Taxpayers' Withdrawal of Excess IRA Contributions Weren't Timely; Seventh Circuit Upholds Penalty

(Parker Tax Publishing September 2016)

The Seventh Circuit affirmed a district court's holding that married taxpayers weren't entitled to refunds for 2009 of the annual 6 percent excise tax penalty imposed on their excess IRA contributions originally made in 2007 but not withdrawn until 2010. The court concluded that a rule allowing a taxpayer to withdraw excess contributions by his or her Form 1040 filing deadline to avoid the penalty applies only for the tax year in which the excess contribution is made, not to subsequent years in which the funds remain in the retirement account at year's end. Wu v. Comm'r, 2016 PTC 330 (7th Cir. 2016).

Background

In 2007, Michael and Christine Wu each contributed $200,000 to their individual IRAs, using proceeds from the sale of their home. For that tax year, the maximum allowable contribution to an IRA was $4,000. In March 2010, when the Wus realized their mistake, they withdrew from their IRAs the excess contributions and corresponding earnings. They jointly notified the IRS about the excess contributions and asked that the resulting excise taxes under Code Sec. 4973(a) for 2007 through 2009 be waived. The IRS declined to waive the penalties, informing the couple that the taxes had already been assessed for each year.

The Wus promptly paid the excise taxes, and in February 2012 each filed with the IRS a claim for a refund of the taxes attributable to 2009 only. The Wus asserted that they were not liable for the excise tax liability for tax year 2009 because they had withdrawn the excess contributions and corresponding earnings before the filing deadline for their 2009 tax return. In 2013, the IRS rejected their claim and the Wus jointly sued for refunds in a federal district court.

Analysis

Code Sec. 4973(a) provides that "excess contributions" to a retirement account, including an IRA, incur an excise tax of 6 percent for each year the excess remains in the account at the end of each tax year. Code Sec. 4973(b) provides that any contribution which is later withdrawn in a distribution to which Code Sec. 408(d)(4) applies is not treated as an amount contributed for purposes of determining excess contributions and the related penalty. Code Sec. 408(d)(4) allows for the tax-free reversal of IRA contributions up until a taxpayer's Form 1040 filing deadline (including extensions).

Observation: The 6 percent excise tax on excess contributions is distinct from the 10 percent penalty on early withdrawals from a retirement account. While distributions of excess contributions are generally not subject to the early withdrawal penalty, distributions of net income from such contributions are, unless an exception applies.

Before the district court, the Wus argued that the reference to Code Sec. 408(d)(4) in Code Sec. 4973 means that a taxpayer can avoid the 6 percent penalty by withdrawing any excess contributions in an IRA up until the taxpayer's 1040 filing deadline, regardless of whether the excess contributions were made in that tax year or a previous one. The IRS argued that that the Code Sec. 408(d)(4) reference applies only to distributions made by the return deadline for the tax year when the excess contribution was made, not withdrawals of contributions made in earlier tax years.

The district court sided with the IRS's interpretation of Code Sec. 408(d)(4) and held that because the Wus' excess contributions had been made in 2007, they missed the opportunity to avoid incurring taxes again in 2009 by not taking a distribution before the last day of that tax year. The Wus appealed to the Seventh Circuit.

The Seventh Circuit affirmed the district court's holding, concluding that the Wus' interpretation of the relevant Code sections was incorrect and agreeing with the IRS's reading. The phrase "such taxable year" in Code Sec. 408(d)(4), the court said, refers to the tax year in which the contribution was made to the account. The court noted that the Wus made their excess contributions in 2007, stating that for that tax year they could have avoided incurring the annual tax on excess contributions by withdrawing the excess before the return-filing deadline for that tax year (i.e., April 15, 2008). But for any later year, the court said, the Wus could avoid the annual tax only by taking the distribution before the tax year ended.

Finding the Wus' arguments unpersuasive, the Circuit Court affirmed the district court's dismissal of their refund claim.

For a discussion of excess IRA contributions and the excise tax imposed on them, see Parker Tax ¶134,522.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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