Money Matters: Removing excess Roth IRA contributions

Jeff Witz, CFP

It is not uncommon for residents and fellows to contribute directly to a Roth individual retirement account (IRA) while completing their training. However, many can find themselves in a precarious position in the year their training ends and their first attending position begins. That year may be split between a role that paid a modest amount and a new role that pays significantly more. Many don’t realize that if their annual income is above certain amounts, they are prohibited from contributing directly to a Roth IRA. As a result, Roth IRA contributions are made that shouldn’t have been, which the Internal Revenue Service (IRS) refers to as an excess contribution. This can lead to costly taxes and penalties if the excess is not removed in a timely manner.

Fortunately, the IRS recognizes that there are several reasons why someone might make an excess contribution and provides ways to correct it. As mentioned, you could have had a spike in income, accidentally contributing directly to your Roth IRA instead of going through the backdoor IRA conversion process, or maybe you were just unaware that the IRS sets income limits on Roth IRA contributions. Depending on how quickly you discover the error and correct it, the IRS may not penalize you at all or give you time to fix the error. However, if the money stays in the account long term, the penalties can be severe.

As a reminder, your income plays a significant role in determining whether you can contribute to a Roth IRA. If you file your taxes as single, your ability to contribute to a Roth IRA in 2024 is limited if your modified adjusted gross income (MAGI) is more than $146,000 and is eliminated altogether with a MAGI of more than $161,000. If you file your taxes as married filing jointly for 2024, those income level limitations jump to $218,000 and $228,000, respectively. If you are married and file separately, your ability to contribute is eliminated at a MAGI of $10,000.

If you earned more than these limits and directly contributed to your Roth IRA, you have made an excess contribution and corrective actions must be taken. The IRS penalty for failing to remove an excess contribution can be substantial—6% each year the excess amount remains in the account. If you don’t catch the error for many years, the penalty can really add up.

These are your options for correcting an excess contribution:

Withdraw the excess contribution before filing your tax return. The IRS treats this as though the contribution never happened, and no 6% penalty will apply. You must also remove any earnings on the investments during that time period. The earnings must be included in your income, and you will have to pay income taxes on them. If you are younger than 59 years and 6 months, you will also need to pay a 10% early withdrawal penalty, but only on the investment earnings attributed to the excess contribution. The sooner you remove the excess contribution, the less likely there will be substantial investment growth, so less tax and penalty will be owed.

Withdraw the excess contribution before the October 15 tax extension deadline. If you didn’t catch the error before you filed your taxes, you can still withdraw the money and submit an amended tax return up to 6 months after your initial tax filing due date (usually October 15). The same rules as above will apply, and there is no additional penalty.

Apply the excess contribution to the subsequent year. If this was a 1-time occurrence where your income exceeded the limits but the following year you will be eligible to contribute to a Roth IRA, you can have the excess contribution amount moved to the next year. You will still have to pay the 6% penalty for the current year, but at least you will avoid incurring future penalties. This option is not available if your income will still be above the MAGI limits the following year.

Withdraw the money at a later time. Some people do not catch their error for years. This can be an expensive mistake, but you will always have the option of taking the money out and correcting the error. However, remember that each year the money stays in the account, you will owe a 6% tax on the excess contribution amount. For example, if you made a $7000 excess contribution and did not catch the error for 3 years, you will owe $1260 in taxes ($ 7000 × 6% × 3 years) when you remove the money from the account.

An excess contribution into a Roth IRA can be a hassle, but it is correctible. The sooner you fix the error, the less painful and less expensive the process will be. If you discover you made an excess contribution into your Roth IRA, we highly recommend speaking with your financial adviser and certified public accountant to assist you with making the necessary corrections.

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MEDIQUS Asset Advisors, Inc. does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.