“Excess IRA Contributions Cannot be Ignored, Unless You Don’t Mind Being Assessed an Annual 6% Penalty”
If a contribution is made to an Individual Retirement Account (IRA) in excess of the allowable amount, that contribution is referred to as an excess contribution. It is subject to an annual 6% excise tax unless the excess, plus earnings, are withdrawn by the due date for the taxpayer’s tax return for that year (including extensions).
How Excess Contributions are Made
Exceeding the Annual Limit
The 2019 annual contribution limit is $6,000, with an additional $1,000 allowed for persons over age 50. While this limit seems rather straightforward, it may become a greater challenge for persons (1) who make an annual contribution to multiple IRA accounts and lose track of the individual contributions and (2) those whose income unexpectedly exceeds the earnings limits.
Exceeding the IRA Income Limits
If a taxpayer makes an IRA contribution but has too much income, an excess contribution is deemed to have been made. Fortunately, there are no income limits for Traditional IRAs (but there are income limits for tax deductible contributions).
There are phase-out income limits for Roth IRAs which begin when ones modified adjusted gross income is greater than $122,000. Roth IRA contributions that exceed the income limitation are subject to an annual 6% excise tax.
Insufficient Earned Income
To make an IRA contribution, the taxpayer must have sufficient earned income. Earned income consists of W2 wages and self-employment income (including those of your spouse in certain circumstances). It does not include social security, rental income nor investment income.
A trap for the unwary is that gains from self-employment are offset by losses from self-employment. Thus a taxpayer who has two Schedule C businesses, one showing net profits of $10,000 and a second with a loss of $12,000, this taxpayer has zero net profits for IRA contribution limits.
Too Old For a Traditional IRA
When you reach the year that you attain age 70 ½, you can no longer contribute to your Traditional IRA. Accordingly, contributions made for a year when you are age 70½ or older are excess contributions subject to the annual excise tax.
There are no age limits for Roth IRA contributions.
The IRS rollover rules have changed in recent years and taxpayers could thus fall afoul of the new rule which allows only one rollover per 12-month period. In addition, taxpayers could also fail the 60-day rollover period requirement. In such cases, an excess contribution has occurred.
To avoid the one rollover rule, consider making direct transfers directly from one IRA account to another where you do not have access to the funds.
RMDs Not Eligible for Rollover
RMDs (Required Minimum Distributions) for the tax year cannot be rolled over. The excess contribution can arise when a taxpayer converts a traditional IRA to a Roth IRA, and then takes a RMD. That rolled over RMD is considered an excess contribution by the IRS subject to the excise tax. The RMD must be taken before the rollover to an IRA occurs.
You cannot make contributions to Inherited IRAs for persons other than your spouse. You also cannot combine that account with another IRA account. If you do, you have an excess contribution.
How To Fix Excess IRA Contributions
Should an excess contribution occur, you need to take immediate action to avoid the 6% IRS penalty in the year of the excess contribution and subsequent years if corrective action is not taken.
To fix the problem, you need to withdraw the excess contribution amount PLUS any earnings associated with the contribution. So if you made an excess contribution of $500 and the earnings for the entire account was $3,000, you need to work with the financial advisor where the IRA account is being held to determine what portion of the $3,000 earnings are attributable to the $500 excess contribution.
Tax Planning Tip:
If you are self-employed, you likely will not know your net earnings until you close out your books. Accordingly, while it may be best to make an early contribute to maximize earnings on the retirement account, you need to be aware that your contribution amount will not be known until the books are closed for the year. Accordingly for some persons, it may make sense not to make your (full) contribution until the net earnings of the business is finalized with your tax advisor or accountant.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
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About F. Bryan Haarlander, EA, CTRS:
Bryan Haarlander is an IRS licensed Enrolled Agent and who owns and operates a specialized tax services firm serving clients in the western suburbs of Philadelphia, PA, which includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, Frazer, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, West Chester in Berks, Chester, Delaware, Montgomery and Philadelphia Counties, as well as clients in Delaware, New Jersey, New York and throughout the continental USA.
A Certified Tax Resolution Specialist, Bryan is well-known for his IRS tax resolution expertise and his book How to Resolve Your IRS Tax Debt Problems.