Investing in a self-directed IRA comes with some great tax benefits – and you can bet the IRS keeps a close eye on IRA transactions to ensure compliance with the tax rules. The IRS receives data from IRA custodians each year that reports all the dollars that go in and out of your IRA. If you contribute more than the annual limit or more than you’re eligible for in a year, the IRS will likely find out.
An excess contribution can happen when you
• Contribute more than the limit for the year ($5,500 for 2018 and $6,000 for 2019 (plus an extra $1,000 if you’re 50 or older))
• Contribute when you’re not eligible to contribute (e.g., over age 70½ for a Traditional IRA, or income exceeds the limit for a Roth IRA)
• Make an improper rollover (e.g., past 60 days, more than 1 IRA rollover in 12 months, rolling over an RMD)
You cannot take a tax deduction for an excess contribution. And if you don’t correct the excess, you will be subject to an additional 6% tax on the excess amount. The 6% tax applies every year until the excess is corrected. You must report and pay the 6% tax with your federal income tax return for the year using IRS Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax-Favored Accounts.
Here are three ways you can correct an excess IRA contribution.
#1 – Remove
To avoid the 6% excess contribution tax, you can remove the excess contribution from your IRA, along with any investment earnings associated with the excess amount. Your IRA custodian can help you calculate the applicable earnings. You must make the withdrawal by your tax-filing deadline, plus extensions, for the year in which the excess was made. If you typically file your taxes by April 15 for the prior year, this means you generally have until October 15 to correct the excess. You will not have to pay tax on the excess contribution you remove. Any earnings withdrawn with the excess must be included in your taxable income and are subject to the 10% early distribution tax if you are under age 59½.
If you do not remove the excess by your tax-filing deadline, plus extensions, you may still remove the excess contribution to avoid the 6% excess contribution tax for the next year, but the taxation rules on the removal are a bit different. For more information, see IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs).
#2 – Recharacterize
If you have an excess contribution because you were not eligible to contribute to the IRA to which you made the contribution (Traditional or Roth IRA), you can “recharacterize” your contribution to another type of IRA. This method of correcting an excess allows you to leave your contribution in an IRA but treat it as though it was originally made to another type of IRA. This option is only available if you are eligible to contribute to that other type of IRA, and you complete the recharacterization by your tax-filing deadline, including extensions, for the year for which the contribution was made. When recharacterizing a contribution, any investment earnings related to the contribution must also be moved to the other type of IRA.
Ivy made a Traditional IRA contribution for 2018, but she was not eligible for a Traditional IRA because she was over age 70½. Since she has earned income that falls under the maximum income limits to be eligible for a Roth IRA, she may recharacterize her 2018 Traditional IRA contribution as a Roth IRA contribution for 2018. She must complete this transaction by October 15, 2019. There are no tax consequences for a recharacterization except that you must follow the tax rules for the type of IRA that receives the recharacterized amount and investment earnings. For example, if you move a Roth IRA contribution to a Traditional IRA, you will take a tax deduction for the amount recharacterized (if you are eligible for the deduction).
#3 – Redesignate
You may choose to leave an excess contribution in the IRA and redesignate, or carry over, the excess amount to “use it up” in a following year. You will owe a 6% tax for each year an excess amount remains in the IRA, but you will not be obligated to remove any money from the IRA. To complete this correction method, you must be eligible to contribute to the IRA in the year you claim the contribution.
If you have an excess IRA contribution for 2018 or 2019, contact your tax or financial advisor or STRATA Trust to review your options for correcting your excess.
You can contact STRATA Trust at 866-928-9394 or Service@StrataTrust.com.