The Roth IRA danger zone (part 3): How I resolved an excess contribution

With a number of different ways to resolve this problematic situation, here is how I dealt with an excess contribution to a Roth IRA.

More posts in this series:

Last year, I wrote two posts about contributing too much a Roth IRA.

The Roth IRA is an amazing tool in your investment and retirement arsenal, and generally speaking, if you can take advantage of the Roth IRA, you probably want to do so.

For most people, this is not a problem. There is a certain amount you are allowed to contribute each year, and you just remember to not go over this limit.

But this limit is not fixed for everyone. In fact, the yearly contribution limit is adjusted by two factors: your age and your income.

The age part is easy: If you’re over 50, you can contribute an extra $1,000 each year.

But it’s the income part that gets tricky, because the amount you can contribute changes depending on your income (specifically your Modified Adjusted Gross Income, or MAGI).

Meaning, if your MAGI is $125,000, your maximum contribution will be different from if your MAGI is $126,000. A small difference makes a big difference (see these charts for reference). And your MAGI can vary for lots of reasons. It’s not as simple as knowing your salary.

And so it happened that, because of some unexpected employee stock transactions that triggered for me, I ended up smack dab in the middle of the Roth IRA danger zone last year.

This is what I did about it.

Reviewing the options for an excess contribution

While I had an idea that I might have an excess contribution, it was only when I started to do my taxes that I confirmed this was the case.

TurboTax’s warning message to me

As I mentioned in a previous post, there are two primary ways to deal with an excess contribution: withdrawal and recharacterization.

And you can deal with this either before you file your taxes or after.

Before is most definitely easier, and offers fewer penalties, avoiding a 6% penalty every single year that that excess contribution remains in your account. (Yikes.)

But which option to choose? There were pros and cons to both. In brief:

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Withdrawal:

  • Pros: Simplest, most flexible
  • Cons: Have to pay taxes on earnings

Recharacterization:

  • Pros: Don’t need to take money out of your account, no taxes paid
  • Cons: More complex situation

The administrative pain

I called Vanguard (where my Roth IRA is held) and asked them what my options are, in the hope of getting “advice” from my person (in quotes because I know that they can’t offer real advice).

And while I didn’t really get much in the way of advice, I did learn that the recharacterization is actually a giant pain.

In that option, you convert that excess contribution from a Roth (post-tax) contribution to a Traditional (pre-tax) contribution. A Traditional IRA has no income limits, so that’s not a problem.

But there arises a different problem. That excess contribution has already had taxes paid on it, and you can’t pay taxes on money twice, so that money needs to be treated separately from within the account.

In effect, that money becomes sort of “quarantined” as a totally separate kind of money. And it will be that way forever.

Having two different kinds of money (taxed, untaxed) in the account means that you get into these complex situations where, for example, when you withdraw money from the account, a proportion of the withdrawal is taken from that taxed money at the same proportion of the taxed money to the non-taxed money.

So, if you had $100,000 in a Traditional IRA, with $1,000 recharacterized from a Roth, then if you went to withdraw $10,000, then $9900 would come out of the pre-tax money and $100 would come out of the post-tax money.

(I think the above is correct. I’m not a tax pro and don’t claim to be. But after talking to two tax pros plus Vanguard, this is how I understood it.)

Keeping it easy

Confused? Annoyed? Think the above is too complex? Well, I felt the same way.

Yes, I wouldn’t have to pay taxes on that excess contribution, but instead, I’d be dealing with an administrative headache for pretty much the rest of my life.

Personally, I’d rather pay the taxes.

And in my specific situation, how much tax could I possibly owe? Remember that you only pay taxes on earnings in a Roth, not the original contributions.

So if I earned 10%, then I’d have to pay taxes and penalties on only that? How much could that possibly be? I made the excess contribution at the end of the year. It couldn’t have been that much.

For my specific situation, it made so much more sense to withdrawal the excess contribution and pay any penalties I needed to pay rather than incur the headache of recharacterization.

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Would that be the same situation for you? Not necessarily. You might have a lot of penalty to take, and recharacterization may not be as big of a pain for you as it seemed to me.

This is just what I did. But if you’re in a situation similar to me, perhaps it will help.

(And is it weird to be dealing with this kind of situation given what else is going on? In a word, yes.)

In the next installment of this series, I’ll show how exactly I went about removing the excess contribution.

Would you have done this differently? Did you do this differently? I’d love to hear about your experiences in the comments below.

One Comment

  1. max

    This! All this! Vanguard nows lets you do this online (thanks COVID). A pro rata nightmare going forward if recharacterize!

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