Paid too much into your traditional or Roth individual retirement account? Don’t panic — it’s not too late to walk back an excess contribution to your IRA. But it’s less trouble if you do it before the April tax-filing deadline.
“It’s a very common problem,” says Denise Appleby of Appleby Retirement Consulting, an Atlanta firm that advises companies on administering IRAs and employer retirement plans.
The annual limit on contributions to an IRA is $5,500 ($6,500 once you turn 50). “Typically when making IRA contributions, people like to pay over time rather than pay the $5,500 limit all at once, and they are not reviewing their statements. So come tax time and they are reviewing with their accountant, that’s often when they realize there’s an over-contribution.”
It’s important to act because you must pay a 6% penalty tax on the excess amount every year it goes uncorrected, Appleby says.
Here’s what you should do, and what you need to know to prevent future excess contributions.
If you’ve contributed too much to an IRA, fix it before filing taxes
- Contact your plan administrator. “The correction involves going to your IRA custodian and letting them know, ‘I have an excess contribution in my IRA totaling X dollars. What kind of paperwork or instructions do I need to fix this?’” Appleby says.
- Withdraw the excess contribution and earnings from the IRA. You can generally avoid the 6% penalty by withdrawing the excess amount and attributable earnings or losses by the tax-filing deadline in April.
- Pay taxes on any earnings. Any earnings you remove from the IRA are taxed as ordinary income. (Earnings are figured through a formula called “net income attributable,” which can be earnings or losses, depending on how the account has performed, Appleby says.) You may have to pay a 10% tax for early withdrawal on any earnings if you are younger than 59½. Consult your plan administrator or tax professional if you need help, Appleby advises.
Discovered excess IRA contributions after filing taxes? Do this
You have a few options if you discover an excess contribution after you file your taxes:
- Contact your plan administrator and file an amended tax return. If you remove the excess contribution and earnings and file an amended return by the October extension deadline, you can avoid the 6% penalty.
- Carry the excess forward to the new tax year. For example, if you overcontributed by $500 last tax year, reduce your contribution this year to no more than $5,000 ($6,000 if you are 50 or older). You’ll pay a 6% penalty while the excess contribution is on the books, but will avoid future penalties.
- Roth IRA option: Move the excess to a traditional IRA. If you have a Roth IRA, another way to avoid penalties is to transfer the excess amount and any earnings into a traditional IRA. The IRS calls this move a “recharacterization.” Rules state this should be done before tax day, but allows an extension if you filed your taxes on time and take “corrective action” toward the recharacterization within six months of the filing deadline.
- Do nothing and pay 6% on the excess every year. Not the recommended option, but Appleby says some IRA holders intentionally overcontribute. “Some people think, ‘What’s it going to cost me, 6% every year? But the market is doing better than that,’” she says. “But people are playing with fire here … you definitely want to stay on the straight and narrow with the IRS when contributing to your IRA.”
Common reasons for excess IRA contributions
To help you avoid this problem in the future, know the main culprits for excess IRA contributions:
- You’ve exceeded the IRA limit through one or more accounts. The annual limit on IRA contributions is the combined total of traditional and Roth IRAs, not just any one IRA. “Some people think if you have two IRAs you can double up, but that’s not the case,” Appleby says. “If you have a traditional IRA and a Roth, you are still subject to that one $5,500 limit.”
- You’ve set your automatic investment plan too high. Automatic contributions are a great way to stay on plan; just make sure they don’t add up to more than the overall limit.
- You make too much income for a full Roth IRA allowance. Unlike traditional IRAs, Roth IRAs sets income limits as to who qualifies, and contributions are reduced or phased out at higher income levels. Consult a Roth IRA calculator to determine how much you can contribute.
- You’re too old to contribute to your traditional IRA. Traditional IRAs don’t allow regular contributions in and after the year you turn 70½, Appleby says. Roth IRAs are exempt from this rule, as are rollover contributions to either type of account.
Overcontributions to your IRA are a nuisance, but more of a speed bump than a roadblock on your way toward saving for retirement.