Put too much in your IRA last year? Ed goes over what remedies are available to federal employees.
Edward A. Zurndorfer
For the year 2021, all federal employees are eligible to contribute a maximum $6,000 to an Individual Retirement Arrangement (IRA). If an employee was over age 49 as of Dec. 31, 2021 (that is, the employee was born before January 1, 1972), then the employee can contribute to an IRA an additional $1,000 in “catch-up” contributions, for a maximum of 2021 IRA contribution of $7,000.
The maximum 2021 IRA contribution of $6,000/$7,000 applies to contributions made to a traditional IRA, to a Roth IRA, or to a combination of both types of IRAs. The deadline for making one’s 2021 IRA contribution is the 2021 federal income tax filing deadline of April 18, 2022. This is the case even if an individual files for a six-month federal income tax filing extension.
There are some federal employees who, during the year 2021, completed making their 2021 IRA contributions and who may have inadvertently contributed more than the maximum allowed. There may be employees who may have contributed to the type of IRA they are not eligible to contribute to. For example, an employee may have contributed to their Roth IRA. Roth IRAs each year have income limitations in order for individuals to make contributions. A federal employee was not aware of these income limitations. Because the employee’s 2021 income exceeded the limit for contributing to a Roth IRA for the year 2021 and the employee is, therefore, ineligible to contribute, the employee’s Roth IRA contributions are considered “excess contributions”. The employee should have instead contributed to a traditional IRA.
In both situations – either overcontributing to an IRA or contributing to the wrong type of IRA – can result in an IRS “excess contribution” penalty. This column discusses what employees who have overfunded their IRAs or who have contributed to the wrong type of IRA for the year 2021 can do at this time do in order to avoid the IRS “excess contribution” penalty when they file their 2021 federal income tax returns in spring 2022.
The following is an example of a federal employee who made excess contributions to her IRA for the year 2021:
Carla is a federal employee, age 44, who contributed $7,000 to her traditional IRA during 2021. Carla did not realize that the maximum $7,000 IRA contribution for the year 2021 only applies to individuals aged 50 or older as of 12/31/2021. Carla was under age 50 as of 12/31/2021. She is only age 44 and therefore has made a $1,000 excess IRA contribution for the year 2021.
IRS Penalty for Excess IRA Contributions
The IRS penalty for IRA excess contributions is 6 percent of the amount of the excess contribution. In the example above, Carla, therefore, owes a penalty of 6 percent of $1,000, or $60, “excess contribution” penalty tax on her $1,000 excess contribution.
There is a remedy for Carla’s 2021 excess contribution to her IRA. That remedy is called a corrective distribution. For individuals who made contributions to the wrong type of IRA, there is a remedy called a recharacterization. The corrective distribution remedy is discussed below. Note that as a result of the Tax Cut and Jobs Act of 2017 (TCJA), recharacterization of Roth IRA conversions are not allowed as of Jan. 1, 2018. But recharacterizations of IRA contributions continue to be permitted.
Before discussing the corrective distribution remedy, it is important to present some background information with respect to Carla’s 2021 traditional IRA contributions. Since Carla’s 2021 adjusted gross income (AGI) was above $100,000 and she was covered by FERS in addition to participating in the Thrift Savings Plan, Carla is not eligible to contribute to a deductible traditional IRA. But she is eligible to contribute to a nondeductible traditional IRA. The fact is that there are no income limitations for individuals in order to contribute to a nondeductible traditional IRA whereas someone like Carla whose income is too large and is participating in an employer-sponsored retirement plan is not allowed to contribute to a deductible traditional IRA.
The 6 percent excess contribution penalty tax is not imposed if the excess contributions, plus any accrued earnings – interest, dividend, capital gains, or any other type of income, are withdrawn by the due date of the tax return for that year.
An excess contribution that is withdrawn from an individual’s traditional IRA before the due date of the tax return of that year’s federal income tax return is not included in the individual’s gross income if the following conditions are met: (1) No deduction was allowed for the excess contribution; and (2) any accrued earnings on the excess contribution were also withdrawn.
In the example above, Carla needs to contact her traditional IRA custodian to withdraw the $1,000 excess contribution from her non-deductible traditional IRA. She must do this before April 18, 2022 (the due date of the 2021 federal income tax return). The $1,000 refunded amount will not be included in Carla’s 2021 gross income because the $1,000 contribution was made with after-taxed monies.
But any accrued earnings of the $1,000 excess contribution that are withdrawn from the IRA are considered as taxable income. This income is to be included on the tax return for the year in which the excess contribution was made. The withdrawal of the accrued earnings may be subject to the 10 percent penalty tax if the IRA owner is under age 59.5 at the time of distribution. In most cases, the IRA trustee or custodian determines the net income that must be withdrawn.
In the example above, Carla’s IRA custodian should be able to compute the accrued earnings on her excess $1,000 non-deductible traditional IRA contribution.
Suppose Carla’s IRA custodian notified her that the accrued earnings on her $1,000 excess contribution is $150. Carla withdraws the $150 on January 19, 2022. Carla will include the $!50 as gross income on her 2021 federal income tax return, the year in which the excess $1,000 IRA contributions were made. She must also pay a penalty tax of $15 (10 percent of $150). The $15 represents the 10 percent additional tax on Carla’s early IRA distributions of the IRA earnings because Carla is not yet 59.5 years old. She does not have to report the excess $1,000 contribution as income or pay the 6 percent excess contribution tax.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those, Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.