In part 1 and part 2 of this series, we explained how excess IRA contributions and the tax treatment for corrections work. In this article we'll show you how to make sure your IRA contributions corrections meet statutory requirements. Failure to remove the correct amount could result in the IRS determining that the correction did not occur and assessing penalties.

Earnings Are Prorated
A common mistake when calculating excess contributions is to assume that the earnings apply only to the assets in which the contribution was invested. But this is not the case. The earnings on excess IRA contributions are determined for the period during which the excess amount remained in the IRA, taking into account the performance of all the assets in the IRA.

For example, let's say John contributed an excess amount of $3,000 to his IRA and immediately invested the $3,000 in 100 shares of XYZ stock. John's IRA also includes 100 shares of ZZZ and $5,000 in money-market funds. When John removes the excess contribution, he must base the earnings on the performance of all the IRA assets, not just the XYZ stock. Note also that the excess amount can be removed either in cash, securities or both, providing the value of the assets removed is equal to the excess amount plus earnings.

Excess Earnings - The Formula
The new formula, issued in TD 9056, is a pro-rata allocation of earnings or losses to the excess amount. This is quite unlike the old rules, which often resulted in an inequitable amount of earnings being allocated to the excess. The new formula is as follows:


Proper application of the formula requires understanding of the terms used:

• Adjusted opening balance is the fair market value of the IRA at the beginning of the computation period (defined later) plus any transfer credits, contributions (including excess contributions being removed) and amounts recharacterized to the IRA during the computation period.
• Adjusted closing balance is the FMV of the IRA at the end of the computation period, plus any transfer debits, distributions and recharacterizations from the IRA.
• The computation period begins immediately prior to when the excess amount was contributed to the IRA and ends immediately before the excess contribution is removed. For IRAs that are valued on a daily basis, the beginning of the computation period is the day before the amount was contributed and the ending period is the day before the amount was removed from the IRA. For IRAs that are not valued on a daily basis, the month-end balance, or any other regularly determined FMV that is available before the date the excess amount was contributed is the beginning of the computation period. For instance, if the amount was contributed on January 15, the IRA owner may use the ending value provided on the account statement for December if the FMV for January 14 is not available.

The following examples demonstrate the application of the earnings formula. 

Example 1 Mary contributed $3,000 to her Traditional IRA #1 on February 15, 2008, for the 2007 tax year. When filing her tax return, Mary realizes that, because she did not have eligible income, she is not eligible to contribute to her IRA for 2007. To ensure that she removes the correct amount, Mary needs to compute the applicable earnings on the $3,000. Mary's IRA is not valued on a daily basis, so she must use the closing balance provided on her account statement for January 2008, which is $5,400. Mary decides to remove the excess amount on April 15, when the balance of IRA #1 is $16,800. Between February 15, 2008, and April 15, 2008, Mary transfers $8,000 from her Traditional IRA #2 to her Traditional IRA #1. No distributions occurred during that period. Mary computes the earnings as follows:  The earnings on the excess contribution are $73. To correct the excess contribution, Mary must remove $3,073 from IRA #1. The IRA custodian will issue IRS Form 1099-R for 2008 to report the correction. The form will reflect $3,073 in box 1 (the total amount distributed), $73 in box 2a (the taxable amount) and code 8 in box 7, to designate that the amount was contributed to the IRA in 2008 and that the earnings are therefore taxable in 2008. Mary must add the $73 to her 2008 tax return as taxable income. If she is under age 59.5, she may owe the IRS an early-distribution penalty of $7.3 ($73 X .1).

 

Example 2 Harry contributed $3,000 to his IRA on June 15, 2007, when the FMV of his IRA was $7,700. Harry later realized that he was eligible to contribute only $2,500. On January 15, 2008, when his IRA was valued at $10,500, Harry contacted his IRA custodian to have the excess amount of $500 and the earnings removed from his IRA. During the computation period, no transfers or distributions occurred in the IRA. The earnings were computed as follows: Harry must remove $491 ($500 -$9) from his IRA as a return of excess.

Additional Rules:

• Excess must be corrected from same IRA - The excess contribution must be removed from the IRA to which the amount was contributed. Therefore, an individual with multiple IRAs cannot cherry pick the IRA from which the correction will occur.
• Last contribution is excess contribution - If an individual made multiple contributions to the IRA, the last amount contributed is deemed to be the excess contribution. For instance, in example 2 above, had Harry made contributions of $500 every two months instead of in one lump sum, then the $500 excess would be the last $500 that was contributed to the IRA. The computation period would begin with the applicable period in which the last $500 was deposited to the IRA.
• Distribution of entire balance is sufficient for correction of excess - If the excess amount is the only contribution made to the IRA, and no other contributions, distributions, transfers or recharacterizations occurred in the IRA, the IRA owner may correct the excess by simply distributing the entire IRA balance by the applicable deadline.
• Non-timely corrections do not apply to Roth IRAs - The rules explained under "Non-Timely Corrections" in part 2 of this series do not apply to a Roth IRA. Roth IRA excess contributions removed after the deadline are treated as regular Roth IRA distributions, which means that the amount is tax-free and is not subject to the 10% early distribution penalty. However, the 6% excise tax will apply for every year the amount remains as an excess contribution in the Roth IRA.

Conclusion
In an honest attempt to fund their retirement accounts, many individuals contribute amounts in excess of the allowable limits. The IRS anticipates that this will happen and has provided guidelines to assist individuals in making the corrections. As we have demonstrated, there are no negative effects if the excess is corrected on time. The key is to keep accurate records of your IRA contributions. This includes tallying contributions made to multiple IRAs. Should you discover that your contribution is in excess of the limits, contact your IRA custodian immediately. Finally, as with any issues relating to retirement plans, consult your tax professional for assistance in determining your best course of action.

by Denise Appleby (Contact Author | Biography)

Denise Appleby is a retirement plans consultant, freelance writer and editor. Before starting her own business, Appleby Retirement Consulting, Denise worked for Pershing LLC for almost 10 years. While at Pershing, Denise rose to the rank of vice president, and held many positions including retirement plans product manager, manager of the retirement plans technical assistance group and retirement plans training manager. Appleby Retirement Consulting provides technical assistance to financial institutions and financial professionals; content for newsletters, websites and magazines; and technical editing services for books and other retirement plans material. Denise holds several retirement professional designations.