Internal Revenue Service (IRS) rules can be complicated, and penalties steep. 

 

“I didn’t intend to…” is not a sufficient reason for the IRS to waive the 6% or 10% penalty for not adhering to rules on IRA contributions and 529 Plan withdrawals.

 

To avoid penalties, you must understand and follow the rules.

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If you realize you've made a mistake, don't hope it "won't get noticed," - immediately consult with a tax professional to take the right corrective steps.

 

Below are key highlights of relevant IRS rules.

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Individual Retirement Accounts  (skip to 529 Plans)

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To encourage people to save for retirement the government provides certain tax benefits. An individual retirement account (IRA) allows you to save for retirement with tax-free growth or on a tax-deferred basis. In exchange for these tax benefits, the IRS sets limitations on the amount that may be saved each year. Failing to comply with regulations governing these special purpose accounts will result in stiff penalties.  

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6% Penalty each year until excess is removed 

An excess contribution will be assessed a 6% penalty – not once, but each and every year the excess contribution remains in the IRA.

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How much is allowed and what is an excess IRA contribution? 

The general allowable limit for 2020 and 2021 is $6,000 total across all IRA accounts. 

For 2020 and thereafter, there is no age limit on making regular allowable contributions to traditional or Roth IRAs. (The prior age limit was age 70½)

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Excess contributions (besides the obvious greater than permitted dollar amount) will arise if 

you (or your spouse) did not have taxable compensation from an employer or net positive self-employment income.

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Traditional IRA - Allowable Contributions 

$6,000 if under age 50 

$7,000 if age 50 or over 

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Roth IRA - Allowable Contributions 

In addition to general limits, permitted Roth IRA contributions are phased-out based on income and tax filing status:

       

SINGLE and earning:

< $124,000 = $6,000 total

$124,000 - $138,999 = reduced by formula 

> $139,000 = $0 

 

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MARRIED filing jointly and earning:

<$196,000 = $6,000 total 

$196,000-$205,999 = reduced by formula 

>$206,000 = $0

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For 2021, tiers will increase by $1,000 if single ($125,000) and $2,000 if married ($198,000). 

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When to Correct   

As soon as realized.  It is best to correct your excess contribution as quickly as possible to minimize the assessed penalty, and whenever possible, before filing your tax return.

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Although the deadline for correcting an error - with an amended tax return, is not until October 15, 2021, if you correct the error before filing your 2020 tax return (deadline April 15, 2021), you can avoid having to file an amended return, and may even be able to roll the excess contribution forward.

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How to Correct

There are various case-specific ways to correct an excess contribution. Which method you use will depend on the characteristics of your particular situation. Two common ways are:

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1. Withdraw the contribution and any attributable earnings. Any earnings will be subject to the 10% early distribution penalty if you are under age 59-½ 

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2. Re-characterize the contribution. Simply put, transfer the contribution amount from one type of IRA to another type of IRA (i.e., Traditional IRA to Roth IRA) where the contribution does not trigger an excess classification. Re-characterizations - when executed properly, are not taxable or subject to penalty.

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Your brokerage firm is likely to have the required forms for a pre-tax-filing correction on their website under a tab titled: /ira/excess-contribution. Customer service should be able to provide information on earnings and estimate the total amount to be withdrawn.

 

TIP: Request to speak with the dedicated Retirement Accounts customer service department.  

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Deciding which method to use 

This is when having a relationship with a trusted advisor becomes critical, as the answer depends on the facts of your individual financial situation.

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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.

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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 (for years prior to 2020), 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.

 

TIP: Excess IRA contribution rules are complicated. The advice of a knowledgeable tax and financial advisor will save your time and money.

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529 Plans and Education Tax Credits (return to IRAs) 

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​A 529 plan can be an effective way to save for educational expenses, but the tax benefits quickly disappear if the funds are not withdrawn properly.

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To qualify for tax-free status, withdrawals must not exceed the amount of eligible educational expenses paid during the same calendar (tax) year.

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Non-qualified withdrawals incur a 10% penalty in addition to being taxed.  

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Currently, qualified educational expenses include:

1. Tuition, fees, books, computers and sometimes on-campus room and board for college.

2. Up to $10,000 per year for tuition at K-12 schools.

3. $10,000 per lifetime for qualified student loan repayments.

 

TIP: IRS rules governing educational tax benefits are complex and fluid, with exception provisions for scholarships, grants and other special circumstances.  It is important to carefully review all rules pertinent to your personal situation, preferably with a tax specialist and your financial advisor.

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How to calculate the right 529 withdrawal amount 

When calculating how much to withdraw from your 529 plan in any year, you will want to consider other available tax benefits – as one may be more beneficial than another for you personally or preclude use of another.

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The IRS prohibits double-dipping – counting the same expense twice to qualify, so you will want to coordinate the requirements for claiming an education tax credit with your 529 withdrawal.  

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Example: Peter has $14,000 in qualified education expenses. To receive the full education credit available ($2,500 for $4,000 in expenses), he will withdraw only $10,000 from his 529 plan.  Alternatively, if he wants to withdraw $14,000 from his 529 plan, he may not claim the credit.

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Balancing 529 Qualified Withdrawals and Educational Tax Credits Eligibility  

Below are the two most common education tax credits, each with its own benefits, rules and limitations. How to maximize educational tax benefits will depend on your unique personal financial situation and future plans. 

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American Opportunity Tax Credit (AOTC) reduces your federal tax bill dollar-for-dollar by up to $2,500 per year (eligible expenses of $4,000 or more), for each eligible student during the first four years of higher education if you are within income limits. To qualify for the full credit, single parents must have a modified adjusted gross income of $80,000 or less ($160,000 or less for married filing jointly).

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Lifetime Learning Credit is 20 percent of the first $10,000 of qualified education expenses or a maximum of $2,000 per return provides up to a $2,000 tax credit on the first $10,000 of college expenses if your modified adjusted gross income is $69,000 or less for single files, $138,000 if married and filing jointly. There is no limit to the number of years this credit can be claimed, but it is not refundable – it can be used only to pay any tax owed.

 

TIP: Any expense paid with a grant received under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), must be excluded for any deduction or credit. Emergency Financial Aid Grants under the CARES Act, such as for expenses related to the disruption of campus operations due to the COVID-19 pandemic, are not includible in your gross income. Consequently, it is not possible to claim any deduction or credit for expenses paid with the grant including the tuition and fees deduction, the American opportunity credit, or the lifetime learning credit.

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The Bottom Line:  Maximizing available education tax benefits requires advance planning and coordination in compliance with IRS provisions. There are stiff penalties for error. Working with a financial and tax professional who understands education funding and filing will save you time, money, and sleepless nights.

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