Excess Contribution

If someone deposits more than he or she is eligible to contribute to an IRA, the individual has an excess contribution and may be subject to a six percent penalty tax. Whether the tax applies to the excess contribution depends on how the excess contribution is handled and when the excess contribution is corrected and removed.

Unwanted Contribution

The IRS allows an IRA holder to remove any current year contribution and treat the contribution as the removal of an excess, if the contribution and earnings attributable to the contribution are removed. Individuals generally do this if they have made a contribution to a Traditional IRA only to find out the contribution is not deductible.

Recharacterization of a Conversion

The IRS allows an IRA holder to correct a conversion from either a Traditional IRA or Employer Plan by moving the amount of the failed conversion plus the earnings attributable back to a Traditional IRA. Any funds converted directly from the Employer plan cannot go back to the Employer Plan.

Correction Methods

Deadline to Correct

• The deadline to correct or remove contributions is October 15, of the year following the year the contribution occurred for.
• The deadline for a failed conversion is the tax filing deadline plus extensions for the year during which the conversion was made to the Roth IRA.

Options to Correct

• Removal - If the IRA holder removes the excess before the due date (including any extensions) of his or her return, he or she must:
  • remove the amount of the excess from the account
  • remove any net income attributable (NIA) – (earnings) to the excess amount
  • and include the NIA to the excess in income for the year the contribution was made
    • If the IRA holder is under age 59½, he or she must pay a 10 percent early distribution penalty tax on the NIA to the excess. The 10 percent penalty tax does not apply to the excess contribution itself, only to the NIA to the excess.
• Recharacterization
  • If an individual makes a contribution or conversion to a Roth IRA, or a contribution to a Traditional
    IRA (the first IRA), and later transfers either all or a portion of the original contribution or
    conversion, plus the NIA, to another IRA (the second IRA), the individual may elect to treat the
    original contribution as having been made to the second IRA and report it as such.

Correction Procedures

The procedures to follow will depend upon whether the individual chooses to Remove or Recharacterize the excess/unwanted contribution.

• Correction via Removal
  • The client should fill out a distribution request form requesting a distribution or recharacterization. The form should identify the following:
    • The amount of the excess to be distributed
    • The earnings (NIA) to the excess amount to be distributed
• IRS Reporting Upon Removal
  IRS Form 1099R
  
  The codes indicate to the IRS that the earnings (NIA) are taxable in the year that the contribution actually was made.
  
  Traditional IRAs, if the excess contribution is removed before the tax return due date, plus any extensions, the distribution reason codes on Form 1099-R will be either 8 (removal of current year contribution) or P (removal of prior year contribution) with code 1 or 4 (depending on the recipient’s age and if the recipient is a beneficiary).
  
  Code 8 is included in Box 7 if the contribution was made in the same year that it is being removed, while code P is included in Box 7 if the contribution was made in the year prior to the year it is being removed.
  
  For Roth IRAs, the distribution reasons codes will be either 8 or P (depending on the year of contribution and removal) with code J.
  
  The gross distribution (excess and NIA) appears in Box 1 of Form 1099-R and only the NIA is reported in Box 2a.
• Correction via Recharacterization
  
  A recharacterization is performed much like a transfer between different types of IRAs.
  
  Example: In 2008, Chelsea, a single individual, deposited $6,000 as a regular contribution to her Traditional IRA. In March 2009, while working on her 2008 tax return, Chelsea discovers that her modified adjusted gross income (MAGI) for 2008 is $68,000. Since Chelsea was an active participant in her employer-sponsored retirement plan for 2005, she is ineligible for a deduction for her Traditional IRA contribution. While Chelsea could leave the nondeductible contribution in the Traditional IRA, she instead decides to make a recharacterization election to move the $6,000 nondeductible Traditional IRA contribution to the Roth IRA.
  
  By the recharacterization deadline, Chelsea instructs the trustee of her Traditional IRA (the sending IRA) to transfer the amount of the regular Traditional IRA contribution, plus the NIA, to the trustee of a new Roth IRA (the receiving IRA). Chelsea notifies both the trustee of the sending IRA and the trustee of the receiving IRA that she is recharacterizing her IRA contribution. Chelsea also provides the list of required recharacterization information.
• Correction Procedures via Recharacterization
  • The client should fill out a distribution request form requesting a distribution or recharacterization.
  • The form should identify the following:
    • the amount of the excess to be recharacterized
    • the earnings (NIA) to the excess amount to be recharacterized
• IRS Reporting Requirements Upon Recharacterization Correction
• IRS Form 1099R
• A recharacterization is a reportable event. The distributing IRA will generate distribution reporting on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc. Prior-year recharacterizations are reported using code R, while same-year recharacterizations are reported using code N. IRS Form 5498
  
  The receiving IRA will report the recharacterization as a recharacterization contribution on Form 5498, IRA Contribution Information.