Excess Annual Contributions

How to handle an excess annual contribution to a Roth IRA.

If you make an annual contribution to a Roth IRA that's not permitted, or in a larger amount than permitted, you've made an excess contribution. You can fix this problem in any of three ways described below.

Source of the Problem

There are various ways you could find yourself with an excess annual contribution to a Roth IRA:

• The total amount of your annual contributions to one or more Roth IRAs and traditional IRAs for one year exceed the dollar limit for that year. For 2004, the limit is $3,000 ($3,500 if 50 or older by the end of the year).
• Your total annual contributions to traditional IRAs and Roth IRAs exceed your taxable compensation income for the year.
• Your permitted Roth contribution was reduced or eliminated because of the size of your modified adjusted gross income.
• Your filing status changed in a way that made you fail the modified adjusted gross income test.

Whatever the reason may be, a penalty tax will apply if you don't take action to correct an excess contribution. We'll take a look at the penalty first, then show how you can avoid it.

Excess Contribution Penalty Tax

If you make an excess contribution and fail to correct it you're required to pay a 6% penalty each year the excess contribution remains uncorrected. For example, suppose you made a $3,000 annual contribution to a Roth IRA early in 2003, 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 2003, you had to pay $72 excess contribution tax (6% of $1,200). And if you left the problem uncorrected beyond the end of 2004, you owe another $72. You'll continue to owe this tax each year until you correct the excess contribution.
    There are three ways to correct the situation. First, you can withdraw the excess contribution and any earnings on that amount. This works in all situations, although it isn't always the best choice. Second, you can recharacterize the excess contribution as a contribution to a traditional IRA. This works if you are over the limit for Roth IRAs without being over the limit for all IRAs in general. Third, you can leave the excess in the Roth and use a deemed contribution to correct it the next year. This choice requires you to pay a penalty for one year, but sometimes that's the lesser of two evils.

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 gets you out of the penalty and works for any situation where an annual contribution results in an excess contribution. There are times when a different choice will work out better.
 

Recharacterization

Another way to correct an excess contribution is a recharacterization. This means moving the excess contribution (and earnings) to a traditional IRA, and treating it as if that was where you made the original contribution. You can do this if you've gone over the limit for Roth contributions because of your income level, but you didn't go over the limit for IRAs in general. Forget about this approach if you exceeded the overall limit for IRA contributions for the year.
    A recharacterization can be as simple as getting the trustee to redesignate your Roth as a traditional IRA if the entire amount of the Roth is being recharacterized. That would be the case if this was the first year you contributed to the Roth and your entire contribution is disallowed. In other cases, a recharacterization will involve a transfer of part of the Roth to a traditional 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 traditional IRA in the first place. You don't have to pay tax on the earnings that are transferred from one IRA to another, because this is treated as a retroactive fix.

Example: Suppose you contributed $3,000 to a Roth IRA early in 2004, 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, 2005 you have the trustee of your Roth IRA transfer $750 plus the earnings attributable to that $750 directly to a traditional IRA. You're treated as if you originally contributed $2,250 to the Roth IRA and $750 to the traditional IRA. You're allowed to do that, so you don't owe a penalty.

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. Of course you'll benefit from a recharacterization only if you're permitted to contribute to a traditional 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.
 

Deemed Contribution

If you don't correct your excess contribution for the year you made it, using one of the methods described above, you may be able to correct it in a subsequent year, using a deemed contribution. This method has the drawback that you'll pay the 6% penalty for the year of the contribution. You may be in a situation where that's the lesser of two evils, or you may have learned about the excess contribution when it was too late to use one of the other methods.
    To use this method, you must be eligible to contribute at least as much as the excess in the following year, and you have to make sure your actual contributions are less than the amount otherwise allowed, leaving enough room to treat the previous year's excess as a deemed contribution for this year.

Example: Last year you somehow ended up with an excess contribution of $50. You could take a corrective distribution or do a recharacterization, but either one seems like a lot of hassle to get out of a $3 penalty (6% of $50). In this situation you might choose to pay the penalty, leave the money in the Roth, and make sure your contribution for the following year is at least $50 below the maximum.

There are three situations where you might consider this approach. One is where the amount of the penalty is too small to justify the hassle of the other methods of correction. Another is when you've missed the deadline for the other methods, so you're stuck with the penalty in any event. A third possibility is that you struck it rich with your investments the year of the contribution, so that the advantage of keeping those earnings in a Roth is greater than the advantage of taking corrective action that gets you out of the penalty, but requires you to pay tax on those earnings, either now (in the case of a corrective distribution) or later (in the case of a recharacterization).
    Bear in mind that if you're wrong about being eligible to make a contribution the next year, you'll still be stuck with the need to take a corrective distribution or you'll pay the 6% penalty over and over again each year until the excess is corrected one way or another.