2021 rollover from nonqualified plan to traditional IRA

[ira_query]

I mistakenly rolled over a death benefit from a variable annuity to my traditional IRA. (No mechanisms to prevent that apparently.) I also have an inherited IRA and in December I took (more than) the RMD for 2021, as a function of my mother's age at the time of her death last year. Is there any way for me to avoid double taxation on the ineligible rollover? Anything I can do with that inherited IRA that would help here given that there's still over two months left before April 18?

Otherwise, my reading of IRS publications suggests I need to do a Corrective Distribution (distribution code 😎 from the Traditional IRA for tax year 2022 which will cause double taxation of the rolled over amount. The variable annuity benefit came with its own 1099-R with income to be reported on my 2021 return and with distribution code 4D, thus preventing rollover of that amount.

[dmertz]

Depositing this money into the IRA is an excess contribution to the extent that you cannot treat it as a regular traditional IRA contribution.  To eliminate the excess contribution and avoid the 6% excess-contribution penalty you must request that the IRA custodian make a return of contribution before the due date of your tax return, including extensions (not a regular distribution).

There will be no double taxation.  The only part of the distribution from the traditional IRA that would be taxable and potentially subject to early-distribution penalty are any gains attributable to the returned amount which are required to accompany the returned amount.

[ira_query]

Thanks very much for your reply. My IRA custodian is a large bank which no longer offers new IRA products in the bank part of the organization. Perhaps the people in that department are not familiar with the "request for return of contribution" form. All they could come up with was another distribution. Is this a formal letter I need to submit perhaps referencing some IRS regulation or code? Thanks again.

[dmertz]

Any IRA custodian should have a form to request a return of contribution from a traditional IRA.  Have the local branch rep contact their IRA department for instruction.

[ira_query]

OK, thanks but I've seen those forms and they all involve doing a distribution. Also, those forms are designed for "contributions" as opposed to rollovers. I've been looking at all kinds of ways to recharacterize my rollover, but that won't work because of the dollar limits on contributions. My rollover is way over those amounts. I'm looking for advice that would suggest that the taxable amount on this distribution could be limited to the interest that was earned (minimal) while the rollover was in the Traditional IRA. Again, my read of the IRS pubs is that I'm needing a Corrective Distribution with a distribution code of eight. I think the taxable amount of such a distribution would be the entire rollover plus interest. At least if the code is eight, the distribution would be for 2022. But still it would be double taxed, once in 2021 and a 2nd time in 2022.

To improve the system, payors need to include distribution codes at the same time they issue the check. In my case, I didn't find out the distribution code until I received the 1099-R nine months later.

[dmertz]

A return of contribution is a special type of distribution, not an ordinary distribution, and the custodian usually has a special form for the purpose because extra information is needed beyond what is needed for an ordinary distribution.  The custodian uses this information to calculate the amount of investment gain or loss attributable to the amount being returned which must also be distributed.

The code will be code P rather than code 8 because the return of the 2021 contribution will be in 2022.  Code P on a 2022 Form 1099-R indicates that any gains (the only amount includible in box 2a as taxable) will be taxable and potentially subject to an early-distribution penalty on your 2021 tax return.

[ira_query]

Here's something I ran across the other day. In the instructions for IRS Form 5329, Additional Taxes on Qualified Plans, Part III—Additional Tax on Excess Contributions to Traditional IRAs, there are following hopeful sounding tidbits, which might be what you're talking about:

"If the excess contribution to your traditional IRA for the year included a rollover and the excess occurred because the information the plan was required to give you was incorrect, increase the contribution limit amount for the year shown in the table above by the amount of the excess that is due to the incorrect information."

Then under line 15:

"You can withdraw some or all of your excess contributions for 2021 and they will be treated as not having been contributed if:
• You make the withdrawal by the due date, including extensions, of your 2021 tax return;
• You don’t claim a traditional IRA deduction for the withdrawn contributions; and
• You withdraw any earnings on the withdrawn contributions and include the earnings in gross income (see the Instructions for Form 8606 for details)."

[dmertz]

If by the due date of your tax return for 2021 you remove the the excess contribution made for 2021, the amount of the excess is irrelevant.  The entire amount can be returned tax free and only the gains are taxable.  The amount of this excess becomes relevant to the tax treatment of the distribution only if you make the corrective distribution after the due date of your tax return.  See the difference between paragraph 408(d)(4) of the tax code (the second part that you quoted which applies in your case if the return of contribution is done timely) and paragraph 408(d)(5) (the first part that you quoted which applies if the distribution of the excess is not done timely).