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This is a kind of a straight forward situation but I made it little complex due to my limited knowledge of Traditional IRA and 401(k).

In the year 2012, I was working as a contractor. I had a traditional IRA account with Fidelity and contributed $4000 to it for the Tax Year 2012.

Later in that year (2012), I got a full time job and my employer enrolled me in their 401(k) plan.

When the time came to file the taxes, I called Fidelity and explained them the situation as I thought I cannot contribute to Traditional IRA as I have employer sponsored 401(k). Someone at the Fidelity said I can withdraw the money as "Excess Contribution Withdrawal". So I filled out the form and pulled $4000 from it. I did not claim the $4000 contribution in my tax return as "Traditional IRA Contribution". I just treated it as like I never contributed that money.

Now I got 1099-R from them saying the $4000 that I withdraw was actually processed as "Early Withdrawal" and I have to pay tax (33%) on it.

When I explained them what happened in 2012, they said they may be able to go back and correct the problem.

What I do not understand is that even if they correct the situation and send me revised 1099-R, I will still pay Tax on $4000 as it will be treated as "Excess Contribution".

Why can this not be simple as I made a mistake when I contributed the money and then I took it back and did not claim so that should be treated as like it never went to my IRA account.

What can I do to avoid paying "Excess Withdrawal" tax as I already paid the tax on this $4000 as I never claimed them on my 2012 return.

Am I missing something here or am I not able to explain them the situation correctly?

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You didn't have a situation of "excess contribution". If you have proof that someone in Fidelity actually told you what you said, you might try to recover some of your losses through a lawsuit. However, their first (and main) defense would be that they're not in the business of providing tax advice, and it is your problem that you asked random person a tax question, and then acted on an incorrect answer.

By the way, that only goes to say that anything you might read here you should, as well, take with a grain of salt. The only one who can give you a tax advice is a licensed tax professional. I explained it in details in my blog post, but in short - it is either an EA (Enrolled Agent, with the IRS credentials), or a CPA (Certified Public Accountant) or Attorney licensed in your State.

Back to your question - "Excess Contribution" to a IRA is when you contribute in excess to the limits imposed. For Traditional IRA in 2012 the limit was $5000. You contributed $4000 - this means that you were not in excess.

There's nothing they can "correct", the 1099-R you got seems to be correct and in order.

What you did have was a case of non-deductible contribution. Non-deductible contribution to your IRA should have been reported to the IRS on form 8606. Non-deductible contribution creates basis in your IRA. Withdrawals from your IRA are prorated to the relation of your basis to your total value, and the taxable amount is determined based on that rate. It is, also, calculated using form 8606.

So in short - you should have filed a form 8606 with your 2012 tax return declaring non-deductible IRA and creating $4000 basis, and then form 8606 with your 2013 tax return calculating which portion of the $4000 you withdrew is non-taxable. If your total IRA (in all accounts) was that $4000 - then nothing would be taxable.

Talk to a tax adviser, you might need to amend your 2012 return (or send the 2012 form separately, if possible), and then do some math on your 2013 return.

If 60 days haven't passed, you might want to consider depositing the $4000 in a Roth IRA and perform what is called "Conversion".

  • Last sentence, I assume you mean deposit in a Traditional IRA and then converting to Roth. – Craig W Mar 23 '14 at 6:17
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    @CraigW no, why? He's withdrawn from Traditional, to complete a conversion he now should deposit into Roth. But this must be done within 60 days of the withdrawal (because it is technically a rollover). – littleadv Mar 23 '14 at 7:04
  • @littleadv: Thank you for the answer. I withdrew $4000 back in 2013 so it is well passed 60 days. – Asdfg Mar 23 '14 at 14:22
  • @littleadv Ah, I see what you mean now. – Craig W Mar 23 '14 at 15:10
  • @Asdfg then there's no way to fix it, you only have the resort of calculating the non-deductible portion and prorating it over the withdrawal. – littleadv Mar 23 '14 at 20:05
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I think there are several issues here.

First, there's the contribution. As littleadv said, there is no excess contribution. Excess contribution is only if you exceed the contribution limit. The contribution limit for Traditional IRAs does not depend on how high your income goes or whether you have a 401(k). It's the deduction limit that may depend on those things. Not deducting it is perfectly legitimate, and is completely different than an "excess contribution", which has a penalty.

Second, the withdrawal. You are allowed to withdraw contributions made during a year, plus any earnings from those contributions, before the tax filing deadline for the taxes of that year (which is April 15 of the following year, or even up to October 15 of the following year), and it will be treated as if the contribution never happened. No penalties. The earnings will be taxed as regular income (as if you put it in a bank account). That sounds like what you did. So the withdrawal was not an "early withdrawal", and the 1099-R should reflect that (what distribution code did they put?).

Third, even if (and it does not sound like the case, but if) it doesn't qualify as a return of contributions before the tax due date as described above (maybe you withdrew it after October 15 of the following year), as littleadv mentioned, your contribution was a non-deductible contribution, and when withdrawing it, only the earnings portion (which after such a short time should only be a very small part of the distribution) would be subject to tax and penalty.

  • As per your second para: That is what exactly i was trying to explain to Fidelity guys. I did not know there was a IRS article on this. I will call them again and show them the IRS article you linked. They put "Early Withdrawal" code on the Tax form they sent. – Asdfg Mar 27 '14 at 15:22
  • Do you know what code should i ask them to put on the Tax Form that they will send me after the correction? – Asdfg Mar 27 '14 at 15:33
  • @Asdfg the list of codes should be somewhere on the 1099-R you got (maybe on the back). – littleadv Mar 27 '14 at 16:57

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