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I just spend two hours going through IRS Publication 590a, and reading all related question here and in some other places (none matched this question exactly).

Situation: X is over 50 and contributed the maximum of 6500 $ to an Traditional IRA in July 2016, in the assumption of being able to deduct it from taxes. However, it turns out it is a non-deductible contribution, as unexpected higher income brought his AGI over the limit.

There seems not much sense in keeping the money in the Traditional IRA, as it would need to be tracked as a 'non-deductible contribution' forever (form 8606), and any gain from it is taxable anyway. It would be easier to invest the amount in a normal brokerage account, so X prefers to get it back.

Question: Can X withdraw the non-deductible contribution without tax or penalties, if he does so before tax due date (Apr/15 or even extended) the following year (so contribution and withdrawal fall in the same tax year)?
Basically, a clean and complete "Undo"?

According to my (limited) understanding of what I read in the publication, if the withdrawal includes all interest and other income from it, it is tax and penalty free.
[The case in question is about a previously empty Traditional IRA, which avoids complex calculations; simply withdrawing the complete amount currently in it should do it]

Any potential interest will need to be added to the taxable income; the basis should be 'home free' (I understood that losses, if any, can also be deducted from taxable income).

Can anyone confirm this? Did I understand the publication correctly?

  • "However, it turns out it is a non-deductible contribution, as unexpected higher income brought his AGI over the limit." I am assuming he was covered by a retirement plan at work (e.g. his 401(k) was contributed to) this year? Only then would there be a limit. – user102008 Mar 6 '17 at 3:39
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    "There seems not much sense in keeping the money in the Traditional IRA, as it would need to be tracked as a 'non-deductible contribution' forever (form 8606), and any gain from it is taxable anyway." But another option other than withdrawing would be to convert it to Roth IRA. – user102008 Mar 6 '17 at 3:40
  • @user102008, thanks a lot for making that point!! I assumed (wrongly) that this was not an option for non-deductible IRA contributions. I read up on this after your comment, and learned that it works perfectly fine - and the rollover is even tax-free - as the money is already taxed. I am now going that way instead of trying to 'undo' the contribution. – Aganju Mar 6 '17 at 13:48
  • Well the earnings will be taxed on conversion (though in your case there were losses). Make sure you don't have any other pre-tax IRAs because conversions take pre-tax and post-tax amounts pro-rata from the total amount in all pre-tax IRAs. The way of contributing to Traditional IRA then converting to Roth IRA is called "backdoor Roth IRA contribution", because it doesn't have income limits which a direct Roth IRA contribution has. If you are not restricted by the Roth IRA contribution income limit, it may be cleaner to just recharacterize the contribution as a Roth IRA contribution. – user102008 Mar 6 '17 at 19:20
  • If you're below the income limit you're better off recharacterizing your contribution from Traditional to Roth. That way if you have a gain, it won't be taxed, whereas it would if you do a conversion. It also avoids the issues with having pre-tax money that @user102008 mentioned. – Craig W Mar 6 '17 at 20:18
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If you made a contribution to a Traditional IRA for Year X (whether made during Year X or made in Year X+1 before the due date of your tax return for Year X), then you can withdraw the contribution and any gains on that contribution by the due date of your tax return. If the contribution was deductible, then of course you must not take a deduction for it in on your tax return for Year X (or any other year for that matter). As for the gains (if any) that were withdrawn, they are taxable income to you for Year X (not X+1, even if the withdrawal occurred in Year X+1).

Publication 590a says

You generally can make a tax-free withdrawal of contributions if you do it before the due date for filing your tax return for the year in which you made them. This means that, even if you are under age 59-1/2, the 10% additional tax may not apply.

and later in the same Publication

If you have an extension of time to file your return, you can withdraw them tax free by the extended due date. You can do this if, for each contribution you withdraw, both of the following conditions apply.
- You did not take a deduction for the contribution.
- You withdraw any interest or other income earned on the contribution. You can take into account any loss on the contribution while it was in the IRA when calculating the amount that must be withdrawn. If there was a loss, the net income earned on the contribution may be a negative amount.

Later, the document says

You must include in income any earnings on the contributions you withdraw. Include the earnings in income for the year in which you made the contributions, not the year in which you withdraw them.

and

The 10% additional tax on distributions made before you reach age 59-1/2 does not apply to these tax-free withdrawals of your contributions. However, the distribution of interest or other income must be reported on Form 5329 and, unless the distribution qualifies as an exception to the age 59-1/2 rule, it will be subject to this tax.

Since you have a loss on the contributions that you are withdrawing, there is no interest or other income that needs to be reported.

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The principal of the contribution can definitely be withdrawn tax-free and penalty-free. However, there is a section that makes me think that the earnings part may be subject to penalty in addition to tax.

In Publication 590-A, under Traditional IRAs -> When Can You Withdraw or Use Assets? -> Contributions Returned Before Due Date of Return -> Early Distributions Tax, it says:

The 10% additional tax on distributions made before you reach age 59½ does not apply to these tax-free withdrawals of your contributions. However, the distribution of interest or other income must be reported on Form 5329 and, unless the distribution qualifies as an exception to the age 59½ rule, it will be subject to this tax.

This section is only specifically about the return of contributions before the due date of return, not a general withdrawal (as you can see from the first sentence that the penalty doesn't apply to contributions, which wouldn't be true of general withdrawals). Therefore, the second sentence must be about the earnings part of the withdrawal that you must make together with the contribution part as part of the return of contributions before the due date of the return. If the penalty it is talking about is only about other types of withdrawals and doesn't apply to the earnings part of the return of contribution before the due date of the return, then this sentence wouldn't make sense as it's in a part that's only about return of contribution before the due date of the return.

  • I did not understand it that way. However, currently the 'earnings' are negative, so paying a 10% penalty on them would not matter (I doubt the IRS gives me 10% of the losses, though) – Aganju Mar 6 '17 at 13:44

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