Generally, any ineligible amount that is credited to an IRA can create excess contributions. In part 1 of this series, we defined and explained the penalties for excess contributions arising from regular IRA contributions that exceed the statutory limits. Now, let's review other IRA transactions that could also result in excess IRA contributions and the tax treatment when excess amounts are distributed from the IRA.

Ineligible Rollover Amounts
Amounts that are rolled over to an IRA must meet certain requirements; otherwise, these amounts are considered excess contributions to the IRA and should be removed by the owner's tax-filing deadline, including extensions. Ineligible rollover amounts include the following:

  • Amounts that did not originate from the following:
    • A similar type of IRA (Traditional or SEP to Traditional or Roth to Roth). Note that a SIMPLE IRA can be rolled over to a traditional IRA if it has been at least
      two years since the first deposit was made to the SIMPLE IRA.
    • A qualified retirement plan, such as a 401(k) or profit sharing plan
    • A governmental 457 (b) plan
    • A 403(b) plan
    • A qualified trust
    • A qualified 403(a) annuity plan
  • An RMD amount from an IRA or other retirement plan
  • A hardship distribution from a qualified plan or 403(b) account
  • Certain substantially equal periodic distributions
  • Corrective excess distributions from qualified plans or 403(b) accounts and any earnings that apply to the excess contribution amount
  • A loan treated as a distribution because it does not satisfy certain requirements
  • Dividends on employer securities
  • The cost of life insurance coverage
  • Distributions to non-spouse beneficiaries, unless the amount is rolled over to an inherited IRA via a trustee-to-trustee rollover
  • Distributions that do not meet the 60-day rule

Roth IRAs
Generally, ineligible conversion amounts are treated as excess Roth IRA contributions.
In addition to the amounts listed above, the following amounts are considered ineligible rollover or ineligible conversion amounts to a Roth IRA:

  • RMD amounts from other retirement accounts that are converted to a Roth IRA
  • A conversion that is done by an individual who does not meet the conversion eligibility requirements

Treatment of Ineligible Credits to IRAs
Generally, ineligible amounts that are credited to an IRA are classified as regular IRA contributions for IRS purposes. Consequently, if the IRA owner is eligible for a regular IRA contribution and has not already contributed the amount to his or her Roth or traditional IRA, the otherwise ineligible amount is deemed to be the individual's IRA contribution for the year the amount is deposited to the IRA. However, this is only allowed for amounts up to $5,500(or $6,500 for IRA owners eligible for a catch-up contribution). Amounts in excess of $5,500/$6,500 are treated as excess contributions.

Example 1
Tina, who is age 75, converted her traditional IRA to her Roth IRA. However, she failed to remove her RMD, an amount of $10,000, from her traditional IRA prior to the conversion. Since this amount representing the RMD is an ineligible conversion amount, the $10,000 is deemed a regular Roth IRA contribution - but Tina is eligible to contribute a maximum of only $6,500 to her Roth IRA, which means she has an excess Roth IRA contribution of $3,500. This amount, along with any applicable earnings must be removed from Tina\'s Roth IRA by her tax-filing deadline, plus extensions, if she is to avoid the 6% penalty. Had Tina not been eligible to contribute to her Roth IRA, the entire $10,000 would have been an excess contribution.

Tax Treatment When Excess Contributions Are Corrected
Timely Corrections
Excess contributions to an IRA must be corrected by the IRA owner's tax-filing date, which is usually April 15. Individuals who file their tax returns by April 15 automatically receive an additional six months to remove the excess amount.

When excess contributions are removed from an IRA on a timely basis, any applicable earnings must also be removed. While the excess distribution is not taxable, the earnings are subject to ordinary income tax, and if the IRA owner is under age 59 1/2, the earnings will also be subject to the early-distribution penalty. The earnings are taxable in the year that the amount was contributed to the individual's IRA. IRA custodians are required to designate the applicable tax year on Form 1099-R, which must be used to report the excess distribution. The designation is made in box 7 (of Form 1099-R) and is indicated by a Code 8 or Code P. Code 8 means that amount is taxable in the current year and Code P means the amount is taxable in the previous year.

Example 2
Sharon contributed $5,000 to her Traditional IRA in 2013. She later found out that she was ineligible to contribute to her IRA because she did not have eligible compensation for 2013. In October 2013, Sharon instructed her IRA custodian to remove the excess amount and applicable earnings of $100. Because the amount was contributed in 2013 and removed in 2013, the $100 income is taxable in 2013. If Sharon is under age 59 1/2, she will also owe a 10% early-distribution penalty on the $100, unless she meets an exception. Her IRA custodian will issue a 1099-R for year 2013, for which the $5,000 will be reported as nontaxable and the $100 will be reported as taxable. The code in Box 7 will be "8" to designate that the $100 is taxable in the year for which the 1099-R is issued (2013).
Had Sharon requested the distribution in 2014, the 1099-R would be issued for 2014 and the code in Box 7 would be "P", to designate that even though the distribution is being reported for 2013, the earnings are taxable in the previous year (2013), which is the year the amount was contributed to Sharon\'s IRA

Non-Timely Corrections
Excess IRA contributions that are not corrected in a timely manner should not include earnings with the excess distribution. Unlike the excess amount that is corrected on time, these distributions may be taxable if the excess amount is in excess of the statutory limit.

Example 3
Assume the facts are the same as in example 1, except that Sharon failed to remove the excess amount by her tax-filing deadline, including the six-month extension. Because the contribution amount is within the statutory limit of $5,500, the distribution is not taxable to Sharon.
On the other hand, assume that Sharon contributed $7,500 instead of $5,500. Because $7,500 is above the statutory limit, and because the amount is corrected after the applicable deadline, Sharon must treat the $7,500 as a taxable distribution. In Example 1, Sharon\'s timely correction ensures that only the earnings of $100 are taxable, but in this example, Sharon must pay ordinary taxes and an additional 10% early-distribution penalty on the $7,500. An exception applies to this tax treatment if the excess is a result of erroneous information provided to the IRA owner by an administrator of a qualified plan from which the rollover occurred. Under this exception, the distribution is tax free, regardless of the amount.

The Bottom Line
It is important that we make it clear that these are just guidelines, as there may be other transactions that could result in the occurrence of an excess IRA contribution. However, these examples should help you recognize the kinds of transactions that could result in excess contributions and associated penalties. When in doubt, please consult your tax professional and/or IRA custodian.

Bear in mind that removing all applicable earnings is an important part of correcting excess contributions in a timely manner.

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