Excess Contributions to Roth IRAs
By Kaye A. Thomas
Updated June 1, 2007
How to handle contributions or conversions that are too large or not permitted.
If you make a contribution or rollover to a Roth IRA that's not permitted, or in a larger amount than permitted, you've made an excess contribution. The law provides ways to fix erroneous contributions, and erroneous conversions, too.
Contribution Problems
There are various ways you could find yourself with an excess contribution to a Roth IRA:
- The total amount of your regular contributions to one or more Roth IRAs and traditional IRAs for one year exceed the maximum allowed for that year.
- Your total regular contributions to IRAs exceed your taxable compensation income for the year.
- Your permitted Roth IRA contribution was reduced or eliminated because of the size of your modified adjusted gross income.
- A conversion failed because your modified adjusted gross income exceeded $100,000, or you're married and filed a separate return.
Whatever the reason may be, a penalty tax will apply if you don't take action to correct an excess contribution. If your excess contribution results from a bad conversion, you may have other problems as well. We'll take a look at the penalty and other problems first, then show how you can avoid them.
Excess Contribution Penalty Tax
If you make an excess contribution and fail to correct it you're required to pay a 6% penalty tax each year the excess contribution remains uncorrected. For example, suppose you made a $3,000 annual contribution to a Roth IRA early in 2007, then got a larger bonus than you expected and found that your permitted contribution was only $1,800. Your excess contribution was $1,200. If you didn't correct the excess contribution for 2007, you had to pay $72 excess contribution tax (6% of $1,200). And if you left the problem uncorrected beyond the end of 2008, you owe another $72. You'll continue to owe this tax each year until you correct the excess contribution.
Failed Conversions Cause Other Woes
A failed conversion generally results in an excess contribution that's subject to the 6% tax if you don't correct it. But you're likely to have other problems if you have a failed conversion:
- If you're under age 59½ you may pay a 10% penalty on the early distribution you took in order to start the conversion.
- The tax you owe because of the bad rollover may cause you to incur another penalty: the penalty for underpayment of estimated tax.
In short, if you find that you've made a bad contribution or a bad rollover, there are pretty good reasons to correct the mistake before penalties apply!
Corrective Action
There are two types of corrective action you can take if you've made an improper contribution to a Roth IRA. One is to withdraw the improper contribution and any earnings on that amount. The other is to redesignate your Roth IRA as a regular IRA. In some situations only one of these alternatives will provide effective relief.
Correction by Withdrawing Excess
If you find that your contribution to a Roth IRA was improper or too large, you can avoid the 6% penalty tax by taking the money out. Relief from the penalty is available only if the following are true:
- You receive a distribution from the IRA on or before the due date (including extensions) for filing your return for the year of the contribution.
- The distribution includes the amount of the excess contribution and the amount of net income attributable to the contribution.
When you choose this method of correction, you're required to report and pay tax on the net income attributable to the contribution in the year of the contribution, even if you take it out during the following year, before the return due date. The earnings will be taxed like any other taxable distribution of earnings from a Roth IRA, and will be subject to the early distribution penalty if you're under 59½ unless an exception applies.
This method of correction may work well if you made an annual (not rollover) contribution to a Roth IRA and later found out your income was too large to qualify for the contribution. This type of correction may not work, however, if you made a rollover to a Roth IRA and later found out your income was too high to qualify for a rollover. When you withdraw your contribution from the Roth IRA you avoid the 6% penalty tax on excess contributions, but you're still left without a qualified rollover, resulting in additional taxes and perhaps penalties as described above. In this situation you should consider a recharacterization.
Recharacterization
Another way to correct an excess contribution is to have the trustee of your Roth IRA make a direct transfer to a trustee for a regular IRA. To avoid penalties, you must meet requirements similar to those described in the previous section:
- The transfer must occur on or before the due date (including extensions) for filing your return for the year of the contribution.
- The transfer must include the amount of the excess contribution and the amount of net income attributable to the contribution.
If you meet these requirements, you'll be treated as if the contribution went to the regular IRA in the first place. And you don't have to pay tax on the earnings that are transferred from one IRA to another. The IRS calls this a recharacterization.
Example: Suppose you contribute $3,000 to a Roth IRA early in 2003, expecting your modified AGI to be less than $150,000 (married filing jointly). At the end of the year you find that your modified AGI is $152,500 and your Roth IRA contribution limit is $2,250. Before April 15, 2004 you have the trustee of your Roth IRA transfer $750 plus the earnings attributable to that $750 directly to a regular IRA. You're treated as if you originally contributed $2,250 to the Roth IRA and $750 to the regular IRA.
A recharacterization transfer provides a bonus. Besides eliminating the 6% penalty tax, it allows you to keep the earnings you may have built up during the year in an IRA, instead of taking the earnings out and paying tax on them. And a recharacterization can come to your rescue if you roll a regular IRA to a Roth IRA and later find that you don't qualify for that rollover. If you make a recharacterization you're treated as if you rolled the money to a regular IRA, which is a tax-free transaction.
Of course you'll benefit from a recharacterization only if you're permitted to contribute to a regular IRA. If your excess contribution to the Roth IRA would also be an excess contribution in a regular IRA you can't use this method to avoid a penalty. For example, if you waited more than 60 days to complete a rollover, you won't be able to fix the problem by making a recharacterization. Full details concerning recharacterization transfers appear in the following pages.
for more info, please refer to:
http://www.fairmark.com/rothira/excess.htm
