Did you put too much in your IRA for 2016? The Supreme Court recently declined to hear a case where taxpayers mistakenly put too much in their retirement accounts, leaving in place a big-time penalty. The couple, Michael and Cristina Wu, sold their house in 2007 and put the proceeds–$200,000 each—into their IRAs. That’s a clear no no. There are strict rules that limit the amount individuals can contribute to IRAs in a given tax year, and if you make any “excess contributions” you’ll face a 6% penalty on that amount for each year you leave the money in the account. You can fix an excess contribution by taking the money out up until six months after the April 15th when your return is due for that tax year.
The Wus took out the excess contributions in early 2010 and conceded that they were stuck with penalties for 2007 and 2008, but argued that they didn’t owe the 2009 penalty of $39,000 because they took the money out before the 200 9 tax year deadline. By denying the Wus’ petition, the Supreme Court let the 7th Circuit Court of Appeals opinion in favor the IRS stand. The court of appeals found that the provision that allows the IRS to waive the penalty only applies to excess contributions which are paid into an IRA during a tax year and distributed by the filing deadline for that same tax year, says Green Bay, Wisc.-based CPA Robert Keebler. “It was a hopeless case,” he says. Basically, they didn’t catch the mistake and correct it in time.
Retirement account rules are convoluted, and mistakes are common, and enforcement is strict. That’s a bad combination for taxpayers. Keebler is unwinding a case where a financial advisor deposited $500,000 into a widow’s IRA that should have gone into a taxable account (proceeds due from a life insurance policy on her late husband). Keebler undid the transaction, taking the money out and reached a settlement with the brokerage firm. “The financial advisor made a tremendous mistake,” Keebler says.
Most IRA excess contribution cases involve smaller amounts. The Treasury watchdog TIGTA found that for fiscal year 2011, 57,484 taxpayers without eligible compensation potentially made $125 million in improper contributions, meaning they owed $7.5 million in excise tax. See The Danger of Overstuffing Your IRA for a list of reasons the IRS is contacting taxpayers about potential excise tax issues.
So how can you avoid the “excess contribution” penalties trap?
One thing that adds to taxpayer confusion is that the deadline for contributions is tax day of the following year. Be extra careful if you’re rushing to make last minute contributions to your IRAs by the tax day deadline. In doing so, you could inadvertently contribute too much, triggering potential penalties. (The deadline for 2016 tax year contributions was April 18, 2017—if you filed on extension, it’s too late to make 2016 contributions.) Keebler suggests using the same custodian to hold your IRAs to help you keep track of contributions. Make your contributions once a year, at the same time each year, or sign up for automatic monthly contributions. If you make contributions online, make sure you check the correct tax year. And if you write out a check, write the tax year in the memo line (and don’t combine two years’ worth of contributions on one check).
The contribution limits for IRAs have been the same for the past few years: the most you can contribute to all of your traditional and Roth IRAs is the lesser of: $5,500 per person, or $6,500 per person if you’re 50 or older by the end of the tax year; or your taxable compensation for the year. Note: that’s one annual total contribution limit across traditional and Roth IRAs. So you can split the contribution: $2,750 to a Roth IRA, and $2,750 to a traditional IRA, for example. But you can’t put $5,500 in a traditional IRA and another $5,500 into a Roth IRA for the same year. (If you rollover money from a 401(k) into an IRA, that doesn’t count.)
If you have side gig employment income and filed for an extension, you can still make SEP-IRA contributions until the October filing deadline. See The Side Gig Retirement Tax Time Play. Interested in holding real estate or other alternative assets in your IRA? There is a legal way to do it with a self-directed IRA (just don’t try putting your house in it). See IRAs Gone Wild: How To Invest In Private Equity, Real Estate, Gold. But note the GAO recently warned investors that this comes with risks, and that account owners—not custodians—are responsible for compliance. See Will Unconventional Assets Doom Your Retirement Or Save It?
“In an ideal world, we could all blindly rely on our custodians to help us; however, we don’t live in an ideal world,” says Keebler.