Options for fixing excess traditional IRA contributions (and reducing the penalties) for 2010 and 2011.
Natalie Choate will be speaking at a location near you if you live in Columbus (7/21/11) or Cincinnati (2/10/12), Ohio; New York City (9/12/11); South Bend (9/15/11) or Evansville (11/16/12), Ind.; Sioux Falls, S.D. (9/16/11); Portland, Maine (9/20/11); St. Louis (9/26/11); San Diego (10/28/11); Boston (11/10/11); Minneapolis (11/14/11); Saint Charles, Ill. (11/15/11); or Memphis, Tenn. (12/1/11). See all of Natalie's upcoming speaking events.
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.
2010: Recharacterize as a Roth Contribution
Though Bill was not entitled to contribute to a traditional IRA in the year 2010 (because he was over age 70½), he could legally have contributed to a Roth IRA for that year. He was eligible to contribute $6,000 to a Roth because:
1. He had compensation income (earned income) of at least $6,000.
2. His modified adjusted gross income for 2010 was under $105,000.
Different standards apply in determining eligibility to contribute to a Roth IRA than apply to a traditional IRA. Although one must have compensation income to contribute to either type of IRA, there is an age test applicable to traditional IRA contributions (no contributions if age 70½ or older), but no age test applicable to Roth IRA contributions. There is an income test applicable to Roth IRA "regular" contributions, but no income test applicable to traditional IRA contributions (and no income test applicable to Roth IRA conversions).
Since Bill was not eligible to contribute to the type of IRA he contributed to, but was eligible to contribute to the other type of IRA, he can "recharacterize" his traditional IRA contribution as a contribution to a Roth IRA instead. He does that by moving the $6,000 contribution (plus or minus any "earnings" thereon) out of the traditional IRA and into a Roth IRA. For more details on this remedy see my March 2010 column.
The deadline for doing this is the same as the deadline for making a "corrective distribution" (see the 2011 discussion above), namely, the due date of his tax return including extensions. Under the IRS's regulations, that means he can make this switch up until Oct. 15 of this year (2011) even though he has already filed his 2010 tax return (and even though he didn't actually get an extension of time to file) as long as the 2010 tax return was filed on time.
If he gets that recharacterization done on time (or withdraws the contribution and the earnings thereon altogether, if he prefers to go the "corrective distribution" route) there will be no penalty for the 2010 excess contribution.
2009: Too Late to Avoid the Penalty
Since the latest possible "extended due date" of Bill's 2009 income tax return was on or about Oct. 15, 2010, it is too late to either do a "corrective distribution" or to "recharacterize" that contribution. Thus Bill owes the 6% penalty for 2009 and also for 2010, since the penalty continues to accrue each year until the excess contribution is either distributed or "absorbed" (treated as part of a contribution for a later year). Barring extraordinary relief from the IRS, he owes 6% of $6,000 ($360) for each of those years, a total of $720. He can avoid having an additional penalty accrue (for the calendar year 2011) on account of that old excess contribution by withdrawing the $6,000 2009 excess contribution from the traditional IRA by the end of calendar 2011.
Note that he only has to withdraw the actual excess contribution ($6,000) by the end of 2011, not any earnings thereon, to stop the penalty on that old 2009 excess contribution accruing for the year 2011. Computing "earnings" on a contribution is involved only when you are trying to do a corrective distribution or recharacterization.
Is there any possibility of getting IRS relief from this penalty? One avenue is to request permission for a "late recharacterization" of the 2009 contribution as a Roth IRA contribution rather than a traditional IRA contribution. The IRS can grant permission for a late recharacterization if there is good cause--for example, if he was receiving erroneous professional advice about his eligibility to contribute to an IRA.
Resources: For complete discussion of most of the things that can go wrong with an IRA, and the IRS's punishments for such transgressions as well as how to escape those punishments (if escape is possible), see Natalie Choate's Special Report: IRAs with Hair: What to Do with an IRA That Has a Shady Past, available after July 11, 2011, for $29.95 at www.ataxplan.com. Most of the material in that Special Report is excerpted from Natalie Choate's book Life and Death Planning for Retirement Benefits (7th ed. 2011, www.ataxplan.com). Information on who is eligible to contribute how much to an IRA or Roth IRA, and the definition of "compensation" income, see Chapter 5 of the book or the following sources: Internal Revenue Code § 219(c), (f); Treas. Reg. § 1.408A-3, A-3, A-4; or IRS Publication 590. Regarding the meaning of the due date of the tax return "(including extensions)," see ¶ 5.6.06 of Life and Death Planning for Retirement Benefits.