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Chapter 2: Income Tax Issues
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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