All you need to know for smart financial decisions
"More Taxes Please," said no one ever.
How to avoid an IRS penalty on IRA contributions and 529 Plan Withdrawals
The Internal Revenue Service (IRS) levies penalties – even for honest mistakes, such as excess IRA contribution or 529 withdrawals exceeding qualified educational expenses.
“But I didn’t intend to…” will not result in the IRS waiving the 6% or 10% penalty for not adhering to often-confusing rules on contributions and withdrawals.
To avoid a penalty, understand the rules.
If you make an honest mistake, consult with a tax professional immediately to take the right corrective steps.
What is an excess IRA contribution?
Anything which is not an allowable contribution as defined by the IRS.
$5,500 in under age 50 in 2016
$6,500 if age 50 or over in 2016
Excess contributions (besides the obvious greater than permitted dollar amount)
You (or your spouse) did not have taxable compensation from an employer or self- employment income
You (or your spouse) is age 70 ½ or older
Permitted contributions phase-out based on income and tax filing status
Single Filer: $117,000-$132,000
Married filing jointly: $184,000-$194,000
6% Penalty each year until removed
An excess contribution will be assessed a 6% penalty – not once, but each year the excess contribution remains in the IRA.
When to Correct
It is best to correct your excess contribution as soon as possible to minimize the assessed penalty.
The deadline for correcting 2016 excess contributions is October 16, 2017.
Although the deadline is not until October, if you correct before filing your 2016 tax return you may avoid having to file an amended return, and may even be able to roll the excess contribution forward.
How to Correct
1. Withdraw the contribution and any attributable earnings or loss. Any earnings will be subject to the 10% early distribution penalty if you are under age 59 ½;
2. Re-characterize the contribution. Simply put, transfer the contribution amount (plus earnings or loss) from a Roth to a Traditional IRA or vice versa. Re-characterizations are not taxable or subject to penalty.
Which Method to Use
This is where having a relationship with a trusted advisor becomes critical, as the answer depends on the facts of your individual situation.
If you have no taxable compensation, for example, and made a traditional IRA contribution, re-characterization is not an option and you will need to correct by withdrawal.
If you are self-employed your contributions must be the lesser of the ceiling or your net income. Correct calculation of your net income and self-employment tax is essential.
If your excess contribution to a traditional IRA is due to age (if you were 71 in 2016, for example), you may be able to re-characterize to a Roth where there are no age limits.
If you contributed to a Roth and traditional IRA in the same tax year and your total contribution went over the allowable IRA amount, you would successfully correct only if you knew to remove the excess from the Roth IRA first.
Bottom Line: Excess IRA contribution rules are complicated. The advice of a knowledgeable tax and financial advisor will save your time and money.
Excess 529 Withdrawals & Education Credits: A Tricky Coordination
Non-qualified 529 withdrawals are subject to a 10% penalty.
529 withdrawals are only tax-free if used to pay for IRS-defined qualified educational expenses (QEE). The earnings portion of all non-qualified withdrawals will be subject to income tax plus a 10 percent penalty.
The American Opportunity Tax Credit (AOTC) reduces your federal tax bill dollar-for-dollar by up to $2,500 per year for each eligible college student for qualified tuition expenses if you are within income limits,
Claiming both the AOTC and a qualified 529 withdrawal takes coordination.
You cannnot claim any of the AOTC for expenses that were used to calculate the tax-free portion of a distribution from a 529 plan (or prepaid plan, or Coverdell) in that year.
For example, if you take $10,000 out of 529, your qualified educational expenses would have to be greater than $10,000 for you to claim any of the AOTC. Calculating how much to withdraw, when from a 529 plan to maximize the education tax benefits available requires advance planning.
Bottom Line: Maximizing education tax benefits requires coordination in compliance with IRS provisions. There are stiff penalties for error. Having a financial and tax professional who understands education funding will save you time, money, and sleepless nights.