We’re quickly approaching the time of year when most contributions are made to IRAs and Roth IRAs. It’s also the time when tax preparers see how much clients have contributed to their IRAs.
But there are limits to how much can be contributed to an IRA, and exceeding them can result in costly penalties. Advisers should monitor their clients’ contributions to make sure they are legal, and help them avoid expensive consequences.
Such was the unfortunate fate for two taxpayers in an August court case.
In 2007, Michael and Christina Wu sold their Illinois home and each deposited $200,000 of the profits into their respective traditional IRAs. The problem with this move may seem obvious to advisers, but not to all average taxpayers.
This created tax problems for the Wus, because in 2007, each of them was allowed to contribute a maximum of $4,000 to an IRA.
A PENALTY HIT
Each $200,000 IRA contribution created an excess contribution for 2007, which was not removed by the October 15, 2008, deadline. The Wus faced the 6% excess contribution penalty, along with penalties for filing Form 5329 late, and interest plus penalties on the late payment.
If your client makes an excess IRA contribution in April 2017 for 2016, he or she has until Oct. 16, 2017, to fix it and avoid the penalty.
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The Wus realized their mistake in early 2010, informed the IRS and corrected the problem by withdrawing the excess contributions from their IRAs. They paid the penalties for 2007 through 2009.
Although they conceded liability for the first two years, the Wus sought a refund for tax year 2009, arguing that they had avoided the 6% excess contribution penalty by removing it before the April 2010 filing deadline for their 2009 tax return.
The IRS disagreed with the Wus, and the case was brought to court (Wu v. United States). The district court sided with IRS, and the Wus appealed.
WHAT IS AN EXCESS CONTRIBUTION?
As the name implies, excess IRA contributions are those that exceed the limit a taxpayer can contribute to an IRA for the year.
Examples include IRA contributions that exceed the maximum annual dollar limit (e.g., $5,500 for someone under age 50 for 2017), as well as rolling over an amount that isn’t eligible (e.g., a required minimum distribution or a rollover after the 60-day clock has expired).
Whenever clients roll over funds that aren’t eligible, the ineligible amount is automatically treated as an annual IRA contribution. In the Wu’s case, they rolled over money they received when they sold their house.
Excess contributions will be subject to the 6% penalty each year until they are fixed. The only way to fix the mistake and avoid the penalty is to withdraw the excess, plus or minus the earnings (what the IRS calls the net income attributable) by Oct. 15 of the year after the contribution was made.
Excess contributions will be subject to the 6% penalty each year until they are fixed. The only way to fix the mistake and avoid the penalty is to withdraw the excess, plus or minus the earnings (what the IRS calls the net income attributable) by Oct. 15 of the year after the contribution was made.
So if your client makes an excess IRA contribution in April 2017 for 2016, he or she has until Oct. 16, 2017 (Oct. 15, 2017 is a Sunday), to fix it and avoid the penalty. If the excess is not fixed by the deadline, the penalty applies each year that the amount is in the account as of December 31, until it is fixed.
The penalty is paid by filing IRS Form 5329, which can be filed with your client’s tax return or as a stand-alone return. Unlike most other tax forms, Form 5329 has its own signature line, like the Form 1040. For that reason, Form 5329 is considered a separate tax return. If it is not filed, the statute of limitations does not start to run, and the IRS can go back indefinitely to assess the penalty on the excess contribution, as well as penalties for failure to file.
POST-DEADLINE FIXES
One way to fix an excess contribution after the deadline is to withdraw it. Otherwise, the penalty continues each year. To do so, you must alert the IRA custodian that this is a withdrawal of excess IRA contributions, so that they issue the 1099-R with the correct coding for tax return filing.
Interestingly, the Tax Code does not require the NIA to be withdrawn. This seems illogical, because these excess earnings/investment gains are tax-deferred inside the IRA (but they don’t belong there because they’re attributed to IRA money that that should not have been contributed in the first place).
Excess traditional IRA contributions withdrawn after the deadline are generally fully taxable. If the IRA owner has after-tax funds, the pro-rata tax rule would apply. Excess Roth IRA contributions withdrawn after the deadline are not taxable.
Another way to fix an excess IRA contribution after the deadline is to leave it there and carry it forward to use up as an annual IRA contribution. However, this method doesn’t work well for large excesses, such as the Wu’s contributions, because the most you can use up in a given year is limited to the IRA contribution limit that year, and the 6% penalty still applies on the excess amounts that remain in the IRA.
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To get back to the Wus, the appeals court agreed with the district court and the IRS, and held that the Wus owed the penalty on the excess IRA contribution for 2009.
The court rejected the Wus’ argument that excess contributions, for whatever year they are contributed to an IRA, are exempt from the penalty in a later taxable year if a distribution is made before a tax return is due for that year.
As the Wus learned, excess IRA contributions can result in a tax nightmare.
According to the court, the Wus made their excess contributions in 2007, so for that tax year, they could have avoided incurring the penalty on excess contributions by withdrawing the excess before the return-filing deadline for that taxable year.
But for any later year, the Wus could avoid the annual tax only by taking the distribution before the taxable year ended. To avoid the penalty for 2009, the Wus would have to remove the excess contributions by December 31, 2009. But they didn’t do that, so they owed the penalty.
A TRICKY BUSINESS
Advice on excess IRA contributions is a tricky business. Advisers should carefully monitor client accounts to ensure that excess contributions don’t happen in the first place. Educating clients on the basics of IRA contribution rules may help.
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For example, there are income limits for Roth IRA contributions, but not for Roth conversions. If clients’ incomes exceed these limits and they contribute to a Roth IRA, that is an excess contribution, and it must be removed by the deadline to avoid the penalty.
Traditional IRAs have no income limits for contributions, but there are age limits. You cannot contribute to a traditional IRA for the year you turn age 70 ½ or later. Sometimes clients are not aware of this and keep contributing beyond age 70 ½. These are excess contributions, because they are not legal.
Roth IRA contributions have no such age limits.
To make IRA or Roth IRA contributions, the client must also have compensation, such as wages or self-employment income. Pension income is not compensation. If a client does not have compensation and makes an IRA contribution, again, that is an excess contribution, and it must be removed.
As the Wus learned, excess IRA contributions can result in a tax nightmare. For advisers faced with these situations, proper action must be taken to fix the error as soon as possible, because an excess contribution is not a problem that will go away on its own.
