Congratulations! You’re a conscientious saver with an eye on a comfortable retirement, and you regularly maximize your annual individual retirement account (IRA) contributions. Then one day your tax advisor says, “Uh-oh, part of your IRA contribution isn’t a great idea this year.”
Say what? The reality is, there are a number of scenarios that could lead to this moment of truth: You’ve got too much of a good thing. Luckily, the Internal Revenue Service (IRS) has provided a mechanism to straighten things out. It’s called removal of excess contributions, or ROE, and it may help you right your unintentional wrong.
The best news is that ROE is nearly as straightforward as it sounds, although there are a few things you need to know.
First, consider timing. To avoid a 6% penalty on the excess and its earnings, both must be removed from your account by your tax-filing deadline for the year the contribution was made. This is usually April 15 of the following calendar year.
If you miss the Tax Day deadline, don’t despair. If you filed your taxes on time, you’ll normally qualify for an automatic six-month extension to mid-October to fix your excess. However, procrastination doesn’t typically pay. Waiting until October to correct your excess generally means filing an amended tax return to include the earnings in your income in the year you made the original contribution. If you already filed for a tax extension to October, then this generally avoids an amended return, of course.
This timely correction allows you to avoid the 6% penalty. Plus, we have some good news for those younger than age 59 ½: Previously you might’ve owed a 10% penalty on the earnings, but that is no longer the case. The 2022 SECURE Act 2.0 did away with the 10% penalty on earnings for those who correct their excess contributions on a timely basis.
If you miss the deadline to fix your excess, then the 6% penalty applies every year until the excess is corrected. Plus, you may also owe a 10% penalty on the earnings if you’re younger than 59 ½. You pay the penalty(ies) when you do your annual taxes by filing IRS Form 5329, which helps you calculate the penalty amount you owe.
Second, consider your earnings on the excess. You’ll have to determine how much you need to remove. This may not sound too tricky, but tax law isn’t known for its simplicity. To determine how much you’ll need to trim in earnings, you (or your IRA custodian or a trusted tax advisor) need to calculate the net income attributable (NIA). And this can be a loss or a gain.
The concept itself is easy, although in practice this can get a little hairy. Rather than looking at your excess simply as the amount you contributed in the first place, the IRS views it as a percentage of your entire IRA. For example, if your $5,500 contribution was 5% of your account balance on the day it was made, you have to take out 5% of the current account balance to ensure that any gains (or losses) in your account that attributed to the extra contribution in question are also removed proportionally. If TD Ameritrade is your IRA/Roth IRA Custodian, we will calculate your earnings on the excess, distribute it to you, and send you the required IRS 1099R distribution tax reporting form. Remember, the IRS requires that 1099R is issued in January of the following year, so you may not always have that form handy when you do your taxes. The 1099R will specify whether you corrected a current year or prior year excess.
Finally, you do have other options then to merely withdraw your excess, although you may still owe the 6% penalty. To learn more about your options for excesses or contributions in general, see IRS Publication 590-a.
Do you learn best by watching? Here’s a short video to help you identify, understand, and correctly report a wash sale to the IRS.
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