time if I leave the contributions in while getting the same amounts of earnings. I might even pay less tax if I continued to contribute while ineligible (without deducting contributions from my income), though at some point I could put so much in that the 6% penalty would really cut into my cash flow. This seems too good to be true...everybody with enough loose cash to handle the yearly penalties would be pumping their IRAs if it were.
I'm new to all this. Am I missing something? Thanks.
Wed Apr 06, 2016 11:37 am
oldguy Senior Member
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quote: Then, when I took my 2015 taxes to H&R Block a few days ago, I learned that since the university doesn't give me a W-2,
If there is no 1099 or W2, that means that you have no taxable income - so why file a return?
Or do you have some other income? (other than the stipends)
Wed Apr 06, 2016 3:11 pm
suecorbett First Time Poster
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Traditional IRA excess contribution strategy
I do agree with you, as I also was not eligible for W-2, however I still was working as you need to live somehow in this world, especially if I need to write my research paper.