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How to Handle Excess IRA Contributions

Maxing out your individual retirement account (IRA) each year is a smart move when you’re focused on growing your retirement fund. But contributing too much money can result in a tax penalty. Many taxpayers work with a financial advisor to avoid excess contributions and optimize their retirement strategies. If you have too much money in your IRA, here’s what you can do about it.

The IRS sets IRA income and contribution limits each year. For tax years 2020 and 2021, you can contribute a maximum of $6,000 ($7,000 if you are older than 50) to your traditional and Roth IRAs. 

For Roth IRAs, the IRS has set an additional limit based on your modified adjusted gross income. So if you are a married taxpayer filing jointly or a qualifying widow(er) in 2020, you must make less than $196,000 (less than $198,000 in 2021) to contribute up to the maximum IRA limit. If you file as single, head of household, or married separately (meaning your spouse does not live with you) in 2020, you must earn less than $124,000 (less than $125,000 in 2021) to contribute up to the maximum limit. And if you’re a married taxpayer who filed separately and lives with your spouse in 2020 and 2021, you must earn less than $10,000 and can only contribute a reduced amount.

Note that if you are over the income limit or if any part of your IRA contribution is in excess to the IRS rules, you might have to pay a 6% tax penalty.

How to Fix Excess IRA Contributions

1. Take the Extra Money Out

The IRS lets you pull out excess IRA contributions without penalty as long as you do it before the tax filing deadline. For contributions made in the current tax year, you have until the April tax filing deadline to take the money back out. If you normally file an extension, you have until the extension deadline to take back your extra money.

When you’re pulling out contributions, you’ll also have to take out any earnings the money generated while it was in the IRA. The earnings then have to be included on your tax return as ordinary income. Aside from paying taxes on the money, you’ll also have to pay a 10% early withdrawal penalty if you’re below the age of 59 1/2.

2. Carry the Excess Contributions Forward

How to Handle Excess IRA Contributions

A second option is to simply apply the excess contributions to your IRA savings for the next tax year. For example, let’s say you saved $6,500 in your Roth IRA for this year. The annual contribution limit is set at $6,000 (for tax years 2020 and 2021), and $7,000 for those aged 50 years and over). Instead of taking the money out, you could carry the $500 difference over and limit your additional contributions next year to $6,000.

Carrying the excess forward is a little easier but you won’t avoid a tax penalty. The IRS applies a 6% penalty to excess contributions for every year they aren’t corrected. If you were to carry forward a $500 contribution, you’d owe a $30 tax penalty (6% of $500 = $30).

Check out our federal income tax calculator.

3. Recharacterize Your Roth

Your ability to invest in a Roth IRA is based on your modified adjusted gross income for the year. If you max out a Roth and then find out that you weren’t eligible to do so because your income was too high, all of that money would be considered an excess contribution. You can get around the 6% penalty, however, by turning your account into a traditional IRA.

When you recharacterize a Roth, the IRS treats it as if you had made the original contributions to a traditional IRA. That means any penalties would be erased, assuming the amount doesn’t exceed the annual contribution limit. If you’re planning to go this route, you’ll need to do it before the tax filing deadline.

You’ll also need to check your eligibility to contribute to a traditional IRA. If you’re over age 72 additional contributions to a traditional IRA aren’t allowed.

Related Article: Roth IRA Conversion

How to Handle Excess IRA Contributions

Bottom Line

When you’re planning to remove your excess IRA contributions, it’s a good idea to do it sooner rather than later. Ideally, you’d want to address the issue before the current tax year is out, instead of waiting until the tax filing deadline.

If you file your return without realizing your mistake, the 6% penalty will automatically apply and you won’t be able to retroactively redesignate a Roth IRA account at that point. In that scenario, you’d be stuck paying the penalty for at least one year until you can figure out what you’re going to do with the extra contributions.

Tips to Reach Your Retirement Goals

  • If you’re struggling to manage your retirement accounts on your own, don’t hesitate to get help from a financial advisor. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors who can help you achieve your financial goals, get started now.
  • If you want to know how much you will need to save to retire comfortably, SmartAsset’s retirement calculator can help you set up and plan your retirement goals.
  • If you are taking advantage of your employer 401(k) matching, SmartAsset’s 401(k) calculator can also help you figure out how much you will have based on your annual contribution and your employer’s matches.

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Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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