By Sarah Brenner
IRA contributions are good, but sometimes you can have too much of a good thing. Excess IRA contributions are a common problem. To help clients, advisers need to understand how excess contributions happen and how they can be corrected.
How Excess Contributions Happen
There are many ways that clients can end up with excess IRA contribution issues. Sometimes the mistakes are basic. A contribution that exceeds the $6,000 limit (or the $7,000 contribution limit if over 50) is an excess IRA contribution.
It is not uncommon for clients to contribute early in the year, forget they did, and then contribute again. Another common error is contributing when a person has no earned income or taxable compensation for the year. Investment income, Social Security and rental income are all examples of income that are not considered “taxable compensation” for IRA purposes. These rules often confuse retirement savers.
Another area where mistakes often occur is with the income limits for Roth IRA contributions. Many clients are unaware of these thresholds. Others may make Roth contributions and then have an unexpected increase in income for the year, resulting in an excess contribution.
An excess contribution can also occur for reasons beyond making annual IRA contributions. For example, an ineligible rollover is considered an excess contribution. A client who misses the 60-day rollover deadline or violates the once-per-year rollover rule may end up with an excess contribution.
Fixing Excess Contributions
While the bad news is that excess contributions happen frequently, the good news is that they can be easily fixed, and penalties can be avoided. The deadline for corrections is Oct. 15 of the year following the year for which the excess contribution occurs. Anyone who files his taxes in a timely manner has this deadline, even those without extensions.
There are two methods available for fixing excess contribution before the deadline and avoiding penalties. The first is to remove the excess contribution, plus the net income attributable (NIA) to it. The NIA is calculated using a special formula required by the IRS. Usually, the IRA custodian will help with this calculation. The distribution will be reported on Form 1099-R. The excess contribution will not be taxable when distributed, but the NIA is taxable for the year in which the contribution was made. The NIA may also be subject to a penalty if the IRA owner is under age 59½. It is important for advisers to ensure that the IRA custodian knows that the transaction is the removal of an excess contribution so it can be reported properly.
Another option to fix an excess without penalty is recharacterization. Some may be surprised by this option, thinking that Congress had done away with recharacterization. This is not completely true. While Roth IRA conversions can no longer be recharacterized, recharacterization is still available for IRA or Roth IRA contributions. Depending on the client’s situation, recharacterization can be a smart strategy. For example, a client who discovers that her Roth IRA contribution is not allowed because her income is too high may want to recharacterize that contribution to a traditional IRA where there are no income limits. Recharacterization is accomplished by a direct transfer from one IRA to another. The NIA must also be moved. While this is a nontaxable event, it is reportable, so clients can expect to receive Form 1099-R.
Advisers should be aware that both removing an IRA contribution (plus NIA) and recharacterizing are strategies that are not limited to excess contributions. These strategies can be deployed to fix contributions that are not true excess contributions at all, but are instead merely unwanted. For example, if a client contributes to a traditional IRA and discovers that contribution, while eligible, is not deductible, this it is not considered an excess contribution. The client can either recharacterize the contribution to his Roth IRA, if eligible, or remove it, plus the NIA. Before the Oct. 15 deadline there is complete flexibility. IRA contributions can be removed as corrective distributions or recharacterized for any reason at all. This can be a valuable planning opportunity. It is a rare “redo” allowed by the tax code.
The 6% Excess Contribution Penalty
After the Oct. 15 deadline, things change drastically. A 6% penalty will apply to any excess contribution. This penalty is serious business because it applies each year that the excess remains in the account. The penalty is paid on Form 5329. Because this is a standalone tax form with its own signature line, the IRS statute of limitations will not start to run until it is filed. This means that an excess IRA contribution is a compounding problem that will not fix itself and could potentially be discovered many years later.
There are two ways to fix an excess IRA contribution after the deadline. The first is to withdraw it. Interestingly, after the Oct. 15 deadline, only the contribution and not the NIA will need to come out. The other option is to carry forward the contribution and use it in a future year. This may be an effective strategy for some clients. For example, if a client made an IRA contribution and had no taxable compensation for that year, but expects to have some in the next year, carrying forward the excess IRA contribution can make sense.
Adviser Action Plan
Of course, the best way to handle excess IRA contributions is to avoid them in the first place. Advisers need to know the IRA contribution rules and carefully guide their clients, so mistakes do not happen. Monitoring of IRA accounts for overcontribution is essential. However, if an excess contribution does happen, it is good to know that it is not an irreversible mistake. There are tools available that a knowledgeable adviser can use to fix the problem. The sooner the excess contribution is addressed the better, as penalties can be avoided if the correction is done in a timely manner.
About the author: Sarah A. Brenner JD, is Director of Retirement Education at Ed Slott and Company.