How to Correct Excessive Amount of Contributions to Your Roth IRA
Here is how to find a solution to the problem and avoid paying any additional tax fines.
Contributing money to a Roth individual retirement account (IRA) could be an excellent way to put money away for retirement; however, if you do it too frequently, you could end up having to pay tax penalties. You are in luck since there are a variety of options available to you that could assist you in resolving the issue and possibly avoiding the associated penalty. The following is something you ought to be aware of.
KEY LESSONS
You have the option of putting money away in a Roth IRA for your retirement, but you need to be careful not to put in too much money.
If you have an unexpected increase in your income, you may contribute additional cash to your Roth IRA and so become ineligible for a full contribution or any contribution at all.
You could also make the maximum contribution at the beginning of the year, only to find out at the end of the year that your pay was smaller than you expected.
You can either withdraw the cash, convert the Roth IRA to a traditional IRA, or add your excess contributions to the Roth IRA for the next year. These are the alternatives available to you.
You will be subject to a tax penalty of 6% per year until such time as you rectify the situation.
Why Are Excess Contributions Made to Roth IRAs
There are a variety of reasons why you might make excessive contributions to your Roth IRA. Take, for example:
Your remuneration fell short of expectations. You run the danger of putting too much money into your Roth IRA if you expect to make less money than you actually do for the year. Both traditional and Roth individual retirement accounts (IRAs) can only be funded with taxable income, which can be money generated through a job or from the owner’s own business. Investment income is not included in this calculation.
You are permitted to contribute the difference between your compensation and the maximum amount that can be contributed to a retirement plan during the tax year. Therefore, if you contributed the maximum amount to your Roth IRA at the very beginning of the calendar year but didn’t wind up making that much money, at least some of the money you gave might be regarded to be excessive. This is because Roth IRA contributions are taxed differently than traditional IRA contributions.
A Roth IRA allows for annual contributions of up to $6,500 for those under the age of 50 in 2023 and $6,500 for those under the age of 50 in 2022. People aged 50 and over have the opportunity to make a catch-up payment of an additional $1,000 if they have already contributed a total of $7,000 or $7,500.
You have an excessive amount of money. The claim that you overpaid for your Roth IRA and generated more money than you expected for the year is the one that is the most reasonable explanation. The income thresholds that must be met in order to contribute to a Roth IRA are the same ones that limit the total amount of money you may put into one. Although there are no income requirements to be eligible to make contributions to traditional IRAs, your income may have an effect on the percentage of your contributions that are eligible for a tax deduction.
You are not qualified to make a contribution to a Roth IRA if, for example, you file your taxes as an individual and your modified adjusted gross income for the year (MAGI) in 2022 is equal to or greater than $144,000. This is because the contribution limit for a Roth IRA is $65,000. If your modified adjusted gross income is between $129,000 and $144,000, you may be eligible for a contribution that is less than the full amount. You are not restricted in any way regarding how much money you can generate so long as it is less than $129,000.
If your modified adjusted gross income for 2023 is $153,000 or higher, you will not be permitted to contribute to a Roth IRA. If your income is between $138,000 and $153,000, you may be eligible for a contribution of up to 50% of that amount. You are free to make as much money as you like, provided that it is less than $138,000 per year.
You will not be able to make a contribution to a Roth IRA if you have an income of $214,000 or more in 2022 and you file your taxes as a married couple filing jointly. If your MAGI is between $204,000 and $214,000, you are eligible for a donation of one half. If you have an annual income that is less than $204,000, you are eligible to receive the full contribution. For the year 2023, the following values and ranges apply: $228,000 or more (no contribution is allowed), $218,000 to $228,000 (partial commitment), and less than $218,000 (full commitment).
Keep in mind that individual retirement accounts (IRAs) are distinct from one another, and if both partners are qualified, they can open a Roth IRA if they so desire.
If your wage is regularly well inside the limits, you typically do not need to worry about this issue. However, if your income is close to the constraints, you should be aware that a significant pay raise or bonus could push you over the threshold, resulting in an excessive contribution, so you should plan accordingly if this happens.
You should be aware that the spreadsheets contained within IRS Publication 590-A can be utilized to establish the new contribution limit that applies to your Roth IRA.
How to Handle Additional Contributions to Your Roth IRA in Three Steps
If you find out that you have contributed too much money to your Roth IRA, you have a few different choices to make on how to handle the situation. In most cases, taking action before the deadline for submitting your annual taxes (including any extensions) is the best way to avoid incurring penalties. At this time, the penalty consists of a tax of 6% that is applied to any donations that are made in excess.
You can choose between the following primary alternatives:
1. Take away any contributions that are unnecessary.
You will not be liable to any penalties if you simply remove your excess contribution before it is due for the return of taxes, including any extensions, along with any income it has generated in the interim. Nevertheless, when figuring out how much you owe in taxes for the entire year, you will need to take into account the earnings component.
These earnings are referred to by their more official name, “net income attributable,” or “NIA.”
Note that even if you have already handed in your tax return for the year, you still have the option to request a withdrawal of the payment during the first six months after the original due date of your tax return (excluding any extensions).
According to the information provided by the IRS, you are required to “file an amended return with ‘Filed according to section 301.9100-2’ printed at the top.” A reason for the withdrawal must be provided, and any earnings related with the transaction must be reflected on the revised tax return. On the revised return, make any additional corrections or revisions that are necessary.
2. Reclassify any contributions you’ve made that are in excess of what was needed
An alternate alternative is to roll over any excess contributions from your Roth IRA into a traditional individual retirement account (IRA). You are able to do this by providing the financial organization that manages your Roth IRA with instructions to transfer the excess amount, along with any income it has accumulated, into a traditional IRA. This IRA can either be held by the same financial organization (referred to as a transfer within the same trustee) or by a different one (referred to as a transfer between trustees), depending on the circumstances.
The Tax Cuts and Jobs Act (TCJA) made it illegal to convert traditional IRAs and other tax-favored accounts into Roth IRAs. However, beginning in 2018, this ban will no longer apply to conversions of excess contributions to Roth IRAs from traditional IRAs.
3. Move any further contributions to the year that is to come
You have the option of transferring the excess contribution as well as any returns it has generated into a Roth IRA for the following year so long as you stay within the guidelines for that particular year.
In spite of this, the annual penalty of 6% can still be applied to your account.
What Are the Consequences of Failing to Remove Excess Contributions to a Roth IRA?
A tax penalty of 6% will be charged each year until any excess Roth IRA contributions in your account are removed, at which point you will be exempt from the penalty.
What are the Contribution Limits for Roth 401(k) Accounts?
Contribution limitations for Roth 401(k)s in 2022 are set at $20,500 for individuals under the age of 50 and $27,000 for those beyond the age of 50. For the year 2023, these amounts are $22,500 or $30,000. If you have both a designated Roth 401(k) account and a normal 401(k), then that total represents the combination of both of those funds.
What Are the Consequences of Making an Excessive Number of Contributions to a Roth 401(k)?
In the extremely unlikely event that you contribute more money to your Roth 401(k) than is allowed, your employer is obligated to provide what is known as a “corrective distribution” to you in the amount of the excess funds. Both your additional contributions and any earnings that were generated from those contributions will be accounted for in that dividend.
The final analysis
There are numerous reasons why you can mistakenly contribute an excessive amount to your Roth IRA. The good news is that there are a lot of options to rectify the situation and maybe avoid any tax penalty.
