Roth IRAs offer a great way to invest after-tax money in what eventually becomes a tax-free retirement savings account. The caveat: No ineligible contributions. First, you must be eligible to participate based on income. Second, if you are eligible, there are limits to the amount you can contribute.
If you violate either (or both) of these rules, you have made an ineligible contribution and may pay a penalty.
If your modified adjusted gross income (MAGI) falls below $193,000 (married filing jointly) or $122,000 (single) you can contribute up to $6,000 individually ($7,000 if you are 50 or over) to a Roth IRA in 2019. (For 2018, those numbers were $120,000 for singles and $189,000 for married filing jointly, and the contribution limit was $5,500/$6,500.)
With income between $193,000 and $203,000 for married filing jointly—and $122,000 and $137,000, if you’re single—the amount you can contribute is reduced but not eliminated entirely. If your income is $203,000 or more ($137,000 if you are single), you are not eligible to contribute directly to a Roth IRA. (There is a way around this rule. See: What Is a Backdoor Roth IRA?)
For 2018 (you can contribute to a 2018 Roth through April 15, 2019), the income that bans you from contributing to a Roth is $199,000 for married filing jointly and $135,000 for singles.
Any year in which you contribute to a Roth even though you make too much to qualify—or if you contribute more than permitted—you’ve made an ineligible (excess) contribution. That contribution is subject to a tax penalty.
The $6,000 (or $7,000) figure above is the maximum you can contribute in 2019 to either or both a Traditional and a Roth IRA. In addition, the amount you contribute cannot be more than your total taxable compensation for the year. (For 2018, those figures are $5,500/$6,500.)
Reasons People Make Ineligible Contributions
Most people who make ineligible contributions to a Roth IRA do so accidentally. This can be due to an increase in income that pushes them beyond the income eligibility range, forgetting about earlier IRA contributions that year (including those to a Traditional IRA), contributing income that isn’t from compensation or other approved sources, or contributing more than they earned in eligible compensation.
Improper conversions can also be a problem. Suppose you transfer money to a Roth IRA that isn’t eligible because you failed to take a required minimum distribution (RMD) before you did so. This would be considered an ineligible contribution.
The penalty for an ineligible contribution is 6% of the ineligible amount. You pay this penalty when you file your income tax return using Form 5329.
If you don’t correct the mistake you will have to pay the penalty each year until it is corrected. If you’re not able to take a qualified distribution from your Roth IRA (to correct the mistake) you will pay an additional 10% early withdrawal penalty on earnings (interest).
Understanding Net Income Attributable (NIA)
The minute you make an ineligible contribution to a Roth IRA that money begins to accrue earnings (interest). These earnings are known as “net income attributable” (NIA) and must be included as part of any corrections you make.
Also, be aware that the NIA must be included as part of your taxable income for the year in question—even if you physically withdraw it between Jan. 1 and April 15 of the following year.
Correcting an Ineligible Contribution
There are several ways to correct an ineligible contribution to a Roth IRA but in most cases, you must act quickly.
You can transfer the ineligible contribution plus NIA to a Traditional IRA on or before the date your taxes are due. To do so, you must qualify to contribute that amount to a Traditional IRA. The good news is that you don’t lose earnings (interest) and the money still goes toward your retirement. And, you’ll get a tax deduction for your contribution, since the money is going to a Traditional IRA.
Withdraw the Excess
If you don’t qualify to contribute to a Traditional IRA, you can withdraw the extra contribution and any NIA before your tax deadline without penalty. You must declare the NIA on your taxes as income.
Apply the Excess to Next Year’s Roth IRA Contribution
Doing this on a future tax return may not let you avoid the 6% tax this year, but at least you will stop paying once you apply the excess.
Withdraw the Excess Next Year
Finally, if you fail to do any of the above, you can withdraw the excess funds by the end (Dec. 31) of the following year. You can leave the earnings in, but must remove the entire excess contribution to avoid that 6% penalty for the following year.
The Best Solution
The best solution for an ineligible contribution is to move it (plus any NIA) into a Traditional IRA before your tax deadline.
If that’s not an option, withdraw the funds and invest them elsewhere before your tax deadline. If you haven’t maxed out your contribution to your company 401(k), you may be able to contribute it there, if permitted.
The other options will result in a minimum of a one-year tax hit, but offer a way to “stop the bleeding” by preventing an ongoing annual 6% penalty. For more see: What to Do If You Contribute Too Much to Your Roth IRA