Overcontribution to a Roth IRA
Roth individual retirement account (IRA) rules are complicated, and it's easy to run afoul of Internal Revenue Service (IRS) rules that govern how much money you can contribute to your account in any given year. Anyone can make a mistake--the important thing is to spot an overcontribution and correct it before you incur a penalty.
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Significance
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Roth IRAs are excellent investment tools, but their benefits are limited--the IRS determines who may contribute to an IRA and how much. As of 2010, people who are married, filing jointly and make up to $167,000 can each contribute $5,000 to an IRA. Couples who make up to $177,000 are phased out, meaning that as their income nears this limit, they can only contribute a percentage of the maximum contribution. Those filing singly can contribute $5,000 if their income does not exceed $105,000 and less if their income is up to $120,000.
Types
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There are several ways you could mistakenly contribute too much to a Roth IRA. If you spread your maximum contribution among multiple accounts, you may have lost track and exceeded the limit. You could have calculated your maximum contribution and deposited that sum into your Roth account, only to discover that, due to a pay increase or bonus, you made too much to qualify for some or all of it. The IRS also requires that IRA contributions be made from earned income--so you could potentially make a contribution from inherited income or capital gains, only to realize that your earned income was not enough to cover it.
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Warning
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If you overcontribute to an IRA and do not correct it, the IRS charges a 6 percent penalty on the excess amount each year it is left in your account. For example, assume you are single and began earning a salary of $97,000 in 2010. Being an intrepid long-term investor, you contributed $5,000 to your Roth IRA in February. But mid-year, you got a promotion, and by the end of 2010 your adjusted gross income was $110,000. According to the IRS's phase-out tables, your maximum allowable contribution is $3,340--which means you contributed $1,660 too much. If you take no action, the IRS can charge you a $99.60 penalty on your excess contribution.
Prevention/Solution
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You have until your filing deadline to correct the excess contribution and fix it--and that includes an extension if you file for one. One way around the penalty is to withdraw the excess contribution you placed in the account--taking care to also withdraw the earnings on that money. The excess earnings are taxed as the previous year's income, even if you withdrew them after December 31.
Potential
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Though there are income limits for Roth IRAs, as of 2010 there are no income limits on rollovers. You could recharacterize your excess Roth IRA contribution, which means you can change your mind about what type of contribution you would like to make. Non-deductible, traditional IRAs offer limited tax savings, but they have no income limits. Once your money is in a non-deductible, traditional IRA, you can roll it into a Roth IRA, regardless of your income, thus avoiding the 6 percent penalty and the taxed earnings from your excess contribution.
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References
- Photo Credit A businessman calculating expenses at tax time image by Christopher Meder from Fotolia.com
