An excess contribution occurs when you put more money into your individual retirement account (IRA) than the law allows. Keep in mind, income from your IRA investments are NOT contributions. IRA contributions are monies added out of your own pocket. If excess contributions are made, they must be removed by the date your tax return is due for the year, including extensions. If they are not removed, they are subject to a 6 percent excise tax.
If you do make an excess IRA contribution, you need to be aware that removing only the amount of the excess contribution is not acceptable. You must also remove the Net Income Attributable (NIA), as well. In other words, through wise investing, that excess contribution could have been used to help increase the value of your IRA. It is critical that you remove the income that is attributable to the excess contribution, along with the excess itself. If your investments performed poorly, it might actually lower the amount that needs to be removed. Thorough calculations must be made to determine these factors.
The formula for calculating the NIA of the contribution is:
Excess Contribution x (Adjusted Closing Balance – Adjusted Opening Balance) / Adjusted Opening Balance
For example, a SEP IRA originally contains $40,000. At the beginning of a new year, an additional $35,000 is contributed, bringing the total balance to $75,000. At the end of the year, the individual realizes their income ended up being less than they expected and they were only eligible to contribute $20,000. The excess contribution total of $15,000 needs to be removed. Let’s also assume that after the $35,000 contribution, the investments in the IRA declined in value due to unfavorable economic conditions. At the time of the excess removal, the total account value had dropped from $75,000 to $65,000. The net income attributable to the excess contribution is:
$15,000 x ($65,000-$75,000)/$75,000 = $ -2,000
The $15,000 excess contribution effectively generated a net loss of $2,000, which must be excluded from the excess removal. To bring the IRA back within the contribution limits, only $13,000 ($15,000-$2,000) needs to be removed.
As always, it is best to review any transaction regarding potential tax consequences with your CPA or financial planner. These professionals can help you determine if your contributions fall within the required limits and assist you in calculating excess contributions to avoid negative consequences and penalties by the IRS.
If you have any questions about this article or the use of self-directed IRAs to build wealth for retirement, please contact Midland Trust.