Computing Income When Refunding a Contribution or Doing a Recharacterization

Computing Income When Refunding a Contribution or Doing a Recharacterization

Barry C. Picker, CPA/PFS, CFP

Any IRA contribution that is returned to the taxpayer pursuant to IRC Section 408(d)(4), and any contribution or Roth conversion that is recharacterized pursuant to Section 408A(d)(6), must include the net income attributable to the amount returned or recharacterized.

The Internal Revenue Service, in Notice 2000 – 39 (July 10, 2000) has issued guidance permitting a new method for calculating the net income attributable to the recharacterized IRA or returned IRA contribution.

The new method is applicable for contributions in year 2000 and later. Currently, the new method is optional, meaning that taxpayers can use either the new method enumerated in notice 2000-39 or the old method enumerated in Regulation 1.408–4(c)(2)(ii). However the Service has indicated that at some future date to be determined, only the new method will be accepted.

The attributable net income under the new method is the contribution multiplied by a factor which is the difference between the IRA balance at the time of the distribution and the adjusted opening balance, divided by the adjusted opening balance. The adjusted opening balance is the fair market value of the IRA immediately prior to the contribution being returned, increased by any contributions made until the distribution date.

Another change applicable to returned IRA contributions is that the net income attributable to a returned IRA contribution can now be a negative number. Previously, this was not the case with returned IRA contributions. For recharacterized contributions, net income has previously been permitted to be a negative number.

Under the old method, a proportionate part of the income for the entire year was attributed to the contribution regardless of when in the year the contribution was made.

Example: An IRA has a value of $18,000 on January 1, 2000. On December 1, 2000, a $2,000 contribution is made. On December 15, 2000, the contribution is recharacterized to a Roth IRA, when the IRA is worth $30,000. The total net income is $10,000, ($30,000 less the sum of $18,000 and $2,000).

The attributable net income is $1,000 ($2,000 divided by $20,000, multiplied by $10,000), so $3,000 is the total moved to the Roth in the recharacterization. In this scenario, when the net income is mainly attributable to the period prior to the contribution, it is actually to the taxpayer’s advantage to make the contribution to the traditional IRA followed by a recharacterization, rather than contributing the money directly to the Roth. Here, the taxpayer successfully moves $1,000 from the traditional IRA to a Roth, totally free of tax.

The new method is designed to eliminate the potential abuse by only using the net income for the actual time the contribution was in the IRA.

In the above example, if the IRA was worth $28,000 immediately prior to the $2,000 contribution, then the net income during the period that the contribution was in the IRA is zero.

In a scenario where the IRA was started with an annual contribution, and no other contributions or distributions were made to that IRA, then a distribution of the entire IRA balance will be deemed to be a return of that annual contribution along with the attributable net income.

When a returned contribution is made, the law states that the attributable net income is included in taxable income for the year of the returned contribution. Example: Taxpayer accidentally makes two annual contributions of $2000 to her IRA for the year 2001. In March, 2002 the taxpayer realizes her error and withdraws the excess contribution, along with $150 of attributable net income. The taxpayer adds the $150 to her taxable income before year 2001, even though the income was not withdrawn until 2002. In addition, if the taxpayer is under 59½, she will pay $15 of early withdrawal tax.

Where multiple contributions were made to one IRA account, the returned contribution is deemed to first come from the last contribution, then from the second to last contribution, etc..

Example: Taxpayer makes an IRA contribution of $800 on April 30, 2000, a contribution of $700 on July 15, 2000, a contribution of $1000 on October 15, 2000, and a contribution of $750 on December 15, 2000. The return of the excess $1,250 contribution will be deemed to be the December 15, 2000 contribution of $750 and $500 of the October 15, 2000 contribution. The net income attributable to each of the returned contributions is separately computed. Assume in the above example the September 30, 2000 account value was $1,750, the November 30, 2000, account value was $3,000, and the value at the time of the distribution is $3,900. The adjusted opening balance of the December 15^th contribution is $3,000 plus $750 for a total of $3,750. The net income attributable to the December 15, 2000 contribution is $30 computed as $750*(($3,900-$3,750)/$3,750). The adjusted opening balance for the October 15, 2000 contribution is $1,750 plus $1,000 plus $750 for a total of $3,500. The net income attributable to the October 15, 2000 contribution is $57 computed as $500*(($3,900-$3,500)/$3,500). Therefore, the distribution of the excess contribution and attributable net income is $750 plus $500 plus $30 plus $57 or $1,337.

There are the few unanswered questions in the notice. One is whether the now permitted negative attributable net income is deductible. It appears from a reading of the statute that the negative net income would go on page one of the Form 1040. But this is far from clear. A second unanswered question is whether a taxpayer who removes the contribution from an IRA can recontribute to an IRA for the same year. Keep in mind that the notice applies to any returned contribution, not just a return of an excess contribution. Example: Taxpayer D makes a year 2001 contribution to his IRA in January, 2001. In July, 2001 D has a desperate need for money and so removes the year 2001 contribution along with the applicable net income. By December, 2001, D is now back on solid financial funding. Can D make a new year 2001 IRA contribution at this time?

Example: Taxpayer J contributes $2,000 to her Roth IRA in August, 2001. In November, 2001, J realizes her year 2001 income will be too high to permit a Roth IRA contribution. Unaware that she can recharacterize her contribution to a traditional IRA, J removes the contribution along with the applicable net income. When J goes to her accountant in March, 2002, she is advised that she could have recharacterized her contribution to a traditional IRA. Can J now make a year 2001 contribution to her traditional IRA?

Example: Taxpayer R makes a year 2001 contribution of $2000 to his Roth IRA in February, 2001. In March, 2001, R and his wife separate, and file separate returns for the year 2000. Thinking that they will also file separate returns for 2001, R removes the Roth contribution along with the applicable net income. R’s divorce is finalized in December, 2001, thus making him single and eligible for a year 2001 Roth IRA contribution. Can R now make a year 2001 Roth contribution?

Example: P made a contribution of $1000 to his IRA in fund ABC. He also contributed $1000 to his IRA in fund DEF. P has no earned income for the year, so his contributions are excess contributions. The attributable net income on the IRA in fund a ABC is $50. The attributable net income on the IRA in fund DEF is a negative $15. Can the two amounts of attributable net income offset? Will the 10% early withdrawal tax be assessed only on the net?

The Internal Revenue Service has requested comments on the Notice, so hopefully the questions will be resolved by future guidance.