Correcting excess contributions to IRAs.

• Author: Blankenship, Vorris J.
• Position: Individual retirement accounts

Taxpayers are generally eligible to make regular annual contributions to their IRAs that are limited to fixed dollar amounts established by statute. (1) The contributions are further limited to the amount of the taxpayer's taxable compensation. (2) Contributions to IRAs in excess of those limits (excess contributions) are generally subject to a 6% excise tax. (3)

The 6% excise tax may also apply to a failed rollover to a traditional IRA from another traditional IRA or from a qualified retirement plan. (4) The failed rollover is treated as an ordinary distribution from the plan or traditional IRA, followed by a separate regular contribution to a traditional IRA. The distribution part is taxable to the extent of the earnings portion of the distribution. (5) The earnings portion may also be subject to the 10% additional tax on early distributions, unless an exception applies. (6) The contribution part of the failed rollover becomes subject to the 6% excise tax to the extent it exceeds the limitation on regular contributions (i.e., to the extent it is an excess contribution). (7)

A failed Roth conversion from a qualified plan or traditional IRA is similarly treated. The distribution part of the failed Roth conversion is an ordinary distribution and is taxable to the same extent it would have been if the Roth conversion had not failed. (8) However, unlike a valid Roth conversion, the earnings portion of the distribution may also be subject to the early-distribution penalty, unless an exception applies. (9) The contribution part of the failed rollover is subject to the 6% excise tax to the extent it exceeds the statutory limitations on regular contributions to Roth IRAs (i.e., to the extent it is an excess contribution). (10)

The most common type of failed rollover is an attempt to roll over a distribution that is not eligible for rollover. (11) This includes, for example, an attempt to roll over a required minimum distribution (RMD). (12) Similarly, failure to complete an indirect rollover to an IRA within the required 60-day period is a failed rollover if the taxpayer is unable to self-certify that there is a permissible reason for the delay (13) and is unable to obtain an IRS waiver of the delay. (14) For some other types of failed rollovers, see Examples 13 through 18.

The 6% excise tax on an excess contribution will continue to apply year after year until mitigated by using the methods described in the remainder of this article. These methods of mitigation are largely the same whether an excess contribution arises from an excessive regular contribution or a failed rollover or whether the excess contribution involves a traditional IRA or a Roth IRA. (15) For that reason, please remember that the term "IRAs" as used in this article includes traditional IRAs (including SEPs), Roth IRAs, and SIMPLE IRAs, unless the context clearly indicates otherwise. (16)

Eliminating excess contributions by making corrective distributions

The 6% excise tax on an excess contribution may be avoided by making a "corrective distribution," provided no deduction has been allowed for the contribution. An IRA makes a corrective distribution by timely distributing the amount of the excess contribution, together with any accumulated net income attributable to the excess contribution.

A corrective distribution is timely if it is made by the extended due date of the taxpayer's tax return for the tax year of the contribution. (17) That date is normally Oct. 15 of the calendar year following the year the taxpayer made the contribution (even if the taxpayer did not need or obtain an extension of time to file his or her return). However, if the taxpayer did not file a timely return for the year of the contribution, the taxpayer must complete the corrective distribution by April 15 of the year following the year of the contribution. (18)

If the conditions for a corrective distribution are met, the original contribution is treated as if it had not been made. (19) However, the distribution of income earned by the IRA on the excess contribution is taxable in the year of the contribution and is subject to the early-distribution penalty, unless an exception applies. (20) Determination of the income earned by an IRA on an excess contribution is simple if the excess contribution is the only contribution ever made to the IRA and the IRA did not make any distributions. In that case, the income earned is equal to all the earnings in the IRA. Thus, a taxpayer making a corrective distribution may simply distribute the entire balance (including the income earned). (21)

Otherwise, the taxpayer must distribute a pro rata portion of the income (or loss) earned by the IRA from the date of the original excess contribution to the date of the corrective distribution. The taxpayer computes the allocated income (or loss) by multiplying the amount of the excess contribution by a fraction. The numerator of the fraction is the adjusted balance of the IRA immediately before the corrective distribution (the "adjusted closing balance") minus the adjusted balance immediately before the excess contribution (the "adjusted opening balance"). The denominator is the adjusted opening balance. (22)

The adjusted opening balance includes the excess contribution. It also includes other contributions and incoming recharacterizations during the computation period. The adjusted closing balance includes distributions, transfers out, and outgoing recharacterizations during the computation period. (23)

Computation of allocable income in Example 1 IRA value before the contribution $150,000 Amount of the contribution a $250,000 Adjusted opening balance (AOB) b $400,000 Adjusted closing balance (ACB) $420,000 Less the AOB $400,000 The income or balance change (ACB - AOB) c $20,000 Income as a percentage of the AOB d = c / b 5% Income allocable to the corrective distribution d x 80,000 $4,000 Example 1: On Feb. 28, 2019, a single, 54-year-old taxpayer made a $250,000 contribution to her traditional IRA, consisting of a $7,000 deductible regular contribution, a nontaxable rollover contribution of $163,000, and an excess contribution of $80,000. The value of the traditional IRA immediately before the contribution was $150,000. Thus, the IRA was valued at $400,000 immediately after the excess contribution. On April 1, 2020, when the IRA was worth $420,000, the trustee made a corrective distribution to the taxpayer of the $80,000 excess contribution plus $4,000 of allocable net income. The trustee computed the allocable income as shown in the chart "Computation of Allocable Income in Example 1." The distributed IRA income of $4,000 is subject to income tax for 2019 and is subject to the additional 10% tax on premature distributions if no exception applies. At an assumed 30% marginal income tax rate, with an early-distribution penalty of 10%, the total tax and penalty on the distributed income is $1,600. If the taxpayer had failed to make a corrective distribution before the deadline, she would have instead been liable for a 2019 excise tax of $4,800 (6% of the $80,000 excess contribution) and would have remained potentially liable for the excise tax in future years.

Although a taxpayer who fails to make a timely corrective distribution generally cannot avoid the excise tax for the year of the excess contribution, he or she may have other ways to avoid or mitigate the excise tax for future years, as described in this article.

Eliminating excess contributions by making dollar-limited distributions

For tax years after an excess contribution is made to a traditional IRA, a taxpayer may be able to distribute the excess contribution and avoid further impositions of the excise tax if total contributions during the year of the excess contribution did not exceed the statutory dollar limit on regular contributions. The taxpayer also must not have been allowed a deduction for the excess contribution. (24) An excess contribution to a traditional IRA might have occurred, for example, because the taxpayer, though mindful of the statutory dollar limit, exceeded the taxable compensation limit on contributions.

The taxpayer may make such a distribution (a "dollar-limited distribution") of an excess contribution at any time after it is too late to make a corrective distribution (described above). (25) Both the amount of the excess contribution and the amount of a later dollar-limited distribution are determined without regard to the phaseout of deductions for IRA contributions applicable to active participants in qualified plans. (26)

Example 2: During 2019, a single, 54-year-old taxpayer made a $7,000 contribution to his traditional IRA (an amount within the dollar limit). The taxpayer was not an active participant in any qualified plan that would prohibit his making deductible IRA contributions. The taxpayer had adjusted gross income of $75,000 for 2019, but only $3,000 was taxable compensation. Therefore, the taxpayer may only deduct $3,000 of the contribution because of the limit on deductible contributions based on taxable compensation. The remaining $4,000 is an excess contribution. However, the taxpayer may make a dollar-limited distribution of the $4,000 excess contribution if it is too late to make a corrective distribution (e.g., it is after Oct. 15, 2020). Alternatively, assume the same taxpayer was an active participant in a qualified plan. In that case, his IRA deduction was completely phased out based on his gross income, and he was not entitled to a deduction for any of his $7,000 contribution. Nevertheless, because a taxpayer's active participation is ignored for purposes of determining both excess contributions and dollar-limited distributions, his excess contribution for 2019 is still only $4,000 (the excess of his $7,000 contribution over his $3,000 taxable compensation). Thus, he may make a dollar-limited distribution of the $4,000 excess contribution after the allowable period...