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.