SECURE Act 2.0 Removes Penalty for Excess Traditional IRA Contributions

A recent column discussed the consequences of a federal employee making excess contributions to both the Thrift Savings Plan (TSP) and to a qualified retirement plan (such as a 401(k) or a 403(b)-retirement plan).

This column discusses the consequences of a federal employee making excess contributions to a traditional individual retirement arrangement (IRA), either an individual retirement account or an individual retirement annuity. It is important to note that one of the provisions resulting from the recent passage of SECURE Act 2.0 in December 2022 is the removal of an IRS penalty imposed on excess traditional IRA contributions.

What is an Excess Traditional IRA Contribution?

For the year 2022, an excess traditional IRA contribution is the amount contributed (other than rollover contributions) to an individual’s traditional IRA for the year that is more than the smaller of:

• $6,000 ($7,000 if age 50 or older by December 31, 2022), or
• Compensation (wages/salary/net self-employment income) for the year.

An excess contribution can be the result of contributions made by the individual, a spouse or the employer, or an improper rollover contribution.

IRS Penalty Tax on Excess Traditional IRA Contributions

If the excess contributions made to a traditional IRA during 2022 are not withdrawn by the due date of the 2022 federal income tax return including extensions (October 16, 2023), then a 6 percent IRS penalty tax (on the amount of the excess contribution) applies. The 6 percent penalty tax must be paid each year that the excess amount that remains in the individual’s traditional IRA at the end of that year.

The following example illustrates.

Example 1. Phillip is 40 years old, a federal employee and single. During 2022, he contributed $7,000 to his traditional IRA. Phillip has made an excess contribution of $1,000. Phillip is under age 50 and therefore his maximum traditional IRA contribution for 2022 is $6,000. The excess $1,000 IRA contribution earned $20 of interest during 2022 and $15 of interest during 2023 before October 16, 2023. If Phillip does not withdraw the $1,000 excess contribution and the $35 of total interest it earned by October 16, 2023, his penalty tax on the excess contribution for 2022 is 6 percent of $1,000, or $60. If Phillip does not withdraw the $1,000 excess contribution and the accrued earnings on the $1,000 excess contribution by December 31, 2024, another 6 percent of $1,000 or $60 penalty tax will be imposed for the year 2024.

Excess Traditional IRA Contributions Withdrawn by the Federal Income Tax Return Due Date

The 6 percent penalty tax is not imposed if the excess contribution is withdrawn by the federal income tax due date (including extensions) of the tax return for the year of the excess contribution. That means if an individual made an excess contribution to a traditional IRA for the year 2022 and withdraws the excess contribution no later than October 16, 2023 (this assumes the traditional IRA owner filed a 6-month extension to file a 2022 federal income tax return), then no IRS excess contribution penalty tax of 6 percent will be imposed.

Treatment of Excess Traditional IRA Contributions Withdrawn by the Federal Income Tax Due Date

Excess traditional IRA contributions that are withdrawn from an individual’s traditional IRA before the federal income tax due date (including extensions) will not be included in the individual’s gross income for that year if both of the following conditions are met:

• (1) No deduction (as an “adjustment to income”) was allowed for the excess contributions, and

• (2) Any accrued earnings (interest, dividends, etc.) earned on the excess contributions are also withdrawn.

Note the following:

(1) If an individual determines that he or she made an excess contribution to a traditional IRA for the year 2022 before he or she files their 2022 federal income tax return, then no deduction was made and therefore condition #1 has been met;

(2) If an individual made a nondeductible traditional IRA contribution for 2022, then the contribution was made with after-taxed dollars. Therefore, the withdrawn contribution, which had been previously taxed (and reported on IRS Form 8606- Nondeductible IRAs) will not be taxed again when withdrawn; and

(3) When there are multiple traditional IRA contributions during the year, then the most recent contributions are deemed to be returned first.

With respect to the accrued earnings that are attributed to the excess contributions that are withdrawn: Any losses attributed to the earnings on the excess contributions while they were in the traditional IRA can be considered when calculating the amount of “net income” (investment gains less investment losses) that must be withdrawn. If there is a net loss, then the amount that must be withdrawn may be a negative amount.

If an individual owns more than one traditional IRA and excess contributions have been made due to contributing to more than one traditional IRA, then the most recent contributions are deemed to be returned first. Also, if an individual has more than one traditional IRA, then the net income calculation is performed only on the traditional IRA containing the excess contributions, and that IRA must distribute both the excess contributions and net income attributed to the excess contributions.

In most cases, the traditional IRA trustee or custodian determines the net income that must be withdrawn to the traditional IRA owner. If the traditional IRA owner needs to compute the net income that must be withdrawn, the following worksheet may be used:

The following example illustrates.

Example 2. Darlene, age 40, is a federal employee and her 2022 salary was $75,000. Starting in January 2022, Darlene contributes $750 on the 15th of each month to a previously existing traditional IRA, resulting in an excess contribution of $3,000 [($750 times 12) minus $6,000 contribution limit]. Darlene requests that the $3,000 excess contribution plus earnings be returned to her. On January 23, 2023 when the IRA is worth $16,800, the IRA trustee distributes to Darlene the $3,000, plus attributable net income.
The excess contributions returned are deemed to be the $750 contributions made on September 15, 2022, October 15, 2022, November 15, 2022 and December 15, 2022. On September 15, 2022, the IRA was worth $12,000 immediately before the $750 contribution. No distribution or transfers, other than the $750 monthly contribution made on January 15, 2023, have been made to the IRA.

The net income attributable to excess contributions is $250 {$3,750 x ($16,800 – $15,750)/ $15,750]. Therefore, the total to be distributed to Darlene as returned excess contributions and earnings is $4,000 ($3,750 excess contributions and $250 accrued net earnings).

How to Treat Withdrawn Accrued Earnings an Excess Traditional IRA Contributions

The net income attributable to the excess contributions and withdrawn from the IRA is taxable income. The net income is included on the federal income tax return for the year in which the excess contributions were made. The withdrawal of the net income may be subject to the 10 percent penalty tax on early distributions if the traditional IRA owner is under age 59.5.

IRS Form 5329 (Additional Taxes on Qualified Plans IRAs and Other Tax-Favored Accounts), is filed to report the excess contributions on an individual’s federal income tax return. A portion of the 2022 Form 5329 showing the calculation of the excess contribution IRS 6 percent penalty is presented here:

With the passage of SECURE Act 2.0 in December 2022, there are excess traditional IRA contribution changes. Effective January 1, 2023, when the net income attributed to excess contributions is removed before the tax filing deadline, the net income will not be not subject to the 10 percent early distribution penalty if the IRA owner is under age 59.5. For excess contributions removed after the filing deadline including extensions, a 6-year statute of limitations now applies to the 6 percent excess contribution penalty – even if Form 5329 was never filed.

During January and February, those federal employees and retirees who made traditional IRA contributions during 2022 are encouraged to review the amount of their total contributions in order to make sure they did not exceed the 2022 $6,000/$7,000 contribution limit. If they did in fact contributed more to a traditional IRA then they are allowed, they need to take appropriate action before April 18, 2023 (the 2022 federal income tax filing deadline) or October 16, 2023 (if they request an extension to file their 2022 federal income tax return in order to being subject to a 6 percent IRS penalty tax on excess traditional IRA contributions for the year 2022.