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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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