The IRS recognizes there are several reasons why you could have made an excess Roth IRA contribution and provides ways to correct it. For example, you could have had a spike in income that now disqualifies you from directly contributing to a Roth. You could have accidentally contributed directly to your Roth IRA instead of going through the backdoor IRA, or you weren’t aware that the IRS sets income limits on contributing to a Roth IRA. Or, maybe you just outright contributed more than the maximum annual amount. Depending on how quickly you discover the error and correct it, the IRS may not penalize you at all or give you time to fix the error. However, if the money stays in the account long term, the penalties can be severe.
As a reminder, your income plays a significant role in determining whether you can contribute to a Roth IRA. If you earned more than these limits and still contributed to your Roth, you have made an excess contribution, and corrective actions must be taken. The IRS penalty for failing to remove an excess contribution can be substantial – 6% each year the excess amount remains in the account. If you don’t catch the error for many years, the penalty can really add up.
These are your options for correcting an excess contribution:
- Withdraw the excess contribution before filing your tax return. The IRS treats this as though the contribution never happened, and no 6% penalty will apply. You must also remove any earnings on the investments during that time period. The earnings must be included in your income, and you will have to pay income taxes on them. If you are under age 59 ½ you will also need to pay a 10% early withdrawal penalty, but only on the investment earnings attributed to the excess contribution.
- Withdraw the excess contribution before the October 15th tax extension deadline. If you didn’t catch the error before you initially filed your taxes, you can still withdraw the money and submit an amended tax return up to six months after your initial tax filing due date (usually October 15th). The same rules as above will apply and there is no additional penalty.
- Apply the excess contribution to the subsequent year. If this was a one-time occurrence where your income exceeded the limits but the following year you will be eligible to contribute to a Roth, you can have the excess contribution amount moved to the next year. You will still have to pay the 6% penalty for current year, but you will avoid future penalties. If your income still won’t qualify the following year, this option is not available.
- Withdraw the money at a later time- Some people do not catch their error for years. This can be an expensive mistake, but you will always have the option of taking the money out and correcting the error. However, remember that each year the money stays in the account, you will owe a 6% tax on the excess contribution amount. For example, if you made a $6,000 excess contribution and did not catch the error for 3 years, when you remove the money from the account, you will owe $1,080 in taxes ($6,000 x 6% x 3 years).
An excess contribution into a Roth IRA can be a hassle, but it is correctible. The sooner you fix the error, the less painful and less expensive the process will be. If you discover you made an excess contribution into your Roth IRA, we highly recommend speaking with your financial advisor and CPA to assist you with making the necessary corrections.
Jeff Witz, CFP® welcomes readers’ questions. He can be reached at 800-883-8555 or at witz@mediqus.com.
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Effective June 21, 2005, newly issued Internal Revenue Service regulations require that certain types of written advice include a disclaimer. To the extent the preceding message contains written advice relating to a Federal tax issue, the written advice is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer, for the purposes of avoiding Federal tax penalties, and was not written to support the promotion or marketing of the transaction or matters discussed herein.
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MEDIQUS Asset Advisors, Inc. does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
