By Sarah Brenner, JD
Director of Retirement Education
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SECURE 2.0 is a mammoth piece of legislation that contains over 90 provisions that affect retirement accounts. While many of these provisions are not game changers, they still can be very helpful to specific groups of retirement savers. One of these is the provision that eliminates the 10% early distribution penalty that applies to net income attributable (NIA) when an excess IRA contribution is corrected by withdrawal.
How Excess IRA Contributions Happen
Excess IRA contributions are contributions that exceed the limit that someone can contribute to their IRA or Roth IRA for the year. Examples of excess IRA contributions include contributions that exceed the maximum annual contribution dollar limit, rolling over an amount that isn’t eligible for rollover, or making a Roth contribution when income exceeds the allowable limits.
NIA No Longer Subject to 10% Penalty
Excess contributions will be subject to a 6% penalty each year the excess amount remains in the IRA until they are fixed. One way to fix the mistake and avoid the 6% penalty is to withdraw the excess, plus or minus the earnings (NIA), by October 15 of the year after the year for which the contribution was made.
When an excess contribution, along with the NIA, is timely withdrawn, the excess itself is not taxable or subject to a penalty. However, the NIA is taxable for the year in which the excess contribution is made. Prior to SECURE 2.0, the NIA was also subject to the 10% early distribution penalty if the IRA owner was under age 59 ½. SECURE 2.0 changes this rule. Now, NIA is taxable, but not subject to penalty regardless of age.
Example 1: On January 7, 2023, Lourdes, age 43, made a $6,000 prior year contribution for 2022 to a new Roth IRA. She later discovered that her 2022 income was too high for her to contribute to a Roth IRA. On February 10, 2023, when her Roth IRA balance is $6,300, she decides to correct the excess amount by withdrawing it. To avoid the 6% excess contribution, she must also withdraw the NIA. When Lourdes takes the $6,300 distribution of the excess contribution, the amount of the excess contribution ($6,000) is not taxable. Only the amount of the NIA ($300) will be included in her income for 2023. However, it will not be subject to the 10% early distribution penalty due to SECURE 2.0’s elimination of the penalty on distribution of NIA when correcting an excess contribution.