Congratulations! You’re a conscientious saver with an eye on a comfortable retirement, and you regularly maximize your annual Individual Retirement Account (IRA) contributions. Then one day your tax advisor says, “Uh-oh, your IRA contribution isn’t a great idea this year.”
Say what? The reality is, there are a number of scenarios that could lead to this moment of truth: that you’ve got too much of a good thing. Luckily, the Internal Revenue Service has provided a mechanism to straighten things out. It’s called removal of excess contributions, or ROE, and it may help you right your unintentional wrong.
The best news is that ROE is nearly as straightforward as it sounds, although there there are a few things you need to know.
First, consider timing. To avoid a 6% penalty on the excess and its earnings, both must be removed from your account by your tax-filing deadline for the year the contribution was made. This is usually April 15 of the following calendar year.
If you file your taxes on time, you’ll normally qualify for an automatic six-month extension to October 15. However, procrastination doesn’t typically pay. Waiting until October 15 generally means filing an amended tax return, and the IRS can penalize you for each year the excess remains uncorrected.
Now, although you can avoid the 6% penalty with a timely removal of your excess, if you’re under 59½ and made money on your investments, you’re still on the hook for a 10% early withdrawal penalty on the earnings.
The next important consideration is determining how much you need to remove. This may not sound too tricky, but tax law isn’t known for its simplicity. To determine how much you’ll need to trim in earnings, you (or your IRA custodian, or a trusted tax advisor) need to calculate the net income attributable (NIA).
The concept itself is easy, although in practice this can get a little hairy. Rather than looking at your excess simply as the amount you contributed in the first place, the IRS views it as a percentage of your entire IRA. For example, if your $5,500 contribution was 5% of your account balance on the day it was made, you have to take out 5% of the current account balance to ensure that any gains (or losses) in your account that attributed to the extra contribution in question are also removed proportionally.
Coming up in Part 2: An in-depth look at calculating NIA.
Do you learn best by watching? Here's a short video to help you identify, understand, and correctly report a wash sale to the IRS.