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Undoing Roth IRA Contribution Mistakes

Written by Nickel - 25 Comments

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?

Published on November 8th, 2006 - 25 Comments
Filed under: Saving & Investing, Taxes

About the author: Nickel is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

25 Responses to “Undoing Roth IRA Contribution Mistakes”

1
Alex Says:
November 8th, 2006 at 9:28 am
Hi

Do you know where I can check actual allowed amount to contribute if you are in between 95-110?
2
Frugal Frugalson Says:
November 8th, 2006 at 11:28 am
I 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!!!!
3
Foobarista Says:
November 8th, 2006 at 6:36 pm
I’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.
4
J Says:
November 8th, 2006 at 10:10 pm
I’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?
5
Cindy Says:
November 10th, 2006 at 7:34 am
This 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.
6
Mike Says:
January 9th, 2007 at 1:10 am
I’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!
7
bubbleboy Says:
February 18th, 2007 at 8:08 pm
Thanks 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?
8
tkduke Says:
March 6th, 2007 at 10:42 pm
If 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?
9
nickel Says:
March 7th, 2007 at 6:31 am
tkduke: Probably, but you’ll need to contact your Roth IRA custodian to know for sure.
10
trustella Says:
March 28th, 2007 at 6:36 pm
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?
11
P. F Says:
January 13th, 2008 at 6:45 pm
how 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.
P.S
I also have a 401k in which i’ve contributed the allowed amount.
12
Heather Says:
February 11th, 2008 at 3:44 pm
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
HB
13
D R Says:
March 4th, 2008 at 11:07 pm
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!
D R
14
CuriousGirl Says:
March 10th, 2008 at 1:35 pm
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.
15
nickel Says:
March 10th, 2008 at 1:48 pm
Contribution 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…
16
Jason Says:
November 25th, 2008 at 4:55 pm
I think I’m going to have to pull some amount out for my over contribution in 08. However, I do not have any earnings on these contributions as the market is getting slaughtered. Do I still have to pay the 10% penalty?
17
Joe Says:
February 5th, 2009 at 10:25 pm
What if you don’t have enough income to contribute to a Roth but earned a large fellowship? I contributed the 5000 max to my Roth but found out that the fellowship does not count as earned income.

Can I recharacterize the Roth to a traditional IRA and then transfer the traditional IRA into my existing Roth account?
18
patsy Says:
January 22nd, 2010 at 10:34 pm
I was 70 in 12/08. I have been converting my tradional iras into roths for the past 5 years and paying income tax when I filed. Last year, I made 2 such transfers to my roth. and planned to pay taxes when I filed in 2010. However, because of the additional tax of the 2nd one, I wanted to change that one back from roth to traditional. If I do this before filing taxes this year (2010) will the tax still be due for the 1 I am recharacterizing back to traditional?
19
JD Says:
March 16th, 2011 at 6:54 pm
“Does anyone else have something that theyâ€™d care to add?”

Yeah, what do you do if you’ve discovered you made excess contributions in PRIOR years (not the current tax year.) Apparently, the IRS instructions do not address that directly and even the retirement representative at Fidelity is unsure.

{The IRS instructions are for a Traditional IRA and doesn’t address ROTH IRAs directly.}
20
Steve Says:
April 9th, 2011 at 9:11 pm
I’m in the same boat as JD only maybe worse. I did not know making contributions as married filing separatly had a 10000 income limit. And the amounts shown on my 5329 for excess contributions are wrong for several years due to changing tax software (prior years weren’t imported) and some other reasons I haven’t quite figured out yet. I’m scared to death about what to do and how much this is going to cost us.
21
Jane Says:
April 12th, 2011 at 10:31 pm
I too want to know further how, when and if the IRS tracks this. I just found out (via watching Suzie Orman!) that I have been making excess contributions for the past 4 years- completely out of lack of knowledge!!! I did not earn enough to make these contributions. Therefore, they were not deducted from my earned income. I have never received any notification from the IRS indicating this error. Now what do I do?? I am under 59.5 and do not want to pay 10% withdrawal penalties, etc. When do they plan on penalizing me, or does it only happen on a random audit basis? Any insight would be helpful.
22
JD Says:
April 13th, 2011 at 11:55 am
I ended up going to H&R Block to have my taxes done. He filled out a worksheet with all my Roth IRA contributions all the way back to 2001 when I started.

This, at least, ended up showing my excessive contribution for 2009 on form 5329 line 18. I did have to pay a 6% “tax” on that money, but no 10% penalty.

For my 2010 excess contribution, he showed me one of his tax documents where the IRS says that if you remove the excessive dollars prior to the tax filing deadline, INCLUDING EXTENSIONS, then the contribution is treated as if it had never been made. So you don’t enter ANYTHING on form 5329 line 20.

BUT, you (or your banker) must determine how much (if any) “earnings” you made from the excess contribution, and pay the tax on that in the year you received the money.

So, for example, I corrected my 2010 contribution this year, and Fidelity determined my earnings. The excess doesn’t need to be reported on my 2010 tax forms, and next year I’ll show the “earnings” from that excess as income.

So I’m fine now with my 2009, 2010 and 2011 excessive contributions. I’m just going to wait and see if the IRS contacts me about my 2008 contribution.

Hope this helps someone else out there
23
JD Says:
April 13th, 2011 at 12:01 pm
Just wanted to clarify, determining the “earnings” from my excessive contribution applied only to my 2010 and 2011 contributions. And you withdraw the excess amount PLUS the earnings, if any. If you lost money then you withdraw the total amount of the excess — you don’t get to claim a loss on that, only the profit. Typical Big Brother greed.

You only withdraw the excess contributions for 2009 and earlier. You don’t have to determine any earnings on those dollars.
24
Bob Says:
May 18th, 2011 at 3:48 pm
Regarding what Jane said (above):

…I have been making excess contributions for the past 4 years- completely out of lack of knowledge!!! I did not earn enough to make these contributions. Therefore, they were not deducted from my earned income. I have never received any notification from the IRS indicating this error. Now what do I do?? ***Key point/question: I am under 59.5 and do not want to pay 10% withdrawal penalties, etc. When do they plan on penalizing me, or does it only happen on a random audit basis? Any insight would be helpful***…

I am in a similar situation. Please… I would also greatly appreciate any advice on this matter. With me it was only for 2 or 3 calendar years. Would it just be worth it to wait and see if the IRS catches on and then just pay them the penalty out of regular funds, without withdrawing from the IRA (if permissible)?
25
Bob Says:
May 19th, 2011 at 1:21 pm
Actually Jane, after having checked around it unfortunately looks like what most others here stated is correct. There is no getting around this without withdrawing the funds (contribution plus dividends interest, & capital gains for prior years) as soon as possible. That’s the best way and probably the only way. Hopefully your bank/brokerage house and accountant will be able to assist you fully and properly in the tax calculations and start on those 5329s and amended return(s) ASAP.

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