Tax planning and compliance for investors
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By Kaye A. Thomas
Updated April 15, 2011
How to handle contributions or conversions that are too large or not permitted.
If you make a contribution or conversion to a Roth IRA that's not permitted, or in a larger amount than permitted, you've made an excess contribution. The law provides ways to fix erroneous contributions, and erroneous conversions, too.
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There are various ways you could find yourself with an excess contribution to a Roth IRA:
Whatever the reason may be, a penalty tax will apply if you don't take action to correct an excess contribution. This is a 6% tax you're required to pay each year the excess contribution remains uncorrected. For example, suppose you made a $5,000 contribution to a Roth IRA early in 2010, then got a larger bonus than you expected and found that due to the income limitation your permitted contribution was only $3,800. Your excess contribution was $1,200. If you didn't correct the excess contribution for 2010, you had to pay $72 excess contribution tax (6% of $1,200). And if you left the problem uncorrected beyond the end of 2011, you owe another $72. You'll continue to owe this tax each year until you correct the excess contribution.
This tax can easily be 100%, or even more than 100%, of the amount of investment income generated by this excess amount in a year. It's important to correct an excess contribution.
There are four ways to correct an excess contribution to a Roth IRA. Two of them can be used to completely avoid the excess contribution penalty, and the other two prevent it from applying to later years after it has applied to one or more years. Depending on your situation, you may find that one or more of these correction methods are unavailable.
Withdrawing excess by due date of return. 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:
When you choose this method of correction, you're required to report and pay tax on the net income attributable to the excess 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.
Recharacterization. Another way to correct an excess contribution is to have the trustee of your Roth IRA make a direct transfer from the Roth IRA to a traditional IRA. To avoid penalties, you must meet requirements similar to those described in the previous section:
If you meet these requirements, you'll be treated as if the contribution went to the traditional IRA in the first place. And you don't have to pay tax on the earnings that are transferred from one IRA to another. The IRS calls this a recharacterization.
Example: Suppose you contribute $5,000 to a Roth IRA early in 2011, expecting your modified AGI to be below the income limitation for Roth IRA contributions. At the end of the year you find that your modified AGI is higher than expected and your Roth IRA contribution limit is $3,000. Before October 15, 2012 you have the trustee of your Roth IRA transfer $2,000 plus the earnings attributable to that $2,000 directly to a traditional IRA. You're treated as if you originally contributed $3,000 to the Roth IRA and $2,000 to the traditional IRA.
Note: Some people mistakenly believe a recharacterization can be used only as a way to undo a Roth conversion, but it can also be used to change the type of IRA to which a contribution was made.
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. But you'll benefit from a recharacterization only if you're permitted to contribute to a regular 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. For example, if you waited more than 60 days to complete a rollover, you won't be able to fix the problem by making a recharacterization.
Later withdrawal. If you fail to take a corrective distribution within the time period described above, you'll incur the excess contribution penalty for the year of the contribution and incur it again for each subsequent year it remains uncorrected. You can prevent it from applying to a subsequent year by withdrawing the excess from your Roth IRA, but the rules here are different than for the type of correction described earlier:
Contribute less than maximum. The last way to correct an excess contribution is to contribute less than the maximum in a subsequent year. For example, if you have a $2,000 excess contribution in 2011 and you contribute at least $2,000 less than the maximum you're allowed to contribute in 2012, you'll incur the excess contribution penalty for 2011 but not for 2012 or later years. The nice thing about this particular method of correction is that it sometimes happens purely by accident: people sometimes discover an excess contribution from a few years earlier and find that it was automatically corrected in a subsequent year when they contributed less than the maximum.
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