I am attempting to remove an excess contribution made to my 2019 Roth IRA account before 2020 tax deadline.

While removing the contribution, Vanguard asks for whether federal and state taxes should be withheld? Under what circumstances would I withhold taxes? I am under the impression that taxes will be withheld when I fill out the 2019 taxes so I am confused as why I would do it here? What would happen if I don't withhold taxes?

Below is a screenshot of the Vanguard screen:

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  • This looks a lot like the election for normal withdrawals/distributions. Did you tell Vanguard this is a corrective distribution not a normal one? This is vital, because they need to code it differently on the 1099-R they will submit to IRS. Jul 26 '20 at 5:39

I am under the impression that taxes will be withheld when I fill out the 2019 taxes so I am confused as why I would do it here? What would happen if I don't withhold taxes?

When you are completing your return taxes aren't withheld, the return is where you document everything and settle the account.

If the calendar year hasn't ended then is can make sense to have the investment company withhold money and send it to the IRS and state tax authority. This is especially true if your tax situation is such that you will ow a lot of money when you file your return. The federal government, and maybe the state government, can impose a penalty for having too little withheld.

If the investor is in that situation they might want to have taxes withheld to make sure they don't get hit with a penalty. You will have to tell them how much to withhold because every tax situation is different.

  • how do I figure out how much to withhold? What are some guide lines ? Feb 25 '20 at 16:44

When you withdraw an excess contribution to an IRA, you are also expected to withdraw any gains attributable to that contribution, and those gains are taxable income (not classified as capital gains) to the IRA holder. For example, your IRA was worth $40K at the end of 2018 and you contributed $10,000 to the IRA for 2019, thus making a $4000 excess contribution. Because you have been fortunate in your IRA investments, your IRA account is worth $60K when you go to withdraw your excess contribution. If you take out only the excess $4000, you have made a tax-deferred profit inside your IRA from that excess contribution which profit you wouldn't have made at all if you hadn't made the excess contribution. That's why you must withdraw the excess gains from that excess contribution, not just the excess contribution. You are liable for tax on that excess gain, and Vanguard just wants to know if you want to have some tax withheld right then and there. If you select 0% (a.k.a. no withholding), you will pay the tax due when you file your return. Tax returns are where you get to compute the tax due and then tell the IRS what you think is due, how much was withheld already, and send a payment for any shortfall or request a refund of the excess withholding. Thus, selecting 0% is not harmful except when you expect you might be penalized for not having paid sufficient tax on a quarterly basis.

  • But for a correction done in the year after the error (which is permitted -- in fact it's permitted until the extended deadline, Oct. 15) any withholding will be applied to current year tax (2020) while the excess contribution earnings are reported and taxed for the prior=error year (2019). If you are underpaid for 2019 it is impossible to correct it by withholding now since time is irreversibie, apparently because of quantum physics. Jul 26 '20 at 5:35
  • @dave_thompson_085 The excess earnings attributable to the excess contribution are taxable income for the year in which they are removed from the IRA, 2020 in this instance, and not for 2019, the year for which the excess contribution was made, regardless if whether the excess contribution for 2019 occurred during calendar year 2019 or before Tax Day 2020. So, the quantum physicists can rest easy; the IRS is not trying to undo their firmly-held beliefs as on now. Jul 26 '20 at 13:30

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