Some clients love IRAs so much that they create problems by contributing more than they should. Now that we're entering the peak season for IRA investing, let's review the contribution basics. The maximum amount that can be contributed to a traditional individual retirement account or a Roth IRA (not including SEP and Simple IRAs) is $4,000 for 2007 or $5,000 for 2008. An account owner age 50 or older also can also make an additional $1,000 catch-up contribution each year.
You cannot contribute $4,000 to a traditional IRA and $4,000 to a Roth IRA in 2007; the maximum is $4,000 combined. If your client has contributed to both a traditional and a Roth IRA and has contributed too much for the year, the excess amount must be removed from the Roth IRA first. Contributions to traditional and Roth IRAs have no effect on the amount that can be contributed to a SEP or a Simple IRA.
There are several ways a client may wind up over-contributing to an IRA.
One is if they make the full contribution but are only eligible for a partial contribution (or no contribution) due to the income eligibility limits.
A second way is if ineligible funds somehow get rolled into an IRA.
Ineligible funds are considered excess contributions and may come from required minimum distributions, hardship withdrawals from employer plans, payments made as part of a 72(t) distribution plan, funds received from an IRA that had a rollover distribution in the past 365 days or from non-qualified employer plans or annuities.
Non-spouse beneficiaries are never permitted to do a rollover of inherited IRA funds. A rollover is a distribution that is made payable to the account owner or is a distribution from an employer plan.
Excess contributions face a 6% penalty each year that the funds stay in the account. The penalty can be avoided by removing the contribution — and any earnings or losses on the contribution — by the tax return due date, including extensions to Oct. 15 of the following year.
For example, if a client makes an IRA contribution in 2008 (for 2007) and it turns out that the contribution was not allowed, the contribution can be removed without incurring a penalty by Oct. 15, 2008 — even if an extension was not filed.
Another way to correct an excess contribution is by recharacterizing, or reclassifying, the contribution. For example, if the IRA contribution was made to a Roth IRA but the client's income was too high, the contribution can be recharacterized as a traditional IRA contribution, assuming the client qualified for a traditional IRA.
If the client does not qualify for a traditional or Roth IRA, the excess contribution, plus earnings, should be withdrawn by the Oct. 15 deadline to avoid the 6% penalty. The earnings withdrawn will be taxable and subject to the 10% early withdrawal penalty for those under age 591/2, unless an exception applies.
If the excess contribution was made to a traditional IRA and a deduction was taken, the tax return must be amended if it has already been filed. If the funds are not withdrawn from the traditional IRA by the Oct. 15 deadline, the excess contribution may be taxable, even if no tax deduction was taken on the return.
Another way to correct the excess IRA contribution is to leave it there and let it be considered a contribution for a future year, if the client qualifies for a contribution for that year. But that approach is not recommended since the 6% excise tax will still apply to any excess amounts that remain in the account each year and it may be necessary to amend the client's tax return for the actual year of the contribution.
Some advisers have asked about intentionally making excess contributions to a Roth IRA and paying the penalty, suggesting that a 6% penalty is a small price to pay for tax-free growth. Don't do it.
The 6% penalty must be paid and reported to the IRS each year that the excess funds remain there — and it's never a good idea for you or your clients to attract the attention of the Internal Revenue Service. Also, your clients would need stellar investment returns each year to overcome the huge bite of an annual 6% penalty. You should never recommend this as a way to build tax-free savings: it's not a strategy, only a direct route to future tax problems.
Ed Slott, a certified public accountant in Rockville Centre, N.Y., has created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.
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