Several paths to correct excess IRA contributions

Q: My son is an enthusiastic contributor to his Roth IRA. Unfortunately, he has been a little too enthusiastic for the last two years. A fairly young single, his modified AGI climbed into the taper-off region of the contribution limits, and without realizing it, he has excess contributions for both 2016 and 2017. I understand it is fairly easy to fix the 2017 situation despite the fact that he has already filed his 2017 taxes. But what are the steps to remedy the 2016 excess contributions?

A: This is a fairly common problem. Excess contributions to a Roth IRA may occur for several reasons. A contribution may simply exceed the allowed $5,500 amount, the taxpayer may not have sufficient earned income to make the contribution, or modified adjusted gross income may reduce or eliminate the allowed Roth contribution.

The tax law imposes a 6 percent penalty on excess contributions until they are corrected. If an excess contribution is not corrected, the 6 percent penalty will continue to apply each year until a correction occurs.

There are four general ways to correct the excess contribution. First, the excess contribution and the earnings on that excess may be withdrawn by the due date of the return for the year of the contribution.

So for the 2017 excess, if the amount of the excess and the earnings are withdrawn by the due date of your son’s return (April 17 or October 15 if he extends the return), then the 6 percent penalty will not apply. He will pay tax on the earnings and will also pay a 10 percent early withdrawal penalty on the earnings. This will be reported on his 2017 return.

If he had enough earned income to make the contribution, your son may also convert the excess Roth contribution and its earnings to a traditional IRA for 2017. This would be correction no. 2.

As you note, the 2016 excess is more difficult to correct. First, it must be withdrawn by the close of the year to avoid any penalty for that year. So the 6 percent penalty will apply for the 2016 and 2017 tax years because the excess was not withdrawn by 12/31/2017.

The third correction would then be to withdraw the excess by 12/31/2018 to avoid a penalty for the 2018 tax year. The penalty applies for 2016 and 2017, but just to the excess contribution (and not the earnings).

The fourth correction would be to contribute less than is allowed for a later year. So, if your son is eligible for a 2018 contribution of $5,500, and the excess from prior years is, say, $4,000, then he should limit the 2018 contribution to $1,500.

These options present choices, so he should definitely withdraw the 2017 excess by the due date of his return and then decide which option is best for the 2016 excess. And, obviously, stop making excess contributions going forward.

Q: I took a home equity loan for $20,000 in 2014 to purchase a car. I’ve been paying it back over 60 months just like I would have done with a car loan. I was told this was the smart thing to do for taxes because I couldn’t deduct a personal car loan but could deduct home equity. Now I hear that is no longer true. Is that true for loans taken out before the new tax law?

A: Your 2014 plan made perfect sense. Interest on a home equity loan was deductible without regard to how the proceeds were used. A regular car loan would have created nondeductible personal interest.

The only limits to your strategy were if you did not itemize deductions or if you were subject to the alternative minimum tax in any year. The interest would not have been deductible for AMT purposes.

But that all changed beginning this calendar year. The home equity interest will no longer be deductible, and it does not matter that the loan was originated before the law changed. You will get no more interest deductions after 2017.

Certain home equity loans may still create deductible interest, but only if the proceeds were used for a purpose, such as a business or an investment, that would allow an interest deduction.