The IRS will charge you a 6% penalty on the excess amount for each year you don't take steps to correct the error. Excess contributions are taxed at 6% per annum for each year in which the excess amounts remain in the IRA. The tax cannot exceed 6% of the combined value of all your IRAs at the end of the tax year. If you discover your mistake before the year's tax-filing deadline, your best bet is to eliminate the excess before you file your taxes.
But wait, it's not as simple as it sounds. You must eliminate your excess contribution and any gains attributable to that excess contribution. However, the IRS also stated that the 6% special tax continues to apply to the excess contribution until it is eliminated through distribution or otherwise. In most cases, it would still be an excess contribution to the beneficiary's IRA, since it would normally exceed the general legal limit applicable to regular IRA contributions.
However, the beneficiary's contribution could only be recharacterized as a contribution to an inherited IRA by the beneficiary (and not as a transfer from trustee to trustee of a plan or IRA). Similarly, a prohibited transfer from a SIMPLE IRA to a Roth IRA over the two-year period can once again be characterized as a tax-exempt transfer from a SIMPLE IRA to another SIMPLE IRA. Consequently, the transfer from trustee to trustee from one inherited IRA to another inherited IRA is considered a mere replacement of trustees. The taxpayer who makes such a requalification must transfer the funds provided in a transfer from trustee to trustee of the IRA who owns the funds (the first IRA) to a different type of IRA (the second IRA).
However, since an ordinary distribution does not reduce the amount of the current year's actual contribution that can be made to a Roth IRA (as is the takeover), the taxpayer should be able to contribute to the Roth IRA the same amount that the IRA would have otherwise absorbed. Since elimination by absorption to the extent it is normally available is substantially more favorable than using an ordinary distribution, the taxpayer should eliminate an excess contribution with an ordinary distribution only to the extent that the excess contribution exceeds the amount that can be absorbed in the same tax year. However, there are some situations where requalifying an accrued contribution to a traditional IRA will not only eliminate an excess contribution, but will also make the reinvestment tax-free. The IRS also states that the 6% special tax continues to apply to the excess contribution until it is eliminated through distribution or otherwise.
Just like requesting the withdrawal of an excess contribution to an IRA, you should contact your bank or investment firm to request requalification. In other words, the IRA automatically absorbs the excess contribution each year until the dollar limit or the taxable compensation limit is reached, which is reduced with other actual deductible contributions made during the year. Therefore, the taxpayer recharacterizes the contribution as originally made to an inherited IRA through a transfer from trustee to trustee. Otherwise, the taxpayer must distribute a proportionate share of the income (or losses) earned by the IRA from the date of the original excess contribution until the date of the corrective distribution.
In particular, the total amount of ordinary distribution (including parts of profits and investments) reduces excess contributions.