Roth IRAs are a great investment tool for retirement planning. But there are certain rules regarding Roth IRA contribution limits that you need to be aware of. For example, contributing too much to a Roth IRA may subject you to additional fees (and unwanted attention from the IRS).
A common example is contributing too much to a Roth IRA based on your income level; the ability to contribute to a Roth IRA begins to phase out at higher income levels. Contribution limits decrease once your Modified Adjusted Gross Income (MAGI) rises above $105,000 for single filers and $167,000 for joint tax filers. You can no longer make Roth IRA contributions once your MAGI rises above $120,000 or $176,000 for joint filers.
Many people can easily plan around these contribution limits because they have a good idea what their income will be from year to year. But sometimes situations arise that make planning Roth IRA contributions a little more difficult. A raise or bonus can easily change the income qualification for some people.
Planning is essential, however, because contributing too much to your Roth IRA may subject you to a 6% excise tax if you don’t take care of the situation in a timely manner. Let’s look at some situations that could cause excess Roth IRA contributions, how you can effectively plan Roth IRA contributions and what to do if you contribute too much to your Roth IRA.
Ways you can contribute too much to your Roth IRA
Earning too much money to be eligible for Roth IRA contributions isn’t the only way you can contribute too much to your Roth IRA. You might, for example, have less earned income than your Roth IRA contribution. Another example could be contributing too much money to your Roth IRA by miscalculating your contributions or contributing too much across more than one IRA account. The IRS treats all IRAs as one account, which means the IRA contribution limits apply to both Roth and Traditional IRAs. (More information about handling multiple retirement accounts).
Planning Roth IRA Contributions
Getting your money in the game early is usually a great idea when investing, and many people like to contribute to their Roth IRAs early in the year so they have a longer period for their money to work for them. Some people prefer to make Roth IRA contributions throughout the year via dollar cost averaging. Both are great ways to make sure you get your money working for you and max out your Roth IRA contributions, if you know you will qualify for a Roth IRA.
Unfortunately, it isn’t always possible to know how much you will make in the course of a year, and some people may find that their income level exceeds the limit which allows them to contribute to a Roth IRA – only they don’t find this out until after they have made their Roth IRA contributions for the year. It might not seem like a big deal, but contributing too much to a Roth IRA can subject you to a 6% excise tax each year the funds remain in your account. Ouch! But don’t pay that tax just yet. This is a relatively easy fix.
Correcting Excess Roth IRA Contributions
According to the IRS Form 590, the 6% excise tax that applies to excess Roth IRA contributions can be avoided by withdrawing excess contributions or recharacterizing them as Traditional IRA contributions. Either action must be completed before the tax deadline, including extensions. There is a third option for correcting excess contributions, assigning your contribution to a future tax year. However, you may have to pay the 6% tax for the tax year your excess contribution is in your Roth IRA. More information about each option is below:
- Remove excess contributions. The 6% penalty tax can be avoided by withdrawing the excess contribution and any earnings or losses by the tax deadline, including tax filing extensions. Any earnings will be subjected to income taxes and a 10% early withdrawal penalty unless they are a qualified distribution (see Roth IRA withdrawal rules for more information).
- Recharacterize excess contributions as Traditional IRA contributions. Recharacterize is a nice word for “reclassify.” Basically, you can tell the IRS you wish to change the excess Roth IRA contributions to Traditional IRA contributions, assuming you qualify for a Traditional IRA.
- Apply excess contributions to a future tax year. You can apply excess Roth IRA contributions to a future tax year, provided the amount you apply to the future year is less than the maximum allowed for that year. The downside to this option is that you may have to pay the 6% tax for the current year.
Which option is best?
This is one situation where I recommend visiting a tax professional and working closely with your IRA custodian. Each individual will have a unique situation, so it is best to contact a tax professional who can offer you specific corrective actions based on your needs. In all cases you will want to resolve this problem before the tax filing deadline so you can hopefully avoid paying any fees or penalties.
{ 27 comments… read them below or add one }
This situation actually happened to me when I was first started a Roth IRA. Turned out that my grandparents were starting IRA’s for all the grandchildren and giving it to them as a Christmas present.
However, they didn’t consider the fact that I already maxed out a Roth IRA for the year with another mutual fund family. Unfortunately, I had to pay a tax on the excess contribution.
I have a Roth set up with Vanguard and once its maxed you don’t have the option to put more in just in case. Or at least I think that is in place. Since you can take out initial contributions, makes sense just to take it out so not to be taxed.
That’s a nice feature. Some people open Roth IRAs at different brokerages or banks, so they may not have that automatic option in place. But it’s a good feature to look for in a broker.
I made an excess Roth IRA contribution in 2008 by accident. I had set up automatic monthly withdrawals from my checking account to my Roth IRA. But when the market headed down, I maxed out my annual contribution in mid-October. When November rolled around, the monthly contribution went in and triggered an excess contribution. Luckily, even if I had missed this myself, the discount broker I used, notified me of the excess contribution and forwarded the necessary paperwork for removing the contribution.
Good to see your broker was on top of things. Hopefully it was caught and taken care of quickly enough that there were penalties or fees involved.
I completed my taxes for 2009, and our AGI (164K) was just under the limt to contribute to 2009 Roth. I opened a Roth account with my MF company on-line for the max 5,000, but they pulled 10,000 from my account and applied it all in 2009. They would not reverse the transaction for me, so I had to withdraw excess contributions, and there was gain.
1) does this apply to my 2009 taxes, i.e. do I need to ammend my 2009 return?
2) shouldn’t a broker’s system have something in place to prevent an error of that kind, contribution in excess of the current limit?
Art, Sorry to hear about that. I’m not sure why the mutual fund company would not reverse the transaction, especially if you caught it right away. I’m not sure how this will affect your 2009 taxes because it will depend on when he contributions were made, when the excess contribution was corrected, and possibly other factors.
Regarding the broker’s system having limits in place, I’m not sure how easy that would be to implement. They could easily put a notification in there if someone were to contribute more than $5,000 to a single IRA for a tax year, but it wouldn’t be easy to monitor all IRA contributions because people can easily contribute to IRAs with different companies, or in a Traditional IRA and Roth IRA in the same tax year. Most mutual fund and investment companies probably take the approach that it is up to the individual investor to monitor and keep track of their investment contributions. That said, there should be measures in place to prevent a double entry from occurring. If that is what happened in your case then I would run it up the chain to make sure the error didn’t happen again, or I would consider moving my money to a new investment house.
Can my husband and I both open and contribute to Roth IRA? our MAGI in 2009 is 165k? And both of us have 401k from our employers.
Another question is that I contribute $1000 into my traditional IRA, then now I noticed that my MAGI is too high for traditional IRA. Do I need to take the $1000 out?
THX! Annie
Annie, the phaseout for Roth IRAs begins at $166,000 for 2009, so you just made it under the limit to maximize your Roth IRA contributions. You and your husband should each be able to open a Roth IRA and contribute the max amount, which is $5,000 each if under age 50, and $6,000 each if 50 or older.
Regarding your Traditional IRA, don’t withdraw the money. Instead, contact your IRA custodian and request to recharacterize it as a Roth IRA, that way you get the benefits of a Roth IRA. Your IRA custodian should be able to help you with the paperwork.
My husband and I each contributed the maximum of $5,000 into our Roth IRAs for tax year 2009, however, our MAGI is going to be around $176,000 for 2009. This means we can’t contribute to our Roths in 2009. I also expect we’ll be above the income limit in 2010 as well. Can we take advantage of the 2010 Roth IRA conversion loophole (no income limits on conversions in 2010 only) by converting our excess 2009 contributions to an after-tax Tradition IRA, then continue to contribute the maximum for 2010 as after-tax Tradition IRA contributions, and finally reconverting back to the Roth IRA before the end of tax year 2010?
Julie, You should be able to do that, but keep in mind that there will likely be taxes due when you make the conversion from the Traditional IRA to Roth IRA. You will also need to consider other factors as well, including any other Traditional IRAs you may currently have in your investment portfolio (the IRS is going to basically treat them all as one IRA). For example, if you rolled over an old 401k into a Traditional Rollover IRA, then that amount will be considered part of your Traditional IRA and will factor into the tax consequences.
I would break this into two steps:
1. Complete your 2009 taxes and determine your MAGI and how much you can contribute to a Roth IRA this year, and recharacterize anything over that limit to a Traditional IRA by April 15th to avoid any taxes or penalties.
2. Look at the Roth conversion as a separate financial transaction, which it is. Because of the many tax considerations and long term implications, I would consider working with a tax professional and/or financial planner.
The good news is that you aren’t up against the tax deadline for the conversion, you have until the end of the year. It may also be a good idea to make 2010 contributions into a non-deductible Traditional IRA as well, just in case you aren’t eligible for the Roth again in 2010.
I contributed to a Roth IRA in February 2010. $5,000 for 2009 and $5,000 for 2010. In March 2010, I realized that I made too much money in 2009 to have a Roth and that I will make too much money this year in 2010 for a Roth. I quickly removed the money and put it back in my savings with a little over $12 of interest paid for the month it was there. I have not finished my taxes yet for 2009. Will I only need to pay tax on the interest earned or will I be penalized in some other way. Thank you for any help or insight in this matter.
David, I think this is a situation where you will want to talk to a tax professional or investment advisor. It may be better to recharacterize the Roth IRA contributions as a non-deductible IRA, that way you keep the money in a retirement account and keep the long term tax benefits. They can also help walk you through your options regarding future investments, and possible penalties.
For 2009 I contributed 3000.00 to my Roth. However, at the end of the year I realized I made to much money (good thing to have happen). Since I had not contributed to a regular IRA I moved the money, along with the 800.00 profit I had made, to the regular IRA. On my taxes I have claimed the 3800.00 put into the IRA but don’t I have to pay taxes on the 800 profit I made?
Scott, yes, you will have to pay taxes on the $800 income you made on your Roth IRA. I recommend contacting your accountant for more information regarding how to do this, or see if your tax software program covers IRA recharacterizations (many will cover this topic, but not all).
Hi Ryan,
Thanks for the helpful post. I’m leaning toward taking the 6% penalty because the formula for computing earnings on my excess contributions works against me, but I’d appreciate if it you could confirm that I’m think about this the right way.
I’m a married grad student with a nice fellowship but little earned income; I learned that the fellowship didn’t count toward earned income and that you can’t contribute more than your earned income when I started doing my taxes this week. So, in May 09 I exceeded my contribution limit by $185 and then, not realizing the mistake, topped up my contributions to $5000 by adding another $3500 in Dec 09. We’re over by $3685. I would take the excess money out and pay the 10% early withdrawal penalty plus additional income tax, but the earnings formula doesn’t take into account when the contributions were made, and so it looks like the 6% penalty will cost me less. As I understand it, the formula will use the account balance from May as a starting point to figure earnings and will treat the excess contribution as a whole, but this ignores the fact that the account’s appreciation during 2009 was not due to an extra $3685, but to all the money that was in the account before, plus the $185, at least up until December. Of course there have been earnings on the $3500 that I invested in Dec, but that money has been in the account for much less time, and it wouldn’t be fair to attribute 2009 earnings to it: using the balance from December to figure the earnings suggests a 7% return on the $3500, whereas doing it the IRS way ($3685 in the account since May) suggests a 33% return. I’ve spoken to Vanguard about this and they say they have to use the IRS formula, so when I do the math it looks like paying the 6% penalty will be cheaper.
I know you don’t have all the data in front of you and this is something to consult a tax professional about, but does my description of how the formula penalizes me at least make sense? I guess it might be the fairest solution the IRS could come up with, and I’ve read that it was worse before, but in this case I think I’m getting the short end of the stick.
Jim, this is a situation where I would leave it to the pros. If you have double checked your numbers and Vanguard verified the calculations, then go with the option that costs you the least amount of money. Sorry to hear it happened, but the goon news is that you caught it fairly early and this didn’t drag on for a couple years!
Thanks for reminding me of the bright side, Ryan. And sorry for throwing all those details at you!
Ryan,
In order to lower our tax due, I had my wife open a Traditional IRA and contribute $5000 for 2009 allowed based on our AGI and that she works for someone that does not offer a retirement plan. What I neglected to consider, was she had already contributed $2600 throughout 2009 to a Roth IRA through a different custodian.
Based on the options you present in your article, I’m thinking I should apply these $2600 contributions towards 2010? Do you think this is the best option? How do I go about doing that? Can I do that even though I made these contributions as long ago as Jan 2009?
Thanks,
Bob
Bob, I think you would be able to do that, but I am not 100% certain. Also keep in mind that if you do convert it to a Roth IRA for 2010, you may still owe taxes or penalties based on any earnings you may have had since your wife made the contribution. It may be easier or even cheaper to leave the Roth IRA as it is and see about changing part of the $5,000 Traditional IRA contribution to a 2010 contribution if possible. You would need to research the feasibility and tax ramifications of both scenarios. I recommend contacting an accountant or your IRA custodian. They will be able to give you the full range of pros and cons.
If I am converting my traditional IRA to a Roth, am I able to make the standard $5000 contribution to the IRA for 2010 AND convert it to the Roth this year as I would do for all contributions and earnings made prior to 2010? I would make it directly, but am above the earning threshold for direct Roth contributions.
Eric, yes, you can make a $5,000 non-deductible IRA contribution and roll it over in the same year.
My wife and I are both 60 years of age and each hve a Roth IRA. My wife stopped working but I still work and we will file jointly for our Income tax. And, our AGI will be under $96000 for 2010. Can we still make a $6000 contribution to each of our Roth IRAs for 2010 or is my wife excluded and only I can contribute.
Bob, as long as you file jointly and otherwise meet income requirements you can have a spousal IRA in your wife’s name. It’s a great way to continue saving additional income for retirement!
Ryan,
Quick thanks for helping all of us out!
I will try to be brief but include all relevant information. I am 25 and recently switched jobs and went to a new company. I moved my old employer sponsored plan (401k) to a traditional IRA. The amount was ~ $5,800. I then turned around and converted the traditional IRA to a Roth and am now concerned I have exceeded my annual contributions? I am planning on paying tax on the amount I converted, but am I in excess of ~800 over the limit?
Thanks-
Paul
Paul, what you did was create what is called a Rollover IRA. A rollover IRA is funds that were previously in another IRA or another qualified retirement account, so they will not count against your annual IRA contribution limits (because they already counted against contribution limits for a different retirement plan). So you are still eligible to contribute to your Roth IRA this year if you still wish to do so. The biggest factor you need to be aware of in this situation is making sure you pay any applicable taxes on the Roth IRA conversion. Best of luck!
Just as I thought- I did do my research!
Thanks for the timely reply!