Life and Death Planning for Retirement Benefits

Chapter 2: Income Tax Issues

101

participant should still withdraw the excess contribution (to avoid accruing additional annual excess-contribution penalties), but such withdrawal will be taxed under the usual cream-in-the-coffee rule ( ¶ 2.2.02 , ¶ 2.2.08 ) unless the limited exception described at “F” applies. On the “bright” side, the excess contribution is added to the participant’s basis in the IRA. See PLR 2009-04029. H. If correcting distribution is late: Effect on 6% penalty. If the excess contribution was not returned (with its net income) by the applicable deadline (see “A”), the participant owes the six percent penalty for the year the excess contribution occurred. This is true even if he qualifies for the special income tax treatment described at “F.” The excess contribution is then “carried over” to the next year; and is treated, for purposes of computing the excess contributions penalty for such following year, as if it were a “regular contribution” for such following year, and for each succeeding year, until it is either “absorbed” or distributed. See Reg. § 1.408A-3 , A-7. An excess Roth IRA contribution can be “absorbed” as a regular contribution ( ¶ 5.3.02 ) for a succeeding year if the individual who made the excess contribution (1) is eligible to make a regular contribution to that account for such succeeding year and (2) does not use up his regular contribution limit by making a cash contribution for such succeeding year. Of course, the most that can be “absorbed” in any one year is the applicable contribution limit amount for that individual for that year ( ¶ 5.3.03 ). Note that:  Once the year the original excess contribution was made has passed, the earnings on the contribution cease to be a factor with respect to the excess contributions penalty. The excess contribution is simply carried forward, dollar for dollar, with no growth factor, from year to year, until it is either “absorbed” or distributed (see § 4973(f)(2) ). To the extent each additional year goes by without having the excess contribution either fully “absorbed” or distributed, there will be a six percent penalty each year.  The fact that the participant can eliminate the excess-contributions penalty by merely withdrawing the contribution after the corrective-distribution deadline has passed, without withdrawing the earnings that were generated by the excess contribution, creates the potential for an abusive Roth IRA transaction. See ¶ 5.1.02 . I. Excess contribution examples. Here are some examples illustrating the discussion above; see also “Gideon Example” ( ¶ 5.2.02 (E)) in connection with a Roth conversion. Lola Example: Lola’s father died in 2009, leaving his $300,000 401(k) plan (all pretax money) to Lola (age 48) as Designated Beneficiary. In 2010, Lola requested the plan administrator of the 401(k) plan to transfer the inherited 401(k) benefit to an “inherited IRA” ( ¶ 4.2.04 ). Due to an error by the financial institution, the funds were transferred into Lola’s own IRA (one she owned as participant), not into an inherited IRA. Because the distribution was not properly rolled over pursuant to the requirements of § 402(c)(11) , the $300,000 distribution from the 401(k) plan is included in Lola’s gross income for 2010. Assume the maximum contribution Lola can legally make to her own IRA in 2010 is $5,000, so $295,000 of this improper rollover is an excess contribution. Lola must withdraw that excess contribution (and all net income attributable to it; assume the “income attributable” is $12,000) no later than October 15, 2011, to avoid being liable