Excess Roth IRA Contributions

How do you handle excess Roth IRA contributions?

The best way is by not making them. But, surprisingly, this is a lot more difficult than you think.

So if you find yourself with an excess contribution, don't panic. It's not the end of the world.

While an excess contribution is subject to a penalty tax, you are given an opportunity to correct the problem before the tax goes into effect. So there's no reason you should ever have to pay a penalty for one.

Let's start by defining the problem...

What's an Excess Roth IRA Contribution?

IRS rules dictate how much money you can contribute to your Roth IRA on annual basis. These are the Roth IRA contribution limits, and they're mostly based on income.

Assuming you have earned income (only earned income can be used to fund a Roth IRA), then you can contribute...

• Up to $5,000 per year if you're under 50
• Up to $6,000 per year if you're over 50

And

You earn...

• $159,000 or less if you're married filing jointly or a qualifying widow(er)
• $101,000 or less if you're single, head of household, or married filing separately and did NOT live with your spouse during the year
• $0 if you're married filing separately and you lived with your spouse during the year

If your earned income exceeds the amounts listed above, you can contribute anywhere from zero to the maximum contribution. Exactly how much you can contribute depends on where your income falls on the scale. (For more information, see Roth IRA income limits.)

Once you determine the amount of your maximum annual Roth IRA contribution, any contribution amount in excess of the allowable limit for that tax year is considered an excess Roth IRA contribution. This is a violation of IRS rules, and left uncorrected, it will lead to an excess contribution penalty tax.

How Does an Excess Roth IRA Contribution Occur?

So how does this occur anyway?

After all, you know how much you can contribute for the year, so how do you end up making an excess contribution? Shouldn't it be easy to avoid?

It's not as easy as you might think.

In fact, in late 2008, I made an excess contribution myself... How?

Let me walk you through what happened...

My Roth IRA is set up with an online discount broker. I set up the account to receive $10 automatic monthly direct deposits from my bank account. So each month, like clockwork, the discount broker withdrew $10 from my bank account and used it to fund my Roth IRA.

Now, here's where the problem occurred. In October 2008, the stock market plunged, making a host of individual stocks much more attractive than they previously were. Wanting to take advantage, I sent an additional deposit to my online broker equal to the amount needed to meet my Roth IRA maximum contribution limit for 2008.

By the end of October, I had contributed $5,000 to my Roth IRA in 2008...

So when November rolled around, my online broker pulled $10 out of my bank account, and...

Viola!

I ended up with a contribution in excess of $10.

Now, it was my fault for forgetting to discontinue the monthly direct deposit, but this example shows just how easy it is to accidently contribute too much.

Are there other ways to accidentally contribute too much?

Of course.

Just a few examples...

Scenario 1 - You're under the age of 50, and you contribute to both a Roth IRA and a Traditional IRA. By either ignorance or accident, you contribute more than the $5,000 total allowable contribution between the two accounts by putting $3,000 into each account.

Scenario 2 - You set up a monthly direct deposit option that puts $400 per month into your Roth IRA. Yet, at year's end, your earned income is less than $4,800. (Remember... pensions, disability payments, and social security payments are NOT considered earned income for purposes of contributing to a Roth IRA). So in this case, your maximum allowable contribution is equal to the amount of your annual earned income.

Scenario 3 - You're single, under 50, and make $100,000 per year. So under the Roth IRA rules, you can contribute up to $5,000 this year. However, after making the maximum contribution, you receive a $20,000 performance bonus. As a result, your new adjusted gross income is above the threshold for making a Roth IRA contribution. You now have a $5,000 too much in your account.

See how this can happen?

These are just three examples, but there are innumerable scenarios in which an excess Roth IRA contribution can crop up.

But don't worry. Like I said before, it's not the end of the world.

As long as you fix it, you don't have to worry about triggering any additional taxes or penalties.

How Do You Fix an Excess Roth IRA Contribution?

Reversing the mistake of contributing too much is simple and painless.

If your broker hasn't noticed your excess contribution and already sent you one, ask for a Distribution Request Form.

The form will look something like this.

Under the heading 'Reason For Withdrawal,' check 'Refund excess contribution for tax year (20__)'. Fill out the rest of the form and send it in to your broker. Your broker will then send you a refund, and you're done... It's as simple as that!

However, keep in mind that you may want to make a copy of the Distribution Request Form for your tax records. You may be required to have this paperwork on file when submitting your tax return.

Also, you must reverse your contribution error BEFORE you file your taxes for the tax year in which you made the excess contribution.

Failure to do so will most likely lead to the much dreaded...

Excess Roth IRA contribution penalty tax!

Is There an Excess Roth IRA Contribution Penalty?

Yes, if you don't fill out the Distribution Request Form and reverse your excess Roth IRA contribution by the time you file your tax return, then you're probably going to get hit with the excess Roth IRA contribution penalty tax.

So what's the excess Roth IRA contribution penalty tax?

It's a 6% annual tax on the amount of the excess Roth IRA contribution. Left uncorrected, you incur this penalty each year until the problem is fixed.

Need an example?

Let's say you're single, under 50, and earn $95,000. Under Roth IRA rules, you can make the maximum $5,000 annual contribution. Early in the year, you max out your Roth IRA.

But midway through the year, you get an unexpected pay raise. You're still eligible to make a Roth IRA contribution, but your maximum contribution changed from $5,000 to $3,000.

You now have an excess Roth IRA contribution of $2,000. Left uncorrected, that $2,000 gets hit with a 6% annual tax of $120 per year. Your Roth IRA will continue to incur that $120 penalty tax year after year until you correct the excess contribution.

Conclusion

Excess Roth IRA contributions happen...

Sometimes due to human error... Other times because of changes in your income, or even a computer glitch.

But an excess contribution shouldn't cause you an abnormal amount of worry or anxiety.

The IRS gives you more than ample time to correct the problem before you get hit with an excess Roth IRA contribution penalty, and the penalty itself only applies to the excess contribution, not your entire account. So you won't see years of savings wiped away by a brief oversight.

If you find yourself with an excess Roth IRA contribution, ask for a Distribution Request Form from your broker. Fill out the form and return it. This should solve the problem and assist you in avoiding the excess contribution penalty tax.