10 Points: Fixing Excess IRA Contributions
Contributing to an Individual Retirement Account (IRA) is a great way to save for the future. However, contributing too much can lead to excess IRA contributions, which may result in penalties. Whether it's due to exceeding limits, ineligible compensation, or missing deadlines, correcting excess contributions promptly is essential. Here’s what you need to know to resolve the issue and avoid unnecessary tax burdens.
1. What Causes Excess IRA Contributions?
Excess contributions occur for several reasons, including:
- Exceeding the annual IRA contribution limit.
- Making a contribution without eligible compensation.
- Contributing beyond Roth IRA income phase-out limits.
- Rolling over ineligible funds, such as a required minimum distribution (RMD).
- Missing the 60-day rollover deadline.
Understanding why excess contributions happen helps prevent future mistakes and ensures compliance with IRS regulations.
2. Deadline to Fix Excess IRA Contributions
The IRS allows taxpayers until October 15 of the year following the excess contribution to correct the issue without penalties. For example, if the contribution error occurred in 2023, the deadline for correction is October 15, 2024.
3. Ways to Correct Excess Contributions Before the Deadline
To avoid the 6% excess contribution penalty, corrections must be made by the October 15 deadline. There are two primary methods for correction:
- Withdrawing the excess contribution plus earnings (Net Income Attributable or NIA).
- Re-characterizing the excess contribution by transferring it to a different IRA type (e.g., Roth IRA to Traditional IRA).
4. Understanding Net Income Attributable (NIA)
Net Income Attributable (NIA) refers to the earnings generated by excess contributions. The IRS requires that NIA be reported as taxable income in the year the excess contribution was made. For example, if an excess contribution was made in 2023 but corrected in 2024, the earnings must be reported on the 2023 tax return.
5. Calculating NIA with IRS Guidelines
The IRS provides a worksheet in Publication 590-A to help calculate NIA. This worksheet factors in the overall IRA performance rather than isolating the excess contribution's specific investment.
6. IRS Form 5329: When Is It Necessary?
If an excess contribution is corrected by October 15, filing IRS Form 5329 is not required. Additionally, under the SECURE 2.0 Act, individuals under age 59 ½ no longer face a 10% penalty on NIA. However, if the correction is made after the deadline, IRS Form 5329 must be filed to report the 6% penalty per year the excess remains in the account.
7. What Happens After the October 15 Deadline?
If an excess contribution is not corrected before the deadline, options become limited. The remaining choices include:
- Withdrawing the excess contribution (without NIA).
- Carrying the excess contribution forward to use in a future tax year.
Re-characterization is no longer available after the deadline. The 6% annual penalty applies for each year the excess remains in the IRA.
8. Do Earnings Need to Be Withdrawn After the Deadline?
Surprisingly, if a correction is made after October 15, only the excess contribution itself must be withdrawn. The NIA can remain in the IRA, though this is an unusual rule.
9. Penalties for Long-Term Excess Contributions
If an excess contribution remains in the account for multiple years, the 6% penalty applies for each year. Additionally, a separate IRS Form 5329 must be filed for each tax year the excess contribution existed.
10. SECURE 2.0 and the Six-Year Statute of Limitations
The SECURE 2.0 Act introduced a six-year statute of limitations for excess IRA corrections. However, a recent U.S. Tax Court ruling determined that this statute does not apply retroactively. This means IRA owners must still correct excess contributions made before 2022. A court case involving a $25 million excess contribution led to an $8.5 million penalty, demonstrating the importance of fixing excess IRA contributions promptly.
Expert Guidance
Why Consulting a Financial Planner Matters
Fixing excess IRA contributions can be complex, especially when dealing with penalties, deadlines, and tax reporting. A Certified Financial Planner (CFP) can help you navigate IRS rules, determine the best correction method, and ensure long-term tax efficiency.
If you're unsure about your next steps, consider reaching out to a financial planner who specializes in retirement accounts. Getting professional guidance can prevent costly mistakes and maximize your retirement savings.
FAQ's About Fixing Excess IRA Contributions
What is the penalty for excess IRA contributions?
The penalty is 6% per year for each year the excess remains in the account. After the October 15 correction deadline, the penalty must be reported on IRS Form 5329.
Can I correct an excess IRA contribution after filing my tax return?
Yes. Corrections can be made until October 15 of the following year without penalty. However, any NIA must be reported in the original year of the excess contribution.
How do I calculate the earnings on an excess IRA contribution?
Use the IRS Publication 590-A worksheet, which calculates earnings based on overall IRA account performance, not individual investments.
What happens if I leave an excess contribution in my IRA?
The 6% penalty applies annually until the excess is corrected. If left unresolved for multiple years, penalties accumulate, requiring separate IRS Form 5329 filings.
Can I re-characterize an excess IRA contribution after the October 15 deadline?
No. After the deadline, the only options are withdrawal of the excess or carrying it forward to use in a future tax year.
Does the SECURE 2.0 statute of limitations apply to past excess contributions?
No. The statute applies only to excess contributions made after 2022. Older excess contributions must still be corrected.
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Christian Cordoba, founder of California Retirement Advisors, has been a member of Ed Slott's Master Elite IRA Advisor Group since 2007.