I've run into a situation in which intentionally leaving an excess IRA contribution of $3800 unremoved (and therefore being penalized $228) reduces the total tax (1040-SR line 16) by over $840. Needless to say, I'm skeptical that everything is being calculated correctly, so I'm comparing the 1040-SRs that result from the two cases—removing vs. not removing—to see what changes.
When TT is told the excess contribution has been removed, the taxable portion of IRA distributions (under income) decreases by the same amount. The taxable portion of social security benefits also decreases a little, but I suspect that's just a knock-on effect. Total taxable income decreases accordingly. I can't think of a reason this would make sense. Can anyone else?
According to TT, the taxpayer would've owed even less tax if they'd maxed out the generally allowable contribution amount for their age, for an even larger excess contribution. Am I overlooking something?
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You keep referring to "taxpayer." Are you a paid tax preparer? If so, please know that TT is not licensed for your use.
An excess traditional IRA contribution is a nondeductible contribution, so it can reduce the taxable amount of some otherwise unrelated traditional IRA distribution [not contribution as I mistyped originally]. It's possible that the resulting reduction in ordinary tax liability exceeds the 6% excess contribution penalty, causing a reduction in total tax liability for the year. However, you must make sure that you have properly entered into TurboTax the year-end balance in traditional IRAs, otherwise the calculation on Form 8606 of the taxable amount of the traditional IRA distribution will be wrong.
Correcting the excess contribution in a later year will still require a distribution of the entire amount of the excess, otherwise the 6% excess contribution penalties will continue, but some of that distribution will be taxable if some of the basis in nondeductible contributions that resulted from the excess contribution was already applied to earlier distributions, so there is no free lunch.
@SweetieJean No, I'm not. The return is a family member's.
I corrected my previous post to say "distribution" where I previously mistyped "contribution."
"An excess traditional IRA contribution is a nondeductible contribution"
Agreed.
"…so it can reduce the taxable amount of some otherwise unrelated traditional IRA distribution"
That doesn't make sense to me. If taxable income is reduced by the amount of the excess, that's effectively identical to getting a deduction for the excess. As agreed above, that's the opposite of the treatment that excess is supposed to get.
Do you know what worksheet the IRA deduction line of form 1040 comes directly from? If I can follow the number upstream I might be able to get more insight into what's going on.
"That doesn't make sense to me. If taxable income is reduced by the amount of the excess,"
I did not say that taxable income is reduced by the amount of the excess. It would be reduced by some amount less than the amount of the excess due to the pro-rata calculation on Form 8606 (the "worksheet" you seek). The excess is still subject to the 6% excess contribution penalty, but the tax savings on regular distribution can be more, resulting in a reduction of the current-year tax liability. The otherwise taxable portion is just moved to a future year and the excess remains, subject to another 6% penalty each year that the excess remains, so you come out behind in the long run. Ignoring any investment gains on the excess, the taxable amount ends up being the same in the long run as it would have been had the excess contribution not been made, but you pay 6% penalties for the 6% excess contribution.
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