3670 / When can IRA contributions be withdrawn or reduced?

If the contribution is withdrawn, together with the net income attributable to such contribution, on or before the due date (including extensions of time) for filing the federal income tax return of the contributing individual, the amount distributed will be treated as if never contributed, regardless of the size of the contribution.¹ Thus, such a distribution is not included in gross income and is not subject to the 10 percent early distribution excise tax. A distribution of an excess contribution also is not subject to the six percent excess contribution excise tax. Moreover, no income tax deduction may be taken for such contribution ( Q 3669).²

If there is net income included with the accompanying distribution, such income is includable in income and may be subject to penalty as an early distribution ( Q 3671, Q 3677).³ Net income attributable to a contribution is determined by allocating to the contribution a pro-rata portion of the earnings or losses accrued by the IRA during the period the IRA held the contribution. Net income may be a negative amount.⁴

Relief may be granted for failure to meet the above deadline if the taxpayer has taken all necessary and reasonable steps, such as properly notifying the financial institution, to comply with the law.⁵ Excess amounts that are not withdrawn by this method are subject to the 6 percent excise tax ( Q 3669) in the year of contribution and are carried over and taxed each year until the year the excess is eliminated.⁶

By contributing less than the maximum limit in a year, an excess contribution in a previous year may be absorbed up to the unused maximum limit for the year.⁷ With respect to traditional IRAs, both the amount contributed and the amount of excess absorbed may be deductible subject to the active participant rules ( Q 3656) and no taxable income or early distribution tax is involved. The deduction must be reduced if the excess was improperly deducted in a year closed to IRS challenge.⁸

Where all or a portion of the excess is attributable to an excess “rollover” contribution that resulted from the individual’s reliance on erroneous information supplied by the plan, trust, or institution making the distribution, distribution of the portion of the excess attributable to the erroneous information is not included in income and is not subject to the 10 percent early distribution tax.⁹ It is not necessary to withdraw earnings on the excess, but any earnings withdrawn would be taxable income and subject to the 10 percent tax if early.

The excess also may be reduced by a distribution includable in income. Such a distribution is subject to the 10 percent excise tax if it is an early distribution, as well as income tax.

Where a taxpayer amended his tax return to include an excess contribution in income in the year contributed, the Tax Court ruled that the distribution of the excess in a later year was not includable under the rules of IRC Section 72, that the excess contribution included in income in the prior year constituted an “investment in the contract,” and that as a result it was not taxable a second time on the actual distribution of such excess.¹⁰ The phrase “aggregate amount of * * * consideration paid for the contract” found in IRC Section 72(e)(6) encompassed the excess contribution made by the taxpayer. The contribution was therefore considered to be an amount paid in consideration for an IRA and, thus, an “investment in the contract.” As a consequence, Section 72 would provide a basis for the excess contribution and, upon distribution, such amount would be distributed tax-free.¹¹

For purposes of the excess contribution rules, if an excess contribution is invested in a time deposit (such as a CD) that is subject to an early withdrawal penalty, the amount reportable as an excess contribution on distribution of the excess is the total amount actually distributed from the plan after the imposition of the early withdrawal penalty.¹²

A decline in asset value does not remove an excess contribution.¹³