So we talked last time about the problems with being on the threshold of the Roth IRA income limits. If you make way too much or way too little, then you know where you stand in terms of being able to contribute. It’s just that middle area, where you may or my not be able to contribute, that can be a problem.
This could happen to anyone. You could get a big raise at work. Anything that adjusts your Modified Adjusted Gross Income upward can do this.
The question is: if it turns out that you’ve contributed too much, what do you do?
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Let’s take an example. Jamie, who is married and filing jointly, has a MAGI of $195,000. Jamie is under 50, so does not qualify for the “catchup contribution”.
If Jamie and partner had made less money, then they would be eligible for the total per-individual contribution rate of $6,000. But because of their income, they are only allowed to contribute $4,800. (See charts here.)
The problem is that Jamie got an unexpected end-of year bonus at work. The couple had contributed the maximum of $6,000 per person throughout the year, but now it turns out that Jamie contributed $1,200 too much.
What can Jamie do?
Option 1: Before taxes are filed
There are two scenarios here: if the error is discovered before filing taxes for the year, or after.
Before filing taxes is much simpler. The deadline, incidentally, can be extended to October 15th, but in general you want to do this as quickly as possible.
This is because you have to withdraw not only the excess contributions, but also the earnings from those contributions.
Vanguard, for instance, doesn’t let you do this online. You have to fill out a form and mail it in.
But this error is still costly. You will be taxed on your earnings as ordinary income, and also possibly be charged the 10% early withdrawal penalty.
So if Jamie wanted to correct this error before April 15th, there would need to be a withdrawal of $1,200 plus earnings (let’s say it was $50; a sample calculation can be found here). Jamie would pay a 10% penalty on that $50 earnings.
There are other things Jamie can do, such as recharacterize the contributions as a Traditional IRA. This lets you keep the money in a valid retirement account, and gets you a bit of a tax break too.
Option 2: After taxes are filed
After the deadline (October 15th if proper extensions are granted), you will be charged a 6% penalty on this extra amount every year until the amount is corrected. Forever.
Even though the amounts we’re talking about are small (for example, 6% of $1,200 is only $72), that’s still money, and an administrative headache you don’t need.
So you’ll want to pay the fee, and then go back and do that withdrawal or recharacterization.
Obviously, it’s best to not get into this situation.
But also obviously, if you’re in this situation, you’ve done well for yourself, income-wise.
Only about 30% of households make more than $100,000 a year in the U.S., and $120,000 puts you above the 77 percentile.
So excess Roth IRA contributions are a problem, but not a big one. Just fix it and move on. And maybe eventually you’ll make too much to contribute at all.
Have you ever contributed too much to your Roth IRA?