Removing Excess IRA Contributions
By Kristiana Rodriguez
In the days leading up to the April 15 federal tax return deadline, you may have received calls from IRA owners trying to remove excess contributions from their IRAs. What some IRA owners may not know is that the deadline for excess contribution removal is generally October 15, the taxpayer’s deadline plus extensions. IRA owners have this extra time for excess contribution correction if their tax return was filed timely.
Here is a refresher for excess contributions and how to remove them.
Note: Because the same rules generally apply to both Traditional and Roth IRAs, this article will make no distinction between the two unless necessary.
What is an Excess Contribution?
There are several reasons an excess contribution may occur in an IRA. But no matter how an excess occurs, it will either be a true excess or a deemed excess.
Deemed Excess
A deemed excess is the removal of an IRA contribution that could have been made to an IRA. It is an eligible contribution that is within the contribution limits, the IRA owner has eligible compensation, and if it is a Roth contribution, the Roth IRA owner’s income falls within modified adjusted gross income (MAGI) limits. The issue in this scenario is that the IRA owner does not want the contribution to remain in the IRA.
IRS regulations allow deemed excesses to be removed if the IRA owner removes the contribution plus the net income attributable (NIA) by the federal income tax return due date, including extensions, of the year for which the contribution was made.
True Excess
When a true excess occurs, the contribution is ineligible. The funds should not have been contributed to an IRA and they must be removed. True excess contributions can occur when the contribution amount exceeds the IRA owner’s contribution limit, the contribution exceeds the IRA owner’s eligible compensation, or, in the case of a Roth IRA contribution, the IRA owner’s MAGI exceeds the applicable limit.
Annual Contributions that Create a True Excess
Traditional IRA
Contribution exceeds individual limit
Contribution exceeds IRA owner’s eligible compensation
Roth IRA
Contribution exceeds individual limit
Contribution exceeds IRA owner’s eligible compensation
IRA owner’s MAGI exceeds limit
Other Types of Excess Contributions
Invalid Rollover
A rollover contribution that was ineligible may or may not create an excess, but commonly does, as described below.
A rollover contribution is generally invalid if it
is made more than 60 days after the individual receives a distribution,
is part of a series of substantially equal periodic payments,
contains a required minimum distribution (RMD),
violates the one-per-12-month rule,
contains a designated Roth account distribution that is rolled over to a Traditional IRA, or
contains other ineligible funds from an employer-sponsored retirement plan.
Invalid Conversion
An invalid conversion may result from converting to a Roth IRA an ineligible amount, such as an RMD.
If an invalid rollover or conversion occurs, the contribution is treated and reported as a regular IRA contribution for the year. Regular contribution eligibility rules apply. This could result in a true excess contribution, or an IRA owner may deem it as an excess contribution before the deadline. The IRA owner may make you aware of an invalid rollover or conversion and ask you to correct the Form 5498, IRA Contribution Information, reporting and report the distribution on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
How do you process an excess contribution removal before the tax return due date, plus extensions?
IRA owners who wish to correct an excess contribution before the tax return due date, including extensions, should remove the excess amount along with the NIA to avoid paying a six percent penalty tax to the IRS.
Note: If the extension deadline falls on a Saturday, Sunday, or legal holiday, IRA owners have until the following business day to complete the transaction.
Before the deadline, the IRA owner may remove any current- or prior-year contribution as an excess contribution, deemed or true excess, as long as the NIA is also removed. The IRA owner may also make you aware of an invalid rollover or invalid conversion amount. Because these are viewed as regular contributions, they can also be removed before the deadline.
IRA owners should take the following steps when removing an excess contribution.
Remove excess contribution
Remove NIA
Do not claim the excess as deductible or nondeductible contribution on tax return
Claim NIA as taxable income in year excess contribution was made
NOTE: The NIA is no longer subject to the 10 percent early distribution penalty tax.
Handling the Distribution
The IRA owner should request the withdrawal of the excess contribution and NIA by completing and signing an IRA withdrawal form. The financial organization must provide the IRA owner with the proper withholding notice and election form and should process a distribution for the total amount of the excess contribution and the NIA, reduced by any income tax withholding requested by the IRA owner.
An excess contribution removed before the deadline isn’t taxable, but the NIA that is removed is taxable income for the year in which the contribution was made.
IRS Reporting
Form 5498
It is the financial organization’s responsibility to report all contributions on Form 5498, regardless of whether excess contributions are removed before the deadline. If the IRA owner makes you aware of an invalid rollover or conversion amount, corrective reporting may be required on Form 5498. Invalid rollover and conversion amounts are reported as regular contributions for the year in Box 1 of Form 5498, even if they exceed the contribution limit.
Form 1099-R
The distribution of the excess contribution and NIA will be reported on Form 1099-R for the year in which the distribution occurred. In some situations, the NIA may be a loss, and if so, the distribution amount would take into account the loss and be less than the excess contribution.
Box 1, Gross distribution – Enter the excess contribution amount plus the NIA.
Box 2a, Taxable amount – Enter the NIA only.
Box 2b, Taxable amount not determined – Leave blank.
Box 7, Distribution code(s) – Use code P or code 8 with either code 1 (if under age 59½) or code 4 (if the IRA owner is deceased) for Traditional IRAs; use code P or code 8 with code J for Roth IRAs.
Mark IRA/SEP/SIMPLE box for Traditional IRAs.
Leave IRA/SEP/SIMPLE box unmarked for Roth IRAs.
Reason Codes
Code 8 An IRA owner distributes the excess contribution and NIA in the same calendar year that the contribution was deposited, but before the tax return due date, plus extensions.
Code P An IRA owner distributes the excess contribution in the calendar year after the contribution was deposited, but before the IRA owner’s tax return due date, plus extensions.
Code 1 Use with code 8 or code P if the Traditional IRA owner has not attained age 59½.
Code 4 Use with code 8 or code P if the Traditional IRA owner is deceased.
Code J Use with code 8 or code P if distribution of a Roth IRA excess contribution.
How do you process an excess contribution removal after the tax return due date, plus extensions?
If the IRA owner does not remove the excess contribution by the due date for filing her return, she must pay an IRS six percent penalty tax on the excess contribution for each year that the excess contribution remains uncorrected. To correct an excess contribution after the tax return due date, plus extensions, the excess contribution amount must be removed or may be applied as a future year contribution. If removed, the NIA on the excess contribution need not be distributed.
An excess contribution that is not distributed with NIA may be applied as a contribution for the next year. In this situation, the financial organization does nothing: the IRA owner will address it when filing her tax return.
IRS Reporting
Form 5498
Financial organizations must report an invalid rollover and conversion amount as a regular contribution for the year in Box 1 of Form 5498, even if it exceeds the contribution limit.
Form 1099-R
When a Traditional IRA excess contribution is removed after the tax return due date, plus extensions, financial organizations should enter either code 1 (for individuals under age 59½) or code 7 (for individuals age 59½ or older) in Box 7. The amount of the excess removed is reported in Box 1 and Box 2a is left blank.
For a Roth IRA, the proper distribution code, depending on the circumstances, is either code J, code T, or code Q. Box 2a is left blank.
