Undoing Roth IRA Contribution Mistakes
While traditional IRAs have income limits if you want to deduct your contributions, there’s no income limit when it comes to simply making a contribution. Roth IRAs contributions are, on the other hand, subject to income limitations, as follows:
(All dollar limits refer to modified AGI)
Married Filing Jointly: Roth IRA contibutions phase out between $150k-$160k
Single or Head of Household: Roth IRA contributions phase out between $95k-$110
Married Filing Separately, Living Apart: Roth IRA contributions phase out between $95k-$110
Married Filing Separately, Other: Roth IRA contributions phase out between $0-$10k
I bring this all up because I recently received a question from a reader who is concerned about whether or not she and her husband will be able to contribute to their Roth IRAs in 2007. It seems that she and her husband may hit the income threshold, and so they are trying to decide if they should max their Roth right of the bat, or if they should wait until later in the year (possibly into early 2008) when they will have a better idea of whether or not they qualify for 2007 contributions.
This really boils down to the treatment of “excess contributions.” The bottom line here is that you will owe a tax penalty if you don’t correct your excess contribution. In fact, if you fail to correct your excess contribution, you’re required to pay a penalty tax of 6% for each year that the problem remains uncorrected.
So how do you fix the problem? Simple. If you’ve made an excess contribution, you can avoid the 6% penalty by taking the money back out of your Roth IRA. More specifically, you can avoid the penalty if:
(1) You receive a distribution from the IRA on or before the due date of your tax return for the contribution year, and
(2) The distribution includes the amound of the excess contribution and the net income attributable to that contribution.
In other words, you need to withdraw the contribution and the earnings. Taxes will still be due on the earnings — they’re earned income, after all — and these earnings will be subject to an early withdrawal penalty if you’re under 59 1/2 (unless an exception applies).
Alternatively, you can recharacterize you contribution from a Roth IRA to a traditional IRA — this is basically a direct transfer trustee-to-trustee transfer from one type of IRA to the other. Here again:
(1) The transfer must occur before the due date for filing your tax return for the contribution year, and
(2) The transfer must include the contribution and any earnings.
If you do these two things, your contribution will be treated as if it went into the traditional IRA in the first place. It may not be deductible, but at least it will grow tax-deferred.
So there you have it… I’m no tax expert, but my read on the situation is that there’s not a lot of harm in maxing your Roth IRA early in the year and then adjusting it later if need be. You just need to be aware of how to fix it and make sure you do so before your taxes are due.
Does anyone else have something that they’d care to add?
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Hi
Do you know where I can check actual allowed amount to contribute if you are in between 95-110?
Comment by Alex — Nov 8th 2006 @ 9:28 amI have to admit that I’ve always found the handling of excess contributions to be pretty confusing.
Excess Roth contributions seem like a PITA to unwind to me. Specifically, how do you determine what the earnings are for your excess contribution? And won’t pulling this money out potentially increase your taxable income, which would therefore further decrease your allowed contribution?
Now suppose you didn’t catch your excess contribution. Would the excess contribution just be eaten away at 6% per year until value of the excess contribution becomes zero? Does this impact the allowed contributions in any way? Ahhhhh!!!!
Comment by Frugal Frugalson — Nov 8th 2006 @ 11:28 amI’ve had to deal with this for the past couple of years. The Roth limits are “modified adjusted gross income” (MAGI) limits, so the only way to fiddle them is by somehow deferring income and/or by maxing out something like a 401K. Tricks that drive up itemized deductions like prepaying property taxes won’t help since they don’t affect MAGI.
We did it last year by getting my company to defer my last paycheck until January, by getting my wife’s December self-employment income deferred until Jan, and maxing out my 401K before the end of the year.
If they’re “on the bubble”, they need to do some calculating right now - there’s still time to get under if they need to.
Comment by Foobarista — Nov 8th 2006 @ 6:36 pmI’m the poster who asked nickel and there’s no way to ask for our paychecks to be delayed. We’re salaried workers with DH getting a signing bonus on December 5th every year for 4 years, counted as income because it’s company stock gifted, so depending on the stock we’re in trouble. Good thing, stock up 20%, bad thing, puts us on the bubble.
The company won’t defer the paycheck, and I get paid once a month in advance, so my December 1st paycheck is for december. We already maxed out the 401k, but that’s the only deduction for MAGI.
How do you calculate the earnings only on that portion of your Roth? And what if you make a mistake?
Comment by J — Nov 8th 2006 @ 10:10 pmThis happened to me for 2005 tax year. I followed the instructions in Pub 590 on http://www.irs.gov. The part about calculating the earnings on the excess portion seems a little loose, but I just documented my rationale and crossed my fingers. So far no love letters from the IRS. IMHO the paperwork was a hassle, and I’ll avoid this issue at all costs going forward. Since there aren’t restrictions on the number of contributions - only the $$$ - I’d recommend making a conservative contribution early in the year and fine-tuning it in 4Q.
Comment by Cindy — Nov 10th 2006 @ 7:34 amI’m facing this situation for the 2006 tax year - I contributed the full amount to a Roth IRA early but bonuses at the end of the year reduced my eligibility.
After spending hours online, speaking with the IRS and with tax specialists, I can confirm that there are in fact 2 options for “undoing” the excess contributions:
1.) Recharacterizing the contributions to a Traditional IRA. As stated in the original post, the excess contributions and any associated earnings are directly transferred to a Traditional IRA. Everything is subsequently treated as if you had originally made the contributions directly to the Traditional IRA in the first place.
2.) Withdrawing the excess contributions along with any associated earnings. If this is done before a certain date in the calendar following the tax year of the excess contributions, then the 6% penalty is waived. The excess contributions themselves are therefore not taxed or penalized. HOWEVER, the earnings will be treated by the IRS as a non-qualified distribution and are subject to a 10% penalty (in addition to normal income tax). This fact was confirmed both by an IRS representative and by a tax specialist.
To summarize, then, the IRS penalizes you for making excess contributions and then withdrawing them to correct the problem - even if you make the correction in a timely manner. There’s simply no way to get around the 10% penalty (unless you meet one of the qualified distribution requirements), no matter how “aware” you are of the situation.
This treatment is unfair, IMHO, and underscores the fact that there can be harm in contributing early if you’re on the bubble. If you end up overcontributing, then you’re forced to either recharacterize or take a 10% hit on any earnings before withdrawing them.
Returning to the recharacterization option, remember that in 2010 Congress is set to eliminate the income limits for converting a Traditional IRA into a Roth IRA. This means that someone in this situation can recharacterize the excess contributions into a Traditional IRA for now, wait a few years, and then recovert the Traditional IRA into the Roth IRA in order to end up with the desired result: a Roth IRA without any Traditional IRA.
It’s been both interesting and annoying trying to figure all this out. Hopefully this information can help anyone else in a similar predicament!
Comment by Mike — Jan 9th 2007 @ 1:10 amThanks for the comment mike. Does anyone know how the IRS enforces this provision? For instance, what if you contributed your 4000 to your roth and then forgot that you went over the limit. Who catches you? Does the IRS have to audit you to catch this or will charlesschwab (or whoever else) tell the IRS how much you contributed?
Comment by bubbleboy — Feb 18th 2007 @ 8:08 pmIf I made a Roth IRA contribution in 2007 and erroneously designated it as a 2006 Roth IRA contribution, can this be changed back to be designated as a 2007 IRA contribution?
Comment by tkduke — Mar 6th 2007 @ 10:42 pmtkduke: Probably, but you’ll need to contact your Roth IRA custodian to know for sure.
Thanks for this very informative and complete post! I found I was in this situation after getting a company bonus so I recharacterized to a traditional non-deductible IRA. Now I’m just not sure how to record this recharacterization properly in Quicken. Anyone have experience with this?
Comment by trustella — Mar 28th 2007 @ 6:36 pmhow do i calculate the earnings of my excess contribution? my income is over the limit and i made a monthly contribution to my roth IRA. I had them stop it the moment i realized my income will go over, but i already put in $2250.00 by end of sept. 2007. i have the form for excess contribution but i’m a bit confused on how to go about withdrawing the excess contribution plus earnings. Please advise.
Comment by P. F — Jan 13th 2008 @ 6:45 pmP.S
I also have a 401k in which i’ve contributed the allowed amount.
Question Please.
I invested $2000 in an Roth IRA in 1998. Here we are in 2008 and my fund is worth $1800+/- or so.
Now, I am 34, not 59 1/2. Can they give me a penalty for early withdrawal since they havent done very well investing for me. It’s a joke.
I’m just finally learning all of this, but am confused how they can penalize me on my principal that i gave them a decade ago.. and the already took tons of fees out?
Thanks
Comment by Heather — Feb 11th 2008 @ 3:44 pmHB
HB,
Just roll your Roth IRA to somewhere else, DON’T cash it in. Then let the new firm manage your Roth, or better yet, pick a great mutual fund and do it yourself (e.g. open a Roth IRA at Schwab or other online trading sites).
Hope that helps!
Comment by D R — Mar 4th 2008 @ 11:07 pmD R
I too am curious to know how the IRS knows if you have made excess contributions to a Roth IRA. Does the IRS have to audit you to catch this? Does the IRA custodian report your annual contributions to the IRS? Thank you.
Comment by CuriousGirl — Mar 10th 2008 @ 1:35 pmContribution information is reported on a form that comes after the tax deadline (by the end of May, I believe). The reason for this is that you have up until taxes are due to make contributions, so that information can’t be reported until afterwards. I think that it’s Form 5498, but I’m not 100% sure.
I would assume that they run an automated check of that info against all returns. Any discrepancies would presumably send up an audit flag. Don’t think for a minute that the IRS isn’t keeping track…