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For 2016 Roth IRA the rules state that:
Greater than $193,000 - Ineligible for a Roth IRA

Let's say someone makes $200,000 pre-tax salary and wants to contribute $5,500 to Roth IRA in early January 2016. How do they know if they can or can't contribute if their Adjustable Gross Income has not yet been calculated.

So, what happens if you contribute $5,500 in 2016 and then when taxes come around in 2017 you find out that you were ineligible?

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When you start preparing your 2016 tax return in early 2017 and realize that you are ineligible to contribute to a Roth IRA, you have the options of

  • withdrawing your contribution as well as any earnings from that contribution from the Roth IRA. The earnings will count as income for 2017 since you will be making the withdrawal in 2017. The original contribution, of course, continues to count as income for 2016.

  • recharacterizing your contribution as a contribution to your Traditional IRA. You need to contact your IRA custodian and tell them about it so that they can change the status of your account from Roth to Traditional IRA. Use the word recharacterization so that they will know exactly what you are talking about. If your income is very high, you might not be able to deduct the Traditional IRA contribution (wholly, or in part) on your 2016 tax return either, and if you are in that high-earner category, you should file Form 8606 with your tax return to tell the IRS that you have made a nondeductible contribution to your Traditional IRA. In later years, when you start taking distributions from your Traditional IRA, that nondeductible contribution will not be taxed upon withdrawal. If you do not file Form 8606, you will owe taxes on that amount when it is withdrawn.

  • doing nothing in which case you will get whacked with all kinds of penalties

Note: if you recharacterize your Roth IRA contribution as a Traditional IRA contribution, then, depending on your Traditional IRA accounts, it might be advantageous to do a "back-door Roth IRA conversion". There are multiple answers on this site that will tell you all about back-door Roth IRA conversion.

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    In the first case, what if the earnings are negative? Suppose the taxpayer bought 100 shares of stock in their Roth IRA at $55. The price drops to $50. (Assume no dividends were earned.) Should they withdraw only $5000? Can they claim a capital loss of $500? – Nate Eldredge Jan 23 '16 at 21:40
  • For recharacterization, the trustee of the Roth IRA generally determines the amount that is transferred to the trustee of the Traditional IRA, but the taxpayer can do so personally too. Publication 590a and 590b has worksheets for this purpose. In your example, the (brokerage) custodian would sell the shares and send $5000 cash to the other trustee (or just transfer the shares from the Roth IRA to the Traditional IRA account). The loss is not deductible until all the Roth IRA accounts have been closed, (continued).... – Dilip Sarwate Jan 23 '16 at 23:12
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    ... (continuation). At that point, if the total distributions from all the Roth IRAs add up to less than the total contributions to Roth IRAs, a loss can be recognized, but only as a Miscellaneous Deduction (subject to the 2% floor) on Schedule A. For most people, this means that there will be no deduction. Nothing beats kicking a man when he is down: the sad sack has not only lost money on his Roth IRA but he can't take a deduction for it either! – Dilip Sarwate Jan 23 '16 at 23:17
  • Thanks. I was actually more wondering about the withdrawal case ("first case") than recharacterization, though. – Nate Eldredge Jan 23 '16 at 23:40
  • @NateEldredge I don't think the loss is deductible, at least not now. What goes into an IRA and comes out of it is cash. Even if you get the custodian to simply transfer the shares to your non-retirement account, it would count as a wash sale: you effectively sold the shares within the IRA for a loss and bought them in a non-retirement account within 30 days (all without having to pay any brokerage fees for the sale and repurchase), and so the loss is not allowed. – Dilip Sarwate Jan 25 '16 at 22:43
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If you have no money in pre-tax IRAs, one way to contribute to Roth IRAs without an income limit is to do a "backdoor Roth IRA contribution" -- contribute to a Traditional IRA, and the immediately convert it to a Roth IRA. The end result is the same as a regular Roth IRA contribution, except there is no income limit.

In your hypothetical situation where the person hasn't contributed yet, but is unsure whether they can directly contribute to a Roth IRA, they should just do a backdoor Roth IRA contribution, just in case. That way, it works regardless of whether his MAGI is above or below the line. There is no downside to a backdoor Roth IRA contribution (again, with the precondition that they have no money in pre-tax IRAs to begin with).

If the person has already contributed, then they should take one of the options in Dilip Sarwate's answer. Note that those options are inferior to having done a backdoor Roth IRA contribution initially, because with either of those options, gains made so far since contribution will be taxed.

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  • I don't agree that there is zero downside to a backdoor Roth: there is additional effort and/or paperwork if nothing else. There's also a small risk that backdoor Roths will all be deemed invalid under the step transaction doctrine. If I were unsure if I would meet the income limit, I would wait until I had prepared my taxes the following spring, and then contribute if I find myself eligble. 99% of people are either sure they are eligible (nowhere near the income limit) or sure they are ineligible. The former should just contribute to a Roth and the latter can use the backdoor. – stannius Dec 1 '16 at 22:53
  • @stannius: If backdoor Roths are deemed invalid under the step transaction doctrine, then they would be considered to be one step, which means that you made a regular Roth IRA contribution. If you were eligible to contribute to a Roth IRA directly anyway, there should be no difference. – user102008 Dec 1 '16 at 23:08
  • Why "immediately"? Can't this conversion be done later in time (same year, next year etc) to avoid single step thing? – alexandroid Dec 15 '17 at 7:10
  • @alexandroid: The longer you wait, the more growth there will be, and any earnings are pre-tax and you must pay tax on it on conversion. Furthermore, if you withdraw that conversion within 5 years, you need to pay a penalty on the taxable part of the conversion. – user102008 Dec 15 '17 at 15:53

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