I Contributed Too Much to My Roth IRA, Now What?!?

May 03, 2022

Roth IRAs can be a tremendous tool to give you flexibility in your journey to retirement. Creating some tax-free income in retirement allows you to be strategic with the amount of money you take out of your taxable accounts.

New presidents (with the help of Congress) can always try and change the tax code, and there is no way to know if that will be in your favor or not. The uncertainty of future tax law has led many of our clients to a Roth IRA.

While a Roth IRA can be a great tool, you need to be aware of specific rules and the consequences of not following them. A common question we hear is, "What happens if I contribute to my Roth IRA when I am not allowed to?" Let's cover the reasons that could happen and then options to remedy if you did contribute when you weren't supposed to.

Why Would You Be Unable to Contribute?

There would be two reasons you have "excess contributions" to your Roth IRA, you either make too little or make too much.

Making too little:

Like a Traditional IRA, you need earned income to contribute to a Roth IRA. Imagine you have worked for years and contributed to your Roth IRA each year. Then, you stop working in November and take a year and a half off. You have an automatic contribution set up, and you ignore it coming out of your savings into your Roth IRA, except this year, you do not have the earned income to allow you to contribute.

Making too much:

Sometimes, you can receive your year-end bonus or commissions paid out earlier than expected or much more significant than expected. We preach the importance of paying yourself first and treating your retirement contributions as another bill. Set up your contributions when you get paid and forget about it. The issue is when we plan these contributions, we know what your income is and whether or not you are in range. Remember, Roth IRAs have income limits when it comes to contributions. A single person can contribute if their modified adjusted gross income, or MAGI, is less than $129,000 in 2022. After that, the contribution amount is phased out until their MAGI reaches $144,000. At that point, they cannot contribute to a Roth IRA.

For example, a single executive who knows their MAGI will be around $120,000, so she contributes to her Roth IRA throughout the year. Then, in December, she receives a bonus that puts her MAGI to $150,000 and now can't contribute to the Roth IRA. The money is already in the account, though; what can you do?

What Is the Penalty?

According to IRS.gov, if you don't remove any excess Roth IRA contributions from your account, you'll be subject to a 6% tax penalty year after year until you do.

What Can You Do to Take Care of the Excess Contributions?

There are three main options that you can utilize to remedy this situation. First, it is best to act as soon as you realize the mistake to try and avoid any penalty.

OPTION 1 – Withdrawal the excess contributions:

To remedy this, withdraw what you put in plus any interest or income from the account. According to IRS.gov, you will have to include the earnings portion as Net Income Attributable (NIA). It seems like a good spot to remind you always to consult a tax professional when situations like this arise.

OPTION 2 – Recharacterize your excess contributions:

Since these are "excess contributions", you can recharacterize them to a Traditional IRA, along with any income or interest earned on the contribution. The easiest way is to inform the financial institution, and they should be able to assist you with it.

OPTION 3 – Apply contributions to the next year:

You could put this contribution to the following year, but you could still be subject to a penalty for the current year. So again, make sure to consult a tax professional if you find yourself in this situation.

The goal is to not put yourself in a situation where you are subject to penalties from the government. Things happen, though, and it is essential to know how to remedy a problem if one does arise.

If you have questions or need more clarity on your overall financial plan, reach out and schedule a 15-minute discovery call with us.

The opinions voiced in this material are for general information only and are not intended to provide specific financial, tax advice, or recommendations for any individual.