Editor’s note: This is the second of a two-part series on Individual Retirement Account tax law considerations. Read part one: “IRA Contribution Oops Moment? Here's Your Penalty Fix.”
If you find yourself needing to remove part or all of an Individual Retirement Account (IRA) contribution to avoid a tax penalty, there is a way. As we learned in part one, investors can fix their oversight using the removal of excess contribution (ROE) rule. Doing so requires a little math, specifically, crunching what the IRS calls net income attributable, or NIA.
The NIA is simply the earnings (or losses) in your IRA account for the period of time the contribution is held there. But you can’t calculate NIA based on how a particular position held in your IRA performed during that time period. Instead, you must take into account the overall value of the IRA, including any contributions, distributions, and/or recharacterizations.
Remember, you’re only taking into account the IRA that contains the excess contribution. You’re not including your entire retirement portfolio. NIA is calculated using Treasury Regulation 1.408-11, or you can find it in IRS Publication 590 in the section labeled Excess Contributions.
Pull Out the Calculator
Here’s the formula and some definitions to get you started:
NIA = Total earnings x (Excess contributions/Adjusted opening balance)
Total earnings is calculated by subtracting your IRA’s adjusted opening balance from the adjusted closing balance prior to removing the excess contribution.
Adjusted opening balance is your IRA’s opening balance at the beginning of the period the excess was contributed, including any contributions, transfers, rollovers, or recharacterizations in the IRA since the excess contribution was made.
Adjusted closing balance is your IRA’s closing balance prior to the removal of excess, plus any distributions (including rollovers, transfers, and recharacterizations) taken from the IRA during the period the excess was in the account. This is the part that tends to get tricky, as you must include anything removed from the account to get an accurate NIA for the period.
Let’s say you’re 40 years old and you—or more likely your tax advisor—notice that $5,000 contributed to your IRA for 2014 was in excess. The closing balance is $8,322.25, and you did not take any distributions. Your IRA opening balance was $3,000.00.
Excess contribution = $5,000.00
AOB = $3,000 + $5,000 contribution = $8,000.00
NIA = $8,322.25 – ($8,000.00) = $322.25 x ($5,000.00/$8,000.00) = $201.41
Therefore you must remove $5,201.41. Remember, you are taxed on the NIA ($201.41), and since you are 40 years old (for this example), the early distribution penalty of 10% applies.
Calculating NIA may appear straightforward, but it can get confusing fast. Always consult your tax professional if you have any doubts. The underlying message is: if you’re over, don’t panic. There’s a fix.
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The information presented is for informational and educational purposes only. Content presented is not an investment recommendation or advice and should not be relied upon in making the decision to buy or sell a security or pursue a particular investment strategy.