By Jim Saulnier, CFP | June 21, 2019
Fixing Excess IRA Contributions
Albert Einstein is said to have said, “We cannot solve our problems with the same thinking we used when we created them.” So, if we managed to create the problem of excess IRA contributions, we might want to involve a knowledgeable advisor when it comes to fixing excess IRA contributions at the least possible cost.
This article does not cover every aspect of fixing excess IRA contributions. However, it will give you an idea of the complexity, the possible penalties and the seriousness of the problem.
You cannot simply remove the amount of excess contributed. There are specific rules you must follow and timelines you must heed.
The best ‘fix’ will depend on when you discover the excess occurred: whether it’s before or after the due date of your individual income tax return (including extensions), or October 15th of the year following the one where you made the excess contribution.
But first, let’s look at two aspects of excess IRA contributions: penalties incurred and any earnings attributed to excess contributions.
The penalties for making excess IRA contributions can be a serious matter. First, the IRS will apply a 6% penalty every year that an excess contribution remains in the IRA.
Next, the IRS can go back indefinitely to assess the 6% penalty tax, plus penalties on failure to file and failure to pay, plus any applicable interest. Even if you filed your Form 1040 on a timely basis, the relevant Form 5329 [Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts] is considered a separate tax return, so your failure to file it means the tax may be assessed at any time.
In short, there is no statute of limitations on the 6% penalty. Waiting for the IRS to come after you – while hoping to run out the statute of limitations – is not a workable strategy.
Calculating the Net Income Attributable
Part of rectifying the situation requires determining the NIA, or the Net Income Attributable to that excess contribution, following a special IRS formula. You might seek help in calculating the NIA from the custodian of your IRA account or from a competent advisor.
If you hold multiple IRAs when calculating the NIA, you only need to consider the performance of the specific IRA containing the excess IRA contribution.
The calculation is independent of whether the contribution that created the excess was a standalone investment into a new IRA or was added to an already existing IRA. It will reflect the performance of the entire IRA during the period in question. The NIA will be positive or negative, depending on whether the value of the IRA rose or fell. If positive, you may have to remove the NIA amount, in addition to the excess amount contributed.
Fixing an Excess Before October 15
If you fix the error before October 15th of the year after the error occurred, you can avoid penalties by filling out Parts 3 and 4 of Form 5329, signing it and submitting it to the IRS before the deadline.
However, any NIA earnings while the excess is in the account will be taxable as gross income in the year you made the contribution, not in the year you removed it. As a result, if you have already filed for the year, you will have to file an amended return.
Both the excess contribution and the NIA will have to be removed. Be sure the custodian of the account is kept apprised of any withdrawn asset – which is considered a distribution. The custodian will report the corrective distribution on Form 1099-R.
Any withdrawn NIA-based earnings will also be subject to the 10% early withdrawal penalty if you were under 59½ when it happened.
Fixing an Excess After October 15
The rules are somewhat different if you only fix the excess IRA contribution after the filing deadline (plus extensions), or October 15th.
You still must file Form 5329 and pay the 6% penalty on the excess contribution for every year it was in the IRA. However, you remove only the amount of the excess contribution, on which the IRS will likely assess income taxes.
You do not have to remove any NIA-based earnings. They can stay in the account and are never subject to the 6% penalty. They will only be taxed when eventually withdrawn.
An Alternative Solution
You can also opt not to remove the excess contribution when you discover it, but rather carry it forward into future years. The excess will be reduced each year by your allowable IRA contribution amount until the excess is wiped out. This process is automatic and requires no special reporting. The cost to you will be the 6% penalty as long as any excess exists.
Wrapping up, we know mistakes happen. And as explained earlier, in the case of excess IRA contributions they can happen relatively easily. Fixing them, though, requires the right steps in the right order.
While consulting with someone knowledgeable would likely have avoided the mistakes in the first place, it can certainly ensure they are not compounded. Give our team a call so we can review your situation.