If you contribute more than is allowed to your IRA and fail to remove the correct amount when correcting the excess, the IRS could determine that the correction did not occur and assess penalties. In this article we'll show you how to make sure your IRA contributions corrections meet statutory requirements.
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. 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, provided the value of the assets removed is equal to the excess amount plus earnings.
Excess Earnings - The Formula
The new formula is a pro-rata allocation of earnings or losses to the excess amount. The formula is as follows:
Proper application of the formula requires an understanding of the terms used:
- Adjusted opening balance - The fair market value (FMV) 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 - The FMV of the IRA at the end of the computation period, plus any transfer debits, distributions, and recharacterizations from the IRA.
- Computation period - This 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.
Mary contributed $3,000 to her Traditional IRA No.1 on February 15, 2013, for the 2013 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 2013. 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 2013, which is $5,400. Mary decides to remove the excess amount on April 15, when the balance of IRA No.1 is $16,800. Between February 15, 2013, and April 15, 2013, Mary transfers $8,000 from her Traditional IRA No.2 to her Traditional IRA No.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 No.1. The IRA custodian will issue IRS Form 1099-R for 2013 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 earnings are taxable in 2013. Mary must add the $73 to her 2013 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).
Harry contributed $3,000 to his IRA on June 15, 2012, when the FMV of his IRA was $7,700. Harry later realized that he was eligible to contribute only $2,500. On January 15, 2013, 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.
1. Excesses must be corrected from the same IRA.
The excess contribution must be removed from the IRA to which the amount was contributed. Therefore, an individual with multiple IRAs cannot cherrypick the IRA from which the correction will occur.
2. The last contribution is an 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.
3. Distribution of the 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.
4. Non-timely correction rule do not apply to Roth IRAs.
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.
The Bottom Line
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 is no 6% excise tax 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. The best brokers for IRAs surely have top-notch service to help in these situations. Finally, as with any issues relating to retirement plans, consult your tax professional for assistance in determining your best course of action.