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Retirement

Excess IRA Contributions: How to Fix Them

Mind the deadline for taking a 'corrective distribution.'

The Tax Code gives IRA owners a limited time to take back their IRA contributions. You can use such a "corrective distribution" to avoid a penalty for an excess IRA contribution. You can also use it when you simply change your mind about an IRA contribution you've made.

What if you made an excess contribution but miss the deadline for the penalty-free cleanup? You still need to "fix it," but the method and timing are different.

The Excess IRA Contribution Penalty If you contribute more to your IRA than you're entitled to contribute, the Code imposes a 6% penalty on the "excess contribution." That penalty accrues annually until the excess amount is removed.

An excess contribution can occur in a number of ways--for example, if you "roll over" into the IRA an amount that is not eligible for rollover, or contribute to a traditional IRA when you are not eligible to do so, or simply make a larger contribution than you are allowed to make.

The penalty is reported on IRS Form 5329.

Corrective Distribution to Eliminate Penalty You can avoid the penalty by taking out of the IRA a certain amount by a certain deadline. The amount that must be removed is the excess contribution itself, plus any "earnings" that have accrued on the contribution between the date of the contribution and the date it is removed.

The deadline for completing this corrective distribution is the extended due date of your tax return for the year the contribution was made. Regulations detail exactly how to determine the "earnings" (which can actually be a loss--if the IRA declined in value after the contribution) and the "extended due date" of your return (which is normally Oct. 15 of the year after the year of the contribution, regardless of whether you requested an extension of time for filing your return).

If you remove the correct amount by that deadline, two good things happen. First, the returned contribution is not income-taxable--i.e., it is not includible in your adjusted gross income. (The "earnings," however, are includible in gross income.) Second, the contribution is deemed not to have been made at all for purposes of the 6% penalty, so you wipe out the penalty.

According to the IRS, the "earnings" portion of the distribution (assuming it is a positive amount) is subject to the 10% premature distributions penalty if the taxpayer is under age 59 1/2 (I disagree with them on that, by the way).

Other Uses for Corrective Distributions You can use a corrective distribution to undo an IRA contribution even if it was not an "excess contribution"--for example, if you simply change your mind and decide you'd rather have the money back. It's handy for a cash-strapped investor to remember that she can take back any IRA contributions (plus or minus earnings thereon) that she happened to make within a limited time frame.

What Happens If You Miss the Deadline? If the taxpayer fails to withdraw the excess contribution (and its earnings) by the applicable deadline, he will owe the 6% penalty for the year the contribution occurred. And this penalty is not "one and done": The penalty will continue to accrue annually until the year the excess contribution is either withdrawn or "absorbed."

To avoid incurring another 6% penalty in a year subsequent to the contribution year, the excess contribution (but not its earnings) must be withdrawn (or "absorbed") before the end of such year (not the tax return due date).

Allen Example: Allen contributed $5,000 to his IRA in 2014. He was not eligible to contribute to an IRA in 2014 because he did not have any compensation income that year. He failed to withdraw the $5,000 and its earnings by Oct. 15, 2015, the extended due date of his 2014 tax return. He owes the penalty ($300, which is 6% of $5,000) for the year 2014. In 2015 he goes back to work and earns over $5,000 of compensation income and he has not attained age 70 1/2. Since he is eligible to contribute $5,000 to an IRA in 2015 (based on his age and compensation income), the carried-over excess contribution is applied to his 2015 IRA contribution. Since the excess contribution is "absorbed" by the 2015 contribution, he does not owe another penalty for 2015.

Barbara Example: Barbara contributed $7,500 to her IRA in 2014. She was only eligible to contribute $5,500. She failed to withdraw the $2,000 excess contribution and its earnings by Oct. 15, 2015, the extended due date of her 2014 tax return. She owes the penalty ($120, which is 6% of $2,000) for the year 2014. In November 2015 she discovers her mistake and withdraws the $2,000 excess contribution (but not the earnings thereon) before the end of 2015. The good news is, since the excess contribution was withdrawn before the end of 2015, she does not owe another penalty for 2015. The bad news is that this late "correction" is not entitled to the special income tax-free treatment granted to a timely corrective distribution. Accordingly her $2,000 distribution will be taxed the same as any other IRA distribution, i.e., it will be included in her gross income except to the extent a proportion of it constituted a distribution of any aftertax money she happens to have in her IRAs.

Where to read more: Regarding the excess IRA contribution penalty, see Internal Revenue Code § § 4973(a), (f), and Treas. Reg. § 1.408A-3, A-7. Regarding corrective distributions see IRC § 408(d)(4) and Treas. Reg. Reg. § 1.408A-6, A-1(d). For complete explanation of excess contributions, how to compute and avoid the penalty, how to determine the "earnings" on a contribution, and the meaning of "extended due date," see the Natalie Choate Special Report "IRAs with Hair," downloadable at http://www.ataxplan.com/.

Natalie Choate will be speaking at a location near you if you live in: Orlando (1/14-15/16) or Palm Beach Gardens (2/4/16), Fla.; Chicago (5/3/16); Indianapolis (6/3/16); Austin, Texas (1/25/16); Waltham (6/1/16), Mass.; Omaha, Neb. (12/4/15); Minneapolis (12/8/15); Manhattan Beach, Calif. (4/29/16); Toledo, Ohio (5/19/16); Madison, Wis. (10/17/16); or Scottsdale, Ariz. (11/11/16). See all of Natalie's upcoming speaking events.

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