By Jim Saulnier, CFP | June 7, 2019

How Excess IRA Contributions Can Happen

If you simply put the right amount of money each year in the right IRA account and allowed it to grow until time to withdraw funds, managing traditional IRAs would be smooth sailing. However, both life – and the desire to maximize the returns on your retirement funds – create opportunities to stumble over IRS rules and regulations. Following are four of the most common ways excess IRA contributions happen that could result in the payment of taxes and penalties:

1. Failed 60-day rollover

The IRS allows you to move money around tax-advantaged retirement accounts under three different scenarios. Two of them, ‘direct rollover’ and ‘trustee-to-trustee transfer,’ are relatively error-free since you never touch the money. (The funds move institution to institution.)

The higher-risk scenario is the ’60-day rollover.’ A distribution from a traditional IRA gets paid directly to you, and you have 60 calendar days to deposit the funds in another qualified IRA account (traditional, SEP or SIMPLE).

If you exceed 60 days, the transaction will be considered a distribution, and you will have to pay ordinary income taxes on the funds distributed, plus a 10% penalty for early withdrawal if you are below age 59½. (Some waivers do exist.)

Whereas most people are aware that you can only make one 60-day rollover per year, they don’t realize that it is one rollover per 365 days, not per calendar year. It is a common mistake. Say you make a 60-day rollover in late 2019, then another in early 2020, believing you are in the clear since it is a new year. However, because less than a year has transpired between rollovers, the second one may be treated as an excess IRA contribution, with penalties in addition to being fully taxable to you.

2. Missed Roth IRA Conversion Deadline

Just as you can move funds from one traditional IRA to another, you can also move them from a traditional IRA to a Roth IRA. However, it will require ‘conversion.’ Since a Roth IRA is purchased with ‘after-tax’ dollars, you will have to pay the tax on any untaxed amounts being taken from the traditional IRA.

However, before making the conversion, any RMD due on the traditional IRA must first be taken. The conversion will be of the funds left in the account after distribution of any outstanding RMD. If you don’t satisfy the RMD requirement, the RMD portion of the conversion will be deemed an excess Roth IRA contribution, and subject to penalties.

Regardless of how the funds are transferred from the traditional IRA to the Roth IRA, conversions are considered 60-day rollovers. They will be deemed a failed 60-day rollover (with defined penalties) if you miss the deadline for having the funds back in a qualified account.

3. Required Minimum Distribution Rollovers

With tax-advantaged accounts, the IRS gives you the equivalent of tax deferral over the years, but it eventually wants to start collecting some taxes. It does so through Required Minimum Distributions or RMDs, and each year the amount you need to take out will be based on an IRS formula that reflects your remaining life expectancy. RMD’s are taxed as ordinary income in most cases.

With a traditional IRA, you will have to start taking distributions in the tax year you reach age 70½. (The IRS defines that moment as six calendar months after your 70th birthday.)

You can accumulate the RMDs due from multiple accounts of the same type and pay them all out of one account as long as it is also of the same type. However, you cannot withdraw RMD funds for three traditional IRAs from a 401(k) account, for example.

With rollovers, you have to take any RMD due on a traditional IRA before rolling its funds over into another IRA account. What you roll over will be what is left in the IRA after the RMD. The RMD portion will be taxed. The rollover portion will not be taxed, assuming you haven’t done a rollover in the prior 12 months.

If you do roll funds over before you take your RMD, the RMD portion of that rollover will be considered an excess IRA contribution, and you could face penalties.

Your annual deadline for taking an RMD will typically be December 31, but if it is your first RMD you have until April 1 of the year following the one in which you reach age 70½. However, that would mean taking two RMDs in one year: one by April 1 and the next one by December 31. Both distributions would be included in income for that same year.

If you withdraw more than the RMD for one year, you cannot carry forward the excess to any future years. If you withdraw too little – or miss a deadline – you could be subject to a 50% excise tax on the shortfall of what you should have distributed.

4. Non-spouse Inherited IRA Rules

If you inherit a traditional IRA from a deceased spouse as a beneficiary, the IRS offers considerable flexibility in the actions you can take. However, that flexibility does not extend to you if you are a non-spouse.

As a non-spouse, you cannot treat the inherited traditional IRA as your own. For example, you cannot make any contributions to the IRA or roll any amounts into or out of the inherited IRA. The single act of doing so will disqualify the entire inherited IRA and will cause it to be immediately taxable. There is no remedy for this mistake.

Nor can you combine an inherited traditional IRA with a traditional IRA of your own. If you do so, the funds that were moved from the inherited IRA will be considered an excess contribution in your existing IRA and will be subject to penalties. Also, they will be fully taxable as a distribution from the inherited IRA, and the IRS offers no remedy such as undoing the transaction.

Fixing an Excess IRA Contribution

You now know some of the more common areas where taxpayers make mistakes when managing their IRAs, and next, we will show you how to fix excess IRA contributions when they happen. Meanwhile, an easy call to our office can help you avoid them altogether.