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Well, in certain situations, earnings in an IRA account become important. Let's take a look at those situations and show you how to make your own computations... just to keep your IRA administrator on the straightandnarrow.
When Are IRA Earnings Important?
Just like playing games as a kid, there are times when you want to call a "doover" and remove or reclassify an IRA contribution... either Roth or traditional. When might that happen? Let me count the ways. You make a traditional IRA contribution. You intended for this IRA contribution to be deductible, but you now find out that if you are covered by a pension plan and/or deferred compensation plan, and your income is above certain limits, your IRA contribution is not deductible. You don't want to deal with nondeductible IRA contributions, so you want to "undo" this IRA contribution.
 You made a Roth IRA contribution, and now realize that your income is too large to allow for a Roth IRA contribution. You now need to "undo" this Roth IRA contribution.
 You converted a traditional IRA to a Roth IRA. Now you find that your modified Adjusted Gross Income (AGI) is greater than the amount allowable to make such a conversion. So, you're now forced to recharacterize your conversion back to a traditional IRA.
 You made a traditional IRA contribution, but realize now that the contribution should have been a Roth IRA contribution. You want to recharacterize your traditional IRA contribution to a Roth contribution.
Now, in most cases, it is the IRA custodian's job to do the legwork and compute the earnings. But, in my experience, many custodians make mincemeat out of the earnings computations. Since, in some cases, those earnings might be subject to tax (and even penalties), it's important that the IRA custodian doesn't hit you with a large earnings component. Since it's your money, I thought you might like the earnings computation formula so you can keep a close watch on your custodian.
Background
IRS Regulation 1.4084(c)(2)(ii) prescribed the method for computing the earnings attributable to these types of transactions. But, there were many problems inherent in this method  the biggest being that, in some cases, net income could not be a negative amount.That's a bit shortsighted, don't you think? It'd be fine if stocks only increased in value, but we all know that they don't. So, not allowing for negative earnings in all cases was a big drawback.
Another problem was that this method required you to review account activity in a preceding year... long before the contribution in question was actually made. How does that help to isolate the gain on any specific contribution or conversion? (Hint: It doesn't.)
So, we'll now refer to these computations as the "old method." Why? Because Uncle Sammy came up with a "new method" (IRS Notice 200039, found in Internal Revenue Bulletin 200030). Is the old method completely out the window? Not necessarily. In the notice, the IRS said that until further guidance is issued, you can use either method. It also stated that future guidance will restrict use to the new method, so you might as well become familiar with this method now, since it looks like it'll be with us for some time.
The new method generally bases the earnings calculation on the actual earnings or losses in the IRA during the time that it held the contribution in question. Additionally, the new method only takes into account the time that the contribution was in the IRA account. There is no reference to any prior periods. (Gee, what a concept... reality!)
The Formula
If you weren't a math major, don't panic. It's simply easier to express the formula mathematically, but first let's try to put the formula into words:Net Income = Contribution, TIMES (the Adjusted Closing Balance, MINUS the Adjusted Opening Balance, DIVIDED BY the Adjusted Opening Balance).
(You do the math in parentheses first.)
No good? Well, let's reduce it to a formula we can deal with. Read the words and look at the formula at the same time. It's really not that bad, once you get your brain around the concept. The formula looks like this:
NI = C x [(ACB  AOB)/AOB]
Where: NI = Net Income, C = Contribution, ACB = Adjusted Closing Balance, and AOB = Adjusted Opening Balance
The Adjusted Opening Balance is the IRA's fair market value (FMV) at the beginning of the computation period, plus any contributions made to the IRA during this period (including the returned contribution).
The Adjusted Closing Balance is the IRA's FMV at the end of the computation period, plus the amount of any distributions made from the IRA during this period.
The Computation Period begins immediately prior to the time that the particular contribution was made to the IRA, and ends immediately prior to the removal of the contribution being returned.
Still sound like Greek to you? Well, it can get a bit complicated. The IRS notice provides a few examples that you might want to check out. We'll provide a few of our own. Really, the easiest way to see the formula in action is to run the numbers.
Running The Numbers
Example #1 On February 1st, (when the FMV of her Roth IRA was $5,000) Josie makes a $2,000 Roth IRA contribution. When she prepared her taxes the following year in March, Josie discovers that her income is too high for her to make a Roth IRA contribution. She immediately notified her IRA custodian of this fact. On April 1st, when the FMV of her Roth IRA is $8,500, the custodian returns her $2,000 contribution plus the earnings. How much are the earnings under the new method?Her Adjusted Opening Balance (AOB) is $7,000 ($5,000 plus the $2,000 contribution). Her Adjusted Closing Balance (ACB) is $8,500. You now have all of the information to compute that her earnings on the contribution amounts to $428.57, and must be returned to her with the $2,000 contribution. The computation looks like this:
Net Income = $2,000 X [($8,500  $7,000) / $7,000] = $428.57
A point to consider  if you have multiple IRA accounts, you only have to compute the earnings on the account into which the original contribution or conversion was placed. This means that Josie's earnings computation would remain the same no matter how many IRA accounts she has. So, for the purposes of computing the earnings from the account, focus only on the account into which the contribution in question was deposited. Do not aggregate all of your IRA accounts when you perform your computations. Remember that the goal of this exercise is to determine the earnings for this specific contribution  the contribution being returned or recharacterized  and not the earnings of all of your IRA accounts combined.
How would negative earnings work? Read on, Fool!
Example #2  On March 1st (when the FMV of his Roth IRA was $80,000), Bennie decides to make a conversion contribution from his traditional IRA to his Roth IRA in the amount of $160,000. (So, after he does the conversion, he now has $160,000 plus $80,000 for a total of $240,000 in his Roth IRA.)
Bennie later determines that he is unable to make a Roth IRA conversion (because of the income limitations), and notifies the IRA custodian to recharacterize his $160,000 conversion  plus the earnings on that money  back to a traditional IRA account.
On March 15th of the following year (when the FMV of the Roth IRA is $225,000), the custodian makes the recharacterization from the Roth IRA back to the traditional IRA. But, the custodian transfers only $150,000 back to the traditional IRA. Why? Because the "earnings" associated with the $160,000 conversion contribution during that time amounted to a loss of $10,000. How? Let's do the math.
The contribution in this case is $160,000. The Adjusted Opening Balance is $240,000 (the FMV of the Roth IRA of $80,000 plus the conversion contribution of $160,000). The Adjusted Closing Balance is $225,000. Plug all of this information into the formula, and you arrive at a negative $10,000. The actual formula looks like this:
Net Income = $160,000 X [($225,000  $240,000) / $240,000] = ($10,000)
Who Cares?
You should care. In some cases, these earnings will be subject to both tax and early distribution penalties. The method you select to compute the earnings might save you considerable tax bucks. So, if your IRA custodian uses one method, but you make out better under the other method, challenge the custodian to elect the method that's best for your individual tax situation.We'll get more information on computing earnings in the future, likely in the form of new regulations. Until that time, remember that you can use the new computation right now and there will be a "window" period where you can use either the "old" method or the "new" method. This "window" will likely be closing soon, but while it's open, take maximum advantage of it.