In almost all cases, the penalties for violating IRS rules end up overriding any potential value derived from the transaction. The one exception may be the act of making excess Roth IRA contributions.
For 2018, the maximum contribution one can make to a Traditional and Roth IRA cannot be more than:
- $5,500 ($6,500 if you’re age 50 or older), or
- your taxable compensation for the year, if your compensation was less than this dollar limit.
With a Traditional IRA, contributions are tax deductible and earnings grow tax-deferred until they are distributed. If a distribution is taken prior to the IRA holder reaching the age of 59 1/2, a 10% early distribution penalty applies in addition to tax on the amount of the distribution. Moreover, a Traditional IRA is subject to required minimum distributions when the IRA holder reaches the age of 70 1/2. Whereas, in the case of a Roth IRA, contributions are after-tax and not tax deductible, but so long as the Roth IRA holder is over the age of 59 1/2 and the Roth IRA has been open and funded for at least five years, all Roth IRA distributions are tax-free and are not subject to the required minimum distribution rules.
In general, an excess IRA contribution occurs if one:
- Contributes more than the contribution limit.
- Makes a regular IRA contribution to a traditional IRA at age 70 1/2 or older.
- Makes an improper rollover contribution to an IRA.
The taxation on excess contributions differs if the excess contribution is made to a Traditional or Roth IRA.
In the case of a Traditional IRA, excess contributions would be subject to a 6% tax per year as long as the excess amounts remain in the IRA. In addition, if the IRA holder is under the age of 59 1/2, a 10% early distribution penalty would apply to the amount of the excess contribution. Furthermore, the excess contribution would be subject to income tax, although the earnings generated from the excess contributions would remain in the Traditional IRA.
For a Roth IRA, excess contributions would be subject to a 6% tax per year as long as the excess amounts remain in the Roth IRA. However, unlike a Traditional IRA, there would be no 10% early distribution penalty or tax on the excess contribution amount. Moreover, the earnings from the excess Roth IRA contributions would remain in the Roth IRA.
The tax on an excess IRA contribution cannot be more than 6% of the combined value of all IRAs as of the end of the tax year. In other words, the 6% tax is payable each year that the excess contribution has not been withdrawn or applied toward an allocable contribution for a future year.
How to avoid the excess contributions tax:
- withdraw the excess contributions from the IRA by the due date of the individual income tax return (including extensions); and
- withdraw any income earned on the excess contribution.
For example, for 2016, Ben is 42 years old and single, his compensation is $33,000, and he contributed $6,000 to his traditional IRA. Paul has made an excess contribution to his IRA of $500 ($6,000 minus the $5,500 limit). Ben does not withdraw the $500 or the interest it earned by the due date of his 2016 return, including extensions. Ben figures his additional tax for 2016 by multiplying the excess contribution ($500) by 6%, giving him an additional tax liability of $30. Ben would not have had to pay the 6% excise tax if he had withdrawn the excess contribution made for 2016, plus any income earned on the excess contribution, by the date for the 2016 tax return, including extensions
In addition, an individual can apply an excess contribution to a traditional IRA to a later year by the amount that the maximum deductible amount for the later year exceeds the amount contributed to an IRA (including a Roth IRA) for that year. However, an individual cannot reduce an excess contribution by applying it against an earlier year for which less than the maximum amount allowable was contributed.
A strategy that has been gaining some popularity as of late surrounds the concept of making excess contributions to a Roth IRA in order to generate additional tax- tax-free returns in the Roth IRA. Since the 6% excise tax only applies to the amount of the Roth IRA excess contribution and no 10% penalty or income tax would apply to the amount of the excess contribution, in addition to the earnings on the excess contribution remaining in the Roth IRA and able to grow tax-free, the idea is that the 6% excise tax on the excess Roth IRA contribution will end up being considerably less than if the investment was made with personal funds subject to the individual income tax rates. Hence, the excess Roth IRA contribution strategy is based on the notion that paying a 6% tax on excess contributions to a Roth IRA, while gaining the tax advantage of having the earnings from the excess contribution remain in the Roth IRA so it can grow tax-free, is a great deal compared to making the same investment with personal funds and having to pay income tax on the earnings and gains.
The IRS has not yet publicly commented on how they will specifically attack the Roth IRA excess contribution strategy, but it is conceivable that the IRS could end up imposing additional penalties. The IRS would receive notification of the IRA excess contributions through its receipt of the Form 5498 from the bank or financial institution where the IRA or IRAs were established.
Making inadvertent excess contributions to an IRA occurs frequently and is typically corrected before the filing of the individual’s income tax return. However, purposely violating the IRA excess contribution rules in order to receive a tax benefit is not advisable and could lead to an IRS audit.