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I wrote awhile back about how to undo Roth IRA conribution mistakes, and a reader named Mike recently left an insightful comment on that post. It seems that Mike is in the unfortunate position of having contributed the full amount to his Roth IRA, but year-end bonuses pushed him above the eligibility threshold. He’s now spent hours online as well as talking to the IRS and tax specialists, and he wanted to shared what he’s learned.
In short, Mike writes that there are two options for “undoing” excess Roth IRA 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 Everything is subsequently treated as if you had originally made the contributions directly to the Traditional IRA in the first place.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. [Note: I did mention this in my original post.]
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. Thereâ€™s simply no way to get around the 10% penalty (unless you meet one of the qualified distribution requirements), no matter how â€œawareâ€ you are of the situation.
Just something to keep in mind when deciding whether or not to contribute to a Roth IRA if you’re “on the bubble.” Truth be told, 10% of the earnings on your contribution won’t usually end up being a particularly large sum of money, but there’s also a major hassle factor involved Remember, you have until April 15th of the next year to make your contributions, so if you’re worried that you might break the threshold and don’t want to deal with undoing your contribution, you might want to set the money aside and wait until you’re confident that you’re in the clear before making your contribution.