Do Returned IRA Contributions Count as an Early Withdrawal?

What happens when your broker reports returned IRA contributions as an early withdrawal? Are you going to take a tax hit? It depends on what happened but probably not.

Were your returned IRA contributions ever in your account?

The first question to ask is whether you ever made a contribution. If the broker flat out rejects your contribution, the answer is no. For example, they might have returned a check you mailed or denied your application to open a new account after you provided your bank ACH info for your initial contribution.

If your contributions were ever in your account, you have a contribution and withdrawal. For example, if you deposit the funds on Monday and on Tuesday your broker decides they no longer want to do business with you, them sending your money back will be an early withdrawal.

Do you lose the ability to make another contribution if your first contribution is returned?

There is nothing stopping you from putting as much money into an IRA as you want. The only thing that will happen is you have to pay 6% per year excise tax on any excess contributions (making it not worth it).

How does this help? Let’s say you contributed $6,000 (the maximum IRA contribution) at Broker A and they returned your money as an early withdrawal. You can still contribute $6,000 at Broker B. Yes, your total IRA contributions for the year will be $12,000 (double the limit), but you don’t have to pay the excise tax if you remove the excess contribution by your tax filing deadline. Since $6,000 was already returned, you avoid the excise tax.

You can remove IRA contributions in the same year without penalty.

If you remove your IRA contributions (along with any gains on those contributions) in the same year that you made them, there is no 10% early withdrawal penalty on the contributions. You only need to pay tax on any gains, and the gains are subject to the 10% early withdrawal penalty.

One thing to keep in mind is that all of your traditional IRAs count as one traditional account and all of your Roth IRAs count as one Roth account for the purpose of calculating gains. This will make more sense with the examples.

Examples

  • $5,500 contribution to a Roth IRA and you didn’t already have one. The money was deposited into a settlement account paying no interest and withdrawn a week later. No tax consequence.
  • Same as above but you earned $1 in interest before you withdrew the money. You must withdraw the $5,500 + the $1. You pay ordinary income tax plus 10% on the $1.
  • You had $5,500 already in a traditional IRA and contributed another $5,500. This made your account value $11,000. When you decide to withdraw your last $5,500 contribution, your account value is $12,000. You must withdraw $5,500/$11,000 x $12,000 or $6,000. There is no tax on the $5,500 contribution and ordinary income tax plus 10% on the $500 gain.
  • Same as above except the first $5,500 was invested at one broker and the second $5,500 sat in a settlement fund at a new broker earning nothing. When you decide to withdraw your last $5,500 contribution, your account value is $11,500. You have to look at all of your accounts not just the account you’re withdrawing from. Even though your money was invested separately, the contribution was half of your account value on the date you made it, so you must withdraw half of your gains since that date. Your withdrawal must be $5,500/$11,000 * $11,500 for a total of $5,750. You’ll pay no tax on the $5,500 and ordinary income tax plus 10% on the $250 gain.
  • Same as above except your account lost value to $10,000 when you decide to withdraw your contribution. You only need to (and only can) withdraw $5,500. That’s $5,500/$11,000 * $10,000. Since you’re below your contribution amount, you don’t pay tax. If you did need that extra $500, it would count as coming from your prior year contribution and be subject to income tax plus the 10% penalty.

Note: Effective for 2018, if you withdraw an IRA contribution at a loss (as in the last example), you can no longer claim the loss as a miscellaneous itemized deduction.

Get Professional Help On This One

Sounds messy? Kind of makes sense but not really? Returned IRA contributions are difficult even for tax pros because of the calculations and paperwork involved, so you’ll probably want to talk to an Enrolled Agent or CPA to help you do it right.