RTS #039 Excess Contributions Require Action

Penalties are easily the worst way to tip the IRS. One challenge is that not all of the “penalties” a taxpayer can be subject to are even called penalties. Take cover contributing to qualified accounts; you are charged a penalty; you are charged an excise tax. In most cases, that excise tax is 6%, and you will be charged it indefinitely until the excess contributions are removed.

Some excess contributions (401(k), 403(b), HSA) will be reported on tax forms (a W-2) that will make it on the client’s tax return, but not all of them (IRA and Roth IRA contributions). Even for the ones that do make it on the tax return, for tax preparers, excess contributions often fall in the bucket of “you should probably do something about that” AND NOT in the bucket of “let me help you fix that.” In fairness to the tax preparer, they are not the ones managing the accounts, but regardless of who feels responsible, your client is the one paying the “penalty.”

The silver lining is that if excess contributions are removed by the filing deadline of the tax year for which they were made, no excise tax will be charged. That means that taxpayers who made excess contributions for 2023 have through the date they file (including extensions). This means for Advisors who are receiving draft tax returns for their clients and are able to review the return before it’s filed, there is an opportunity to avoid all of the pain. 

When you are helping clients remove excess contributions, remember that any income or gains generated from the excess contribution must also be removed. This means that if the excess contribution is not immediately identified, the distribution may have to be larger than the contribution. It’s also important to remember that for pre-tax retirement contributions, it’s possible the excess can be considered non-deductible contributions. In this case, the “excess” does not need to be removed but does need to be reported correctly as non-deductible, and then there needs to be a plan for getting the after-tax dollars converted to Roth.

There are a lot of qualified accounts out there, all with their own rules, and dealing with excess contributions is just one of the issues that can come up. For RTS Essential Members, the February members’ resources include our newest reference guide, giving you a handy “cheat sheet” for this very topic.

What can you do about it?

Get tax returns for every single client every single year. Having a system for how you review them (like a 37-point checklist) will help ensure you can do it effectively and efficiently, but if you aren’t looking at the actual details, things will get missed.

Happy Tax Planning!

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