Answer: The 6% excise tax applies when an excess contribution is made to an IRA, and it is not properly corrected by the IRA owner’s tax filing due date, plus extensions.
For example: If you make an excess contribution to your IRA for 2020 and you do not correct it by you 2020 tax filing due date, including extensions, you will owe the IRS a 6% excise tax for 2020, and for every subsequent year the amount remains in your IRA as an excess contribution.
Therefore, your tax preparation software should not be showing an 6% excise tax for your excess contribution if your indicate that the excess has been or will be properly corrected by your tax filing due date, plus extensions.
Why You Have an Excess Contribution
You must have eligible compensation to be eligible to make a regular contribution to an IRA. Eligible compensation includes wages and self-employment income. Because your only income is social security, you are not eligible to make a regular contribution to an IRA (For purposes of making a contribution to an IRA, social security income is not considered eligible compensation).
Therefore, your entire IRA contribution is an excess contribution.
Since you are still within the deadline for correcting your 2020 IRA excess contribution, you will not owe the 6% excise tax as long as you distribute the excess, along with any net income attributable, by your tax filing due date, including extensions. If you miss this deadline, you will owe the IRS a penalty for 6% of the excess contributions, for every year the excess remains in your IRA.
How to Correct the Excess Contribution
The question now becomes, since you do have an excess contribution, what should be done to have it corrected so as to avoid the 6% excise tax?
The solution: You should remove the amount from your IRA as a ‘return of excess contribution.’ You have until your tax filing deadline, including extensions, to remove the amount as a return of excess contribution. Since you already filed your tax return (which means you filed it by the deadline), you receive an automatic 6-month extension to correct the error (under the return of excess method). This automatic 6-month extension means that you have until October 15 to correct the error.
The 6% excise tax applies only if you fail to remove the excess amount by the deadline.
• Contact your IRA custodian and instruct them to remove the IRA contribution as a return-of-excess contribution. They may have a special form for this purpose.
• Ensure that any net income attributable (NIA) to the excess is removed along with the contribution. NIA can be earnings or losses.
• Amend your tax return to remove the 6% penalty.
Your IRA custodian will send you a Form 1099-R for the correction by January 31 of next year. If there are any earnings removed with the excess, you will need to include them on your tax return filed for this year.
Please be sure to consult with your tax advisor.