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
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
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
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.
|Corrective distribution in a later year. If
you don't take a corrective distribution for the year of the
original contribution as indicated above, you can take a corrective
distribution for a later year to avoid yet another 6% penalty. In
this case you have good news and bad. You don't have to withdraw
earnings at this point, just the original amount of the excess. But
you also don't get to take the corrective distribution after the end
of the year. For example, if you made an excess contribution for
2004, the deadline for avoiding the penalty on your 2004 return is
October 15, 2005, and the deadline for avoiding the penalty on your
2005 return is just 11 weeks later, December 31, 2005.
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
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
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.
|Deadline. The deadline for this action is
October 15 of the year after the year for which you made the
contribution, even if you don't file for an extension. Unless you
obtain special relief from the IRS through the private letter ruling
process, which is costly in time and money, there is no way to do a
recharacterization after you pass this deadline.
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.