Reporting and paying taxes/penalties on excess IRA contributions
My wife and I divorced in 2018, and, as part of our divorce agreement, I help her with her taxes. She made excess IRA contributions in 2018 and 2019 and I’m trying to figure out exactly what to do to help her correct the errors and pay appropriate taxes/penalties. We are in our late 40’s. She filed for an extension for her 2020 return in order to figure out how to fix this. I understand that there will likely be 10% penalties on the gains on those contributions, and 6%-per-year penalties on the contributions.
Here’s what happened:
2018:
– She contributed $5500 to a traditional IRA and deducted that amount on her 2018 return.
– However, she had no earned income. (We thought that her half of my earned income would make her eligible to contribute, since we live in CA, a community property state, but we now understand that that’s not correct.)
– In January 2021, she received a notice from the IRS pointing out that her deduction was not allowed. She has paid the tax and interest due. (She has not filed an amended form 1040, but the IRS has sent a notice confirming the changes to her return.)
2019:
– She contributed $6000 to a traditional IRA and deducted that amount on her 2018 return.
– However, she had no earned income. (She thought that alimony would make her eligible to contribute, but that’s not correct.)
My main questions are:
1) What steps does she take to remove the excess contributions in the lowest-cost way possible?
– My understanding is that she needs to take a non-timely distribution of her two contributions and the associated earnings (which Schwab will help calculate). Should she do this ASAP, or is there anything else she needs to do first?
– I’ve read about a “dollar-limited distribution”, which may help reduce some of of the penalties/excise taxes? Can she do this? If so, how?
2) How does she report the distributions and pay appropriate penalties/taxes?
– I’ve looked at form 5329. For what years does she file a form 5329? Does she file one for 2018 (for the first excess contribution), one for 2019 (for the second), and then one for 2020 (to report the distributions)? If that’s right, does she file an amended return for 2018 and 2019 to pay those penalties/excise taxes?
– Or does she just file a single form 5329 in the year we caught the error? What’s the correct way to do this?
3) I assume she’ll need to pay tax on the 2019 contribution (since she deducted it), but the 2018 deduction got corrected by the IRS and she has paid the tax due on the originally-deducted amount. Is there anything to do to make this clear to the powers that be (e.g., the IRS and Schwab) when she takes her distribution and/or files her 2020 return?
Thank you for any advice!
Permalink Submitted by Erik Stuart on Tue, 2021-09-21 23:35
One additional note – my ex-wife (who made the excess contributions) has a long-term disability (she’s been considered disabled due to being bipolar by Social Security for the last 14 years). Does this allow her to take the “03” disability exception to paying 10% tax on the withdrawn earnings? And does it change anything about the 6% excise tax per year on the excess contributions?
Permalink Submitted by Alan - IRA critic on Wed, 2021-09-22 00:12
These excess contributions are for years for which the deadline has passed to have the excess contributions returned with allocated earnings to avoid the annual 6% excise tax. She must now correct the excess using the procedures for excess contributions withdrawn after the due date for the 2018 and 2019 returns. She owes the 6% excise tax for 2018 to be reported on a 2018 5329. She also owes the 6% excise tax for 2019 on the total of both contributions (11,500) to be reported on a 2019 5329. For 2020, unless she has “space” to apply the prior excess amounts as a 2020 contribution, she will also owe the 6% excise tax on 11,500 with her 2020 extended return. These excise taxes total 1,425. But if some of the 11,500 can be applied as a 2020 contribution, the 2020 excise tax will be less. This is all done on Form 5329 as well just be following the instructions for the form.
Moving to 2021, the same option to apply some of the excess to 2021 if otherwise eligible for a 2021 contribution exists. If not possible to apply any excess to 2021, then these excess amounts should be withdrawn before year end to avoid a 4th year of 6% excise taxes.
If the above distribution is done this year, it should be requested as a distribution of excess contributions per Sec 408(d)(5). That should produce a 1099R with box 2a blank. The 2019 return needs to be amended to remove the IRA deduction, and the IRS has apparently done this for the 2018 excess contribution. Since neither of these contributions will have been deducted, the 1099R reporting the 11,500 distribution in 2021 will not be taxable. An explanatory statement for this sequence should be included with the 2021 return if such distribution is completed this year.
Again, if these excess amounts can be applied to either 2020 or 2021, the excise taxes due will be reduced, and if a deduction is allowed for the later year, it can be taken. Of course, such amounts would not be withdrawn from the IRA in this case, if they can be applied to later year contributions.
For the 2020 return now being filed, the 5329 for 2020 paying the excise tax can be included, and the decision whether part of the 11,500 excess coming into 2020 can be applied to 2020 must be determined. In short, two paths for correction, one without application to 2020 or 2021 and the other if the 5329 allows assignment to these later years.
Form 8606 should not be filed to report non deductible contributions for 2018 and 2019, but would apply if a contribution can be assigned to 2020 or 2021 that is non deductible. See the 8606 Inst for 2020, p 6 middle column that contains an example very similar to this and the example also happens to be for excesses in 2018 and 2019.
Permalink Submitted by Erik Stuart on Wed, 2021-09-22 07:15
Thank you for the comments and clarification! I have two follow-up questions. Note that she does *not* have the option to apply previous contributions to 2020 or 2021 (she has no income in either year). 1) Since she filed for an extension to 10/15/21 to file her 2020 tax return, if she removes the excess contributions from 2018 and 2019 before that date, can’t she avoid the 6% excise tax for her 2020 return (thus paying excise taxes only on her 2018 and 2019 returns)?2) When she receives the distribution of the excess contributions in 2021, they should be non-taxable as you explained (since she’ll amend her 2019 return, and the 2018 return was already amended by the IRS). I assume that the distribution includes the earnings attributable to the $11500 in contributions. Does she need to file a 5329 with her 2021 return, and does that include the exception code “03” because she’s disabled to give her an exception from paying the 10% penalty on withdrawing the earnings? Or does she just not file a 5329 at all, and instead just include a statement explaining that the contributions have already been taxed and that she has a disability exception on the earnings? (Or something else?) Thank you again!
Permalink Submitted by Alan - IRA critic on Wed, 2021-09-22 15:27
Since her excess contributions were for 2018 and 2019, the extended due date for those returns has passed and she is limited to the rules for excess contributions removed AFTER the due date. 10/15/21 is only the due date for 2020 returns, not for prior years. Her next critical date is 12/31/2021, by which the excess amounts must be distributed (without earnings) to avoid an excise tax for 2021. The 2020 excise tax was locked in when the 11,500 was still in the IRA on 12/31/2020 and none of it could be applied to the 2020 year due to no earned income in 2020.
Ok, except that the distribution of earnings does not apply for corrections after the due date. Put another way, paying the excise tax and removal of earnings are mutually exclusive. Since the excise taxes have been incurred for 2018 and 2019, any earnings remain in the IRA and are not taxed. Only the actual excess of 11,500 is distributed. IRA custodian 1099R coding recognizes these rules, and would not even calculate the earnings on any excess contributions prior to 2020.
Yes, she does need to file a 5329 for 2021, but just to show that the existing excess from prior years has been eliminated by the 11,500 distribution. The form will then show that there is no longer an excess contribution. Being disabled waives the 10% penalty, but not the excise taxes. SInce the distribution of 11,500 will be non taxable, there is no early withdrawal penalty to waive. The Box 7 code should be 1, but that only applies if there is taxable income. If there was taxable income, then the 1 could be overridden by a 5329 claiming the disability exception.
While the 11,500 distribution should be requested by indicating to the custodian that the distribution is per Sec 408(d)(5), and the custodian should know how to report that on the 1099R, I think many taxpayers neglect to mention 408(d)(5) and end up with a 1099 R showing the full distribution as taxable in Box 2a. If that were to occur, a thorough explanatory statement with the 2021 return should set the record straight with the IRS. This statement is required with or without a properly coded 1099R.
In short, she get to keep the earnings in the IRA in this situation, a sort of trade off for owing the 6% excise tax.