Excess contributions are costly. Here's how to fix them
- Ineligible (excess) contributions happen when you put more money into your IRA than you’re allowed to.
- Your filing status and income determine how much you can contribute.
- There are several ways to fix an ineligible contribution.
- If you contribute too much, you’ll pay a 6% penalty each year until you fix the mistake.
Roth IRAs offer a great way to invest after-tax money in what eventually becomes a tax-free retirement savings account. While it would be great if you could put all your money into a Roth, the IRS limits how much you can contribute each year. You must be eligible to contribute based on your income. And if you are eligible, there are limits to the amount you can contribute.
If you violate either (or both) of these rules, you’ve made an ineligible, or excess, contribution. You’ll owe a 6% penalty on the amount every year until you fix the mistake.
If your modified adjusted gross income (MAGI) is below $193,000 (married filing jointly) or $122,000 (single), you can contribute up to $6,000 ($7,000 if you’re age 50 or over) to a Roth IRA in 2019.
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’re single), you’re not eligible to contribute directly to a Roth IRA. You might be able to get around income limits with a backdoor Roth.
If you contribute to a Roth even though you make too much to qualify—or if you contribute more than you’re allowed—you’ve made an excess contribution. That contribution is subject to a 6% tax penalty.
The $6,000 (or $7,000) maximum is the most you can contribute in 2019 to all of your IRAs. That means that if you have a traditional IRA and a Roth IRA, your total contribution to those two accounts can’t be more than $6,000 (or $7,000).
And keep in mind: The amount you contribute can’t be more than your total taxable earnings for the year. If your earned income is $4,000, that’s the most you can contribute to your IRAs.
Reasons People Make Ineligible Contributions
Most people who make ineligible contributions to a Roth IRA do so accidentally. Here are some of the main culprits:
- You make more money and it pushes you beyond the income eligibility range.
- You forgot about a contribution you made earlier that year.
- The money you contributed doesn’t count as earned income.
- You contributed more than your earned income for the year.
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 also be considered an ineligible contribution.
The Penalties for Excess Contributions
The penalty for an ineligible contribution is 6% of the ineligible amount. You pay this penalty when you file your income tax return using IRS Form 5329.
If you don’t correct the mistake, you’ll owe the penalty each year until it is corrected. If you’re not eligible to take a qualified distribution from your Roth IRA to correct the mistake, you’ll 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 they 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 withdraw it between Jan. 1 and April 15 of the following year.
How to Fix an Excess IRA Contribution
There are several ways to correct an excess contribution to a Roth IRA.
- Withdraw the excess contribution and earnings. In general, you can avoid the 6% penalty if you withdraw the extra contribution and any NIA before your tax deadline. You must declare the NIA on your taxes as income.
- File an amended tax return (if you’ve already filed). You can avoid the 6% penalty if you remove the excess contribution and NIA and file an amended return by the October extension deadline.
- Apply the excess to next year’s contribution. Doing this on a future tax return won’t let you avoid the 6% tax this year, but at least you’ll stop paying once you apply the excess.
- Withdraw the excess next year. If you fail to do any of the above, you can withdraw the excess funds by Dec. 31 of the following year. You can leave the earnings in, but you must remove the entire excess contribution to avoid that 6% penalty for the following year.
- Recharacterization. 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.
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.