Correcting Excess IRA Contributions

Take-Away: In its most recent publication, the IRS made a subtle change in when an excess IRA contribution needs to be corrected, i.e. withdrawn, in order to avoid the 6% penalty for excess IRA contributions.

Background: The IRS recently updated its Publication 590 that deals with distributions from IRAs, including how to ‘fix’ an excess contribution to an individual’s retirement account. Specifically, the IRS changed the determination of the year in which an excess contribution to an IRA is made, and thus correspondingly the due date of the year in which the excess contribution must be corrected in (or by) so as to avoid the 6% excise tax on excess IRA contributions. [[Treasury/IRS RIN 1545-BL 99 (NPRM REG-107302-14.]

Excess IRA Contributions: IRC 408(d)(4) provides that an individual has up until his/her tax return deadline, including extensions, for the year in which an excess IRA contribution was made to distribute the excess amount to avoid the amount distributed from being treated as a taxable distribution and subject to the 6% tax on excess IRA contributions. [IRC 4973(a).] [Reguation 1.408-4(c)(2)(i).]

Issue: The issue stems from an individual who makes an IRA contribution in the following calendar year, intending that it be treated as an IRA contribution for the prior tax year. A taxpayer can make an IRA contribution for 2020 but actually contribute the funds to the IRA sometime in the first calendar quarter of 2021. The issue is what if that 2021 IRA contribution is an excess contribution which must be corrected in order to avoid the 6% penalty. When must that corrective distribution occur in order to avoid the excise tax?

– Tax Code: IRC 219(f)(3) provides: “For purposes of this section, a taxpayer shall be deemed to have made a contribution to an individual retirement plan on the last day of the preceding taxable year and is made not later than the time prescribed by law for filing the return for such taxable year (not including extensions thereof.”)

Earlier IRS Publication 590: In earlier versions of this Publication an excess IRA contribution made after the end of the calendar year that is treated as made for that prior calendar year, would not be taxable, nor subject to the 6% penalty, if the excess contribution, plus any earnings, are distributed to the IRA owner by the due date, including extensions, for that later year.

Newest IRA Publication 590: The prior interpretation was changed in the newest version of Publication 590. The new interpretation treats all excess contributions made to an IRA for a contribution year as having been incurred during that contribution year, i.e. the calendar year for which the contribution is made, rather than the year in which the actual IRA contribution occurred giving rise to the excess contribution that was made.

The newest version of Publication 590 provides at page 33: “In general, if the excess contributions for a year are not withdrawn by the date of your return for the year is due (including extensions) you are subject to a 6% tax….You must complete your withdrawal by the date your tax return for that year is due, including extensions.”

Example: Betty makes an excess IRA contribution to her IRA on February 15, 2022, which she intends to be her contribution to her IRA for 2021. Betty will have to take a corrective distribution from her IRA of the excess amount on or before her 2021 Form 1040 tax return date is due, April 17, 2022, in order to avoid the 6% penalty. Under the prior interpretation of Publication 590, Betty would have had until April 15, 2023 to take her corrective distribution.

Corrective Distribution Amount: While the above refers to the amount contributed to the IRA which is determined to be in excess of the amount that could legally be contributed as a deduction to the IRA,  the corrective distribution amount also includes the earnings (or loss) attributable to the returned contribution. Those earnings are includible in the individual’s gross income for the taxable year in which the contributions were made. [Regulation 1.408A-6, Q&A-1(d).]

Conclusion: Hopefully no one will ever have to face the problem of making an excess contribution to an IRA. If they do make that mistake, the time in which to ‘fix’ the problem has shortened under the IRS’s newest interpretation of the Tax Code. An IRA owner who relies on an earlier version of IRS Publication 590 could find themselves thinking they had more time to ‘fix’ the problem and take a corrective distribution than is currently the position of the IRS. In short, obtain and rely upon the most recent version of Publication 590- earlier versions can lull an individual into thinking that they have plenty of time to ‘fix’ the excess contribution.