The penalty for an ineligible contribution is 6% of the excess amount. You pay this penalty when you file your income tax return using IRS Form 5329.
If you don’t fix the mistake, you’ll owe the penalty each year the excess remains in your account. If you’re not eligible to take a qualified distribution from your IRA to fix the mistake, you’ll pay an additional 10% early withdrawal penalty on earnings (interest).
How to Calculate Excess Contributions
The IRS provides a specific formula to calculate earnings (or losses) attributable to an excess contribution.
Net income=excess contribution× (ACB−AOB)/ AOB
where:
AOB=Adjusted Opening Balance
ACB=Adjusted Closing Balance
Adjusted Opening Balance: The previous IRA balance plus all contributions (including the excess one), consolidations, and transfers into the account since the contribution occurred.
Adjusted Closing Balance: The current value of the IRA minus all distributions, consolidations, and transfers since the contribution occurred.
Excess Contribution Example
Here's an example that illustrates a mistake and how to apply the formula to calculate earnings:
Mary contributed $3,000 to her traditional IRA last year. When filing her taxes, she realizes she was only eligible to contribute $2,000 because she only had $2,000 in earned income for the year. She requests to remove the $1,000 excess.
Before the contribution, Mary's IRA balance was $12,000 and it's now worth $18,000. She didn't make any additional contributions or distributions. Her adjusted closing balance is $18,000 and her adjusted opening balance is $15,000 ($12,000 + $3,000). She uses the IRS formula to determine the earnings:
=$1000×($18000−$15000)/$15000
=($1000×$3000)/$15000
=$200 earnings
Mary will remove $1,200 ($1,000 excess contribution plus $200 earnings attributable to the excess contribution).
How to Fix an Excess IRA Contribution
There are several ways to correct an excess contribution to an IRA.
- Withdraw the excess contribution and earnings. In general, you can avoid the 6% penalty if you withdraw the extra contribution and any earnings before your tax deadline. You must declare the earnings as income on your taxes. Also, you may owe a 10% tax for early withdrawal on the earnings if you're younger than 59 ½.
- File an amended tax return (if you’ve already filed). You can avoid the 6% penalty if you remove the excess contribution and earnings and file an amended return by the October extension deadline.
- Apply the excess to next year’s contribution. Doing this on a future tax return won’t get you off the hook for the 6% tax this year, but at least you’ll stop paying once you apply the excess.
- Withdraw the excess next year. If you don't do one of the other options first, you can withdraw the excess funds by Dec. 31 of the following year. You can leave the earnings in, but you must remove the entire excess contribution to avoid that 6% penalty for the following year.
Answers are correct to the best of my ability but do not constitute legal or tax advice.
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