Options for fixing excess traditional IRA contributions (and reducing the penalties) for 2010 and 2011.
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Question: We have a new client, "Bill." He is single (his wife died in 2008). He reached age 70½ in 2009 and retired at the end of 2010. In each of the years 2009-2010, he earned compensation income (wages) of $50,000 and his total income was $80,000. He will have zero compensation income in 2011. In each of the years 2009-2011, in January, he contributed $6,000 to a traditional IRA. This was outside of his employment, i.e., these contributions were not made to a "SEP-IRA." He has never taken any deduction for these contributions. However, it appears to us that he was not entitled to make these traditional IRA contributions. Do you agree, and if so, what can we do to repair his excess IRA contributions? Will he have to pay a penalty? He has already filed his income tax returns for 2009 and 2010 on a timely basis.
Answer: Because Bill reached age 70½ in 2009, all his contributions to his traditional IRA in the three years 2009-2011 were "excess contributions." An individual cannot contribute to a traditional IRA on his own behalf in or after the year in which he reaches age 70½. The traditional IRA is the only retirement plan that has an age limit on making contributions.
There is a 6% annual cumulative penalty on excess IRA contributions. However, Bill can fix some of these excess contributions and reduce the penalty. Let's look at each year separately.
2011: Two Ways Bill Can Avoid the Penalty
There are two ways Bill can avoid the penalty for the 2011 excess contribution.
The first way is to take a corrective distribution from the IRA. He would have to withdraw the contribution he made in January 2011 along with the "net income" attributable to the contribution. The deadline for completing this corrective distribution, in order to avoid having the 6% penalty slapped on the 2011 excess contribution, is "on or before the day prescribed by law (including extensions of time) for filing such individual's return for such taxable year." That could be as late as October 15, 2012; see discussion of the 2010 excess contribution below for more on what this deadline means. See "Resources" at the end of this article for how to compute the "net income" on an excess contribution.
The distribution to him of the returned contribution is tax-free. However, any earnings that must be distributed to him along with the returned contribution will be includible in his gross income.
The second way Bill could avoid an excess contribution penalty for his 2011 contribution would be to go back to work and earn $6,000 or more of compensation income in 2011, then "recharacterize" his 2011 contribution as a 2011 contribution to a Roth IRA; see discussion of 2010 for more on this approach.