Traditional IRA contribution for 2021

[streetwolf]

Hi..

In tax year 2020 I was retired collecting Social Security and my wife was working full time.  She had enough income to allow me to open up a traditional IRA for the maximum allowed which is $7,000.  This was done primarily to reduce the amount of taxes we owed.

After my new IRA account was opened I was presented with an option on my brokerage site asking if I wanted to contribute $7,000 for the 2021 tax year.  Without giving it much though I had $7,000 transferred from a money market account. 

 After reading up on the rules for IRA contributions I think I erred in contributing the $7,000 for tax year 2021.  My wife retired on 01/15/2021.  She was paid for the two weeks in January she was still working as well as about a week that was held.  Now our sole income for 2021 is from our Social Security benefits, a small pension I have (~$2,000/yr) and some small interest and dividends.

Based on what I read, in order to contribute $7,000 for 2021 we would need an earned income of at least that amount.  I also read that SS benefits is not considered earned income. I'm not sure about my pension or the interest and dividends. Our earned income for 2021 will nowhere be enough to allow a $7,000 contribution for 2021 If SS benefits is not earned income.

If I withdraw the $7,000 contribution I made for 2021, say to a non IRA account, I don't want it to be taxed as it came from a money market account and I didn't take it as a deduction nor did I plan to do so unless it is allowed.  I don't want to get any surprises when I do my 2021 taxes.

How should I handle this situation without having to pay tax on the seemingly not allowed $7,000 and any penalty?

[DanaB27]

Yes, you are correct you need earned income or as the IRS states it taxable compensation (wages, salary, self-employment) to be able to contribute to an IRA.

You will have to request a withdrawal of the 2021 excess contribution and earnings with your bank to avoid paying paying a 6% penalty on the excess contribution. You will get a 1099-R 2021 in 2022 and the earnings will be taxable on your 2021 tax return.

[streetwolf]

Thanks for the quick response.

Am I correct that moving out the $7,000 will still make it fully taxable when I get the 1099-R 2021?  The $7,000 was moved to my IRA by my misunderstanding of the IRS rules.  It's not like I took a deduction for it like I did for the original $7,000 I opened up via Turbo Tax's recommendation.  In my mind the $7,000 shouldn't be taxed only any earnings from it.  After all if I left it in my money market I would only be paying taxes on any interest.   I don't get an OOPS from the IRS? 🙂

[DanaB27 · Accepted solution]

No, if you request a withdrawal of excess contribution and earnings then only the earnings are taxable. 

Yes, since you cannot deduct the excess contribution on your 2021 tax return then the return of this excess contribution is not taxable. Only the earnings on the excess contribution will be taxable.

[streetwolf]

So to recap.  I should only move the original $7,000 to another non- IRA account, correct? What ever I earned on this $7,000 will be taxable not the $7,000.  I assume that the 1099R will only list the earnings and not the $7,000 as taxable.

[DanaB27]

No, you will have to tell your bank that you need to remove an excess contribution plus earnings. They should have a form to request this. Don't just take the money out or it will be reported incorrectly as a regular distribution.

Yes, only the earnings will be taxable and show as taxable in box 2a of the 1099-R 2021 that you will get (box 1 will show the whole distribution amount).