Deposits to IRA by mistake - How to correct?

[Guest Mike Visse]

I have a client who had an IRA investment disqualified in the 1990's (It was a real estate partnership that upon disqualification ceased to be an IRA and became a personal investment rather than tax deferred).

In 2002 and 2003 the real estate partnership distributed cash. The cash (to the tune of about $50,000 per year) went into his IRA by mistake, instead of going to his non-IRA personal account.

Questions: Is this considerred an excess contribution to the IRA for those years, which would be subject to the 6% excess contribution penalty? Or, is there another remedy to correct this due to it being a deposit in error? No contributions were deducted in 2002 or 2003 because this money that ended up in the IRA was not intended to be a contribution. Therefore, I am not sure if it would be classified as an excess 'contribution'.

The discovery of this is current and the money plus earnings will be withdrawn from the IRA in 2005. Should the 1099-R have only the earnings on it as taxable?

The partnership issues a K-1 and any flow-through income from that will or has been properly reported on his 1040.

Thanks,

Mike

[Locust]

If the money stays in there, it will definitely be an excess contribution.

I'd get the IRA custodian to make a refund of the entire amount to the partnership, and then have the partnership reissue the check to the proper account. And let the IRA custodian know that the payment to it was a mistake and not to report it as a contribution.

I'm not sure what you would do with any earnings attributable to the amount while it was in the IRA. Perhaps those could stay in the IRA and be characterized as a contribution for 2005, but that would be a reporting mess because the individual would have to report the earnings as income and the IRA custodian probably wouldn't report the earnings as a contribution. Or perhaps the earnings could be withdrawn and reported as taxable distributions and pay the penalty for early withdrawal. Or perhaps the earnings could also be distributed to the partnership (if it will accept them). The earnings issue is difficult, but maybe there weren't any?

[Locust]

I hadn't thought of the obvious answer. A more straightforward approach if the individual doesn't want to go through the hoops of going back to the partnership.

The IRS allows the withdrawal of contributions without penalty if it is done by the tax return deadline. Earnings have to be taken too - those are taxable and I believe those are subject to the 10% premature payment tax. Code ss 408(d)