Co-written by: Scott Christensen & Katherine Li
Contributing to a Roth IRA is a great way to receive tax benefits for retirement savers. If you already do or are planning to take advantage of this tax savings vehicle, it is important to familiarize yourself with the rules that govern these accounts. The IRS has put in place strict limits regarding the amount that individuals can contribute to their Roth IRAs, as well as income limits for determining who qualifies.
If you are a single tax filer, you must have Modified Adjusted Growth Income (MAGI) under $140,000 in order to contribute to your Roth IRA. The amount you can contribute to your Roth IRA begins to phase out starting at a MAGI of $125,000; if your MAGI is greater than $140,000, you can no longer contribute to the Roth IRA. For those who file as married filing jointly, your MAGI must be under $208,000 in order to contribute. The phaseout range in this case applies to those with a MAGI between $198,000 and $208,000. The maximum IRA contribution in either case is $6,000 for those under 50 and $7,000 for those 50 and older.
As a result of these strict limits, it is easy for taxpayers to overcontribute. So what happens when taxpayers contribute in excess of their contribution limit?
For every year that your excess contribution goes uncorrected, you must pay a 6% excise tax on the excess contribution. In order to avoid the 6% tax penalty, you must remove the excess contributions in addition to any earnings or losses on that excess contribution by the tax filing deadline in April. To determine your earnings on your excess contribution, you can use the net attributable income (NIA) formula.
Net income = Excess contribution x (Adjusted closing balance – Adjusted opening balance) / Adjusted opening balance
Note: If you find that you have losses on your excess contribution, you can subtract that loss from the amount of your excess contribution that you have to withdraw.
Reasons for Overcontribution
- You’ve contributed more than the annual amount allowed.
- Remember that the $6,000 and $7,000 dollar maximum applies to the combined total that you can contribute to your Traditional and Roth IRAs.
- You’ve contributed more than your earned income.
- Your income was too high to contribute to a Roth IRA.
- Unfortunately, single tax filers who make $140,000 or more and those who are married filing jointly who make $208,000 or more are unable to contribute to a Roth IRA.
- Required minimum distributions (RMDs) are rolled over.
- RMDs cannot be rolled over to a Roth IRA.
- If it is rolled over to a Roth IRA, the amount will be treated as an excess contribution.
- RMDs cannot be rolled over to a Roth IRA.
Removal of Excess Prior to Tax Filing Deadline
If you find that you have overcontributed prior to filing your tax return and prior to the tax filing deadline, you can remove your excess contributions before the tax filing deadline (typically April 15) and avoid the 6% excise tax. However, your earnings from your excess contribution will be taxed as ordinary income. Additionally, those who are under 59 and a half will have to pay a 10% tax for early withdrawal on earnings from excess contributions.
- Keep in mind that it is your earnings that are subject to an ordinary income and early withdrawal tax, not the amount of your excess contribution.
If you find that you have overcontributed after filing your tax return, you can still avoid the 6% excise tax if you are able to remove your excess contribution and earnings and file an amended tax return by the October extended deadline (typically October 15).
Recharacterization involves transferring your excess contribution and any earnings from your Roth IRA to a Traditional IRA. In order to avoid the 6% excise tax, you would have to complete this transfer process within the same tax year. It is also important to note that you can’t contribute more than your total allowable maximum contribution. Thus, you must make sure that you can still contribute more to your Traditional IRA prior to proceeding with recharacterization.
Apply the Excess Contribution to Next Year
You can offset your excess contribution by lowering the amount of your contribution the following year by the excess amount. For example, say that you contributed $7,000 to your Roth IRA when the maximum amount that you could contribute was $6,000. The next year, you can offset this excess amount of $1,000 by limiting your contribution to $5,000. You are, however, still subject to the 6% excise tax due to the fact that you were unable to correct the excess amount by the tax filing deadline, but you won’t have to deal with withdrawals.
Withdraw the Excess the Next Year
If you choose to withdraw the excess the following year, you will only have to remove the amount of your excess contribution, not any earnings. However, you will be subject to a 6% excise tax for each year that your excess remains in the IRA.
These rules can be confusing to navigate which is why we recommend involving your tax accountant or trusted advisor in these situations. We are happy to connect you with a Merriman advisor to discuss your situation.
Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Advisory services are only offered to clients or prospective clients where Merriman and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Merriman unless a client service agreement is in place.