I Think I Over-contributed to My Roth IRA...

Based on how things are looking for my family this year, I think I may have over contributed to my Roth IRA. What should I do to fix this?

— Concerned.

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Dear Concerned,

If you’ve read our blogs or listened to the podcast for long, you probably know we’re fans of Roth IRA accounts. A Roth allows you to save money that you’ve already paid income tax on and let it grow tax free. When the time comes to withdraw the money (hopefully in retirement), you’ll be able to take the money out tax free after age 59 ½ . If this sounds like a great deal that’s because it is. However, not everyone is eligible to make contributions each year.

Roth contributions can only be made by people who have an income that qualifies. If you’re an individual, your ability to make contributions begins to be phased out once your modified adjusted gross income reaches $124,000. If your modified AGI is $139,000 or higher, you’re ineligible to make any contribution to your Roth. If you’re married filing jointly, you will be subject to a phaseout as well, only the income limits are $196,000 to $206,000.

In the question asked, however, the contribution has already been made and it seems as though an adjustment, or recharacterization, might be required.

First, the good news. The adjustment isn’t required to happen until you file your tax return for this year. You don’t need to hurry and make a change prior to that unless you are uncomfortable with the situation. This should give you some flexibility as things can play out a bit longer for you to determine what changes, if any, need to be made.

Let’s assume, however, that you’re right and your income will prevent you from making Roth contributions this year. You’re going to have three options to correct the situation prior to filing your tax return.

1. Withdraw the Money - Contact the company that has your Roth and tell them you made an ineligible contribution to your Roth and would like to remove that contribution and any net income attributable (NIA) to it. The NIA is the earnings the contribution received while it was invested in the account, and it has a surprise waiting for you. If you go this route you’ll owe taxes and penalty (if you’re under 59 ½) on the NIA when you withdraw it. Bummer. You’ll have to sign a form (or two) before the process is finished, but it should be pretty straightforward.

1. Recharacterize the Contribution - If you’re ineligible to make a Roth IRA contribution you’re probably also ineligible to make a deductible traditional IRA contribution. However, you could make a non-deductible IRA contribution. Again, your contribution and any NIA would need to be removed from the Roth and now placed in a traditional IRA account. You won’t get the normal benefit of the tax deduction, but the contribution will be allowed to grow tax free until you withdraw the money in the future. Count on some paperwork for this option, too.

1. Apply Contribution to Future Year - Finally, it’s possible to instruct your IRA plan administrator to simply apply the contribution (and NIA) to the next year as long as it’s done prior to your filing your taxes (plus extensions). And, as you’ve probably guessed, expect to sign a form or two.

If you’re wondering what happens if you don’t get this problem corrected, I’ll tell you. You can expect to be assessed a 6% penalty on the contribution. “Wait a second,” you may be thinking. “That doesn’t seem all that horrible. A 6% penalty might be a reasonable price to pay to keep the contribution in the Roth.”

If it were a one-time penalty, I might be inclined to agree with you. However, it’s a 6% penalty on the contribution every year until the error is corrected. So, let’s get this corrected prior to filing your taxes next year, okay?

Excess contributions to IRAs happen pretty frequently. Thankfully, they aren’t too difficult to get corrected. Contact your investment company and let them know what has happened and they’ll help you get things back in order.