By Sarah Brenner, JD
Director of Retirement Education
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Maybe you made a Roth IRA contribution for 2021, but your income was too high. Maybe you made a traditional IRA contribution without having any earned income. These are both examples of excess IRA contributions. The bad news is that excess IRA contributions happen can easily and often. The good news is that if you properly correct the contribution, you can avoid penalties.
October 17, 2022 Deadline
When it comes to correcting an excess IRA contribution for 2021, the key deadline is October 17, 2022. The statutory deadline is actually the tax-filing deadline, including extensions. However, the IRS has said that the applicable deadline for taxpayers who file a timely return is six months after the original due date for filing the tax return, even if no extension is filed. This year, October 15 is on a Saturday, so the deadline is Monday, October 17.
Why is this date so important? A 6% penalty applies to excess contributions. This penalty is not a one-and-done thing. It will apply every year that an excess contribution remains in the IRA. The only way to avoid the 6% penalty when an excess contribution occurs is to correct it by this deadline.
How to Fix the Excess Contribution
When an excess IRA contribution is discovered before the deadline, you have two choices to fix the error and avoid the 6% penalty. You can recharacterize the contribution or withdraw it. With either option, the slate is wiped clean, and the contribution is treated as though it was never made to the IRA where the excess occurred.
With either choice, the net income attributable to the excess contribution (NIA) must accompany the contribution. The NIA can be a loss if the IRA has lost value. The calculation of the NIA is based on the entire value of the IRA during the time the excess contribution was in the IRA. The NIA is calculated using a special IRS-approved formula. Many times, the IRA custodian will do the calculation. A worksheet with the formula can also be found in IRS Publication 590-A.
One option for correcting an excess IRA contribution is by withdrawal. Be sure to tell the IRA custodian that the distribution is a return of an excess contribution. With this method of correction, the contribution and the NIA are distributed. The contribution is not taxable, but the earnings would be taxable for the year in which the contribution was made. Earnings would also be subject to the 10% penalty if you are under age 59 ½ and an exception does not apply. The IRA custodian will use special reporting on Form 1099-R to reflect that this is a corrective distribution before the deadline.
The second option for correcting an excess IRA contribution is recharacterization. This is often overlooked as a viable strategy. Recharacterization is a way to move an unwanted tax-year contribution from a traditional IRA to a Roth IRA, or vice versa. If a contribution is recharacterized it will move from one type of IRA to another in a reportable, but nontaxable, transfer. The contribution will be treated as though it had been originally made to the IRA to which it is recharacterized.
Professional Advice Needed
Handling excess IRA contributions can be complicated. If you do it right, you can avoid penalties. To be sure that no mistakes are made, this is a good time to seek the advice of a professional tax or financial advisor.