Maxing out your 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. Regardless of how you ended up with excess contributions, it’s important to make sure you correct your mistake and minimize the financial damage. If you’ve got too much money in your IRA, here’s what you can do about it.
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
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 (as of 2019). The contribution limit will also be $6,000 in 2020 (for both 2019 and 2020, the contribution limit for those aged 50 years and over is $7,000). Instead of taking the money out, you could carry the $500 difference over and limit your additional contributions for 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.
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 70 1/2, additional contributions to a traditional IRA aren’t allowed.
Related Article: Roth IRA Conversion
Keep an Eye on the Calendar
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.
And if you’re struggling to manage your retirement accounts on your own, don’t hesitate to get help from a financial advisor. The SmartAdvisor matching tool can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and goals. Then the program will narrow down your options from thousands of advisors to three fiduciaries who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
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