17 May A Roth IRA gift and unexpected trouble

Q. My father has apparently been investing in a Roth for me every year for the past five years, but he never told me. I don’t think I qualify for Roths because of my income. What can I do?
— Concerned

A. That was very thoughtful of your dad, but you’re correct: there could be some tax trouble if you didn’t qualify.

A Roth IRA is a tax-free investment account which allows maximum annual contributions of $5,500 for 2015 & 2016 ($6,500 if you’re age 50 or older). These contributions are subject to income limitations, said Taylor Thomas, a certified financial planner with Round Table Wealth Management in Westfield.

He said once a taxpayer (filing as single, head of household or married filing separately) has modified adjusted gross income (MAGI) that reaches $116,000 (for 2015) the ability to make a Roth IRA contribution begins to be phased out. It’s totally phased out at a MAGI of $131,000.

If the taxpayer is married and filing a joint return or files as a qualifying widow(er), these limits are increased to $183,000 & $193,000, respectively, Thomas said.

The funds in a Roth IRA will grow tax-free and qualified distributions taken from a Roth IRA are not subject to income or capital gain taxes, he said.

“A qualified distribution is any payment or distribution made after the five-year period beginning with the first taxable year for which a contribution was made and the distribution is made 1) after you reach the age of 59½, 2) due to being disabled, 3) to a beneficiary or to your estate after your death or 4) to purchase your first home (up to a $10,000 lifetime limit)” he said.

Thomas said if your father has been making contributions to a Roth IRA titled in your name and your MAGI during the past five years was above the limits allowed to make Roth IRA contributions, you should contact your tax advisor immediately.

“The IRS penalty could be a 6 percent tax on the excess amount for each year in which you don’t take action to correct the error,” he said, offering this example:

If your father contributed $5,000 for you in 2014 and your MAGI was greater than the limit, you could owe the IRS $600 (for two years). In addition, if you are younger than 59½, you’ll be subject to a 10 percent early withdrawal penalty on the earnings amount attributable to the excess contribution, he said.

So talk to your accountant about filing any necessary amended tax returns and to draft a letter to the IRS explaining the mistakes made and request that any tax penalties be waived.

“Since you are bringing this matter to the attention of the IRS — not the other way around — they may be a bit more lenient with the penalties imposed,” Thomas said.

Also know the custodian holding the Roth IRA account is required to issue a Form 5498 each year showing the contribution amount for that particular year, Thomas said.

“If you don’t have these records in your files, you should request these forms from the custodian going back to the date the Roth IRA account was opened for you,” Thomas said. “These forms will help your accountant put the pieces together and make sure that all excess contributions are addressed with the IRS.”

One other issue to consider is that the contributions that your father made to this account were gifts to you, Thomas said.

“The annual gift exclusion allows your father to give up to $14,000 (for 2015) per year without incurring any gift tax,” he said. “If the combination of these contributions and any other gifts from your father to you were less than the annual gift exclusion amount, your father shouldn’t owe any gift taxes.”

You should recommend your dad review this information in order to make sure that he filed any gift tax forms, if applicable, Thomas said.

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This post was first published in May 2016.