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 of 6% so it’s important to stay on top of how much you’re contributing and what your running total for the year is. 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 the tax year 2023, you can contribute a maximum of $6,500 ($7,500 if you are older than 50) to your traditional and Roth IRAs. These contribution limits increase to $7,000 in the tax year 2024 ($8,000 if at age 50 or above).
For Roth IRAs, the IRS has set an additional limit based on your modified adjusted gross income. So i f you are a married taxpayer filing jointly or a qualifying widow(er) in 2023, you must make less than $218,000 to contribute up to the maximum IRA limit. That number goes up to $230,000 in 2024.
If you file as single, head of household, or married separately (meaning your spouse does not live with you) in 2023, you must earn less than $138,000 to contribute up to the maximum limit. ($146,000 in 2024). And if you’re a married taxpayer who filed separately and lives with your spouse in 2023 or 2024, 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 of the IRS rules, you might have to pay a 6% tax penalty on the full amount that is over.
The IRS provides a specific method for calculating any excess contributions that you may have. This can help you determine how much you may need to withdraw from the account or attribute to the following year. In order to make the calculation, you’ll need the excess contribution amount, the adjusted opening balance and the adjusted closing balance.
The adjusted opening balance is your previous IRA balance plus all contributions, including the excess amount. This includes any consolidations or transfers into the account since the contribution occurred.
The adjusted closing balance is the current value of the IRA minus all distributions, consolidations and transfers that took place since the contribution occurred.
The calculation for the net income is:
Net income = excess contributions * ((ACB – AOB)/AOB)
While maxing out your IRA contributions is beneficial, no one wants to pay an unnecessary fee because they contributed too much. Even if a mistake is made, though, it’s not too late to correct it so that you don’t have to pay the fee. Here are the options you can undertake when you determine that you went over the contribution limit.
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 tax filing deadline to take the money back out, which typically falls in April of the year following the tax year. If you 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.
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 $6,000 in your Roth IRA for this year. The annual contribution limit is set at $6,500 in 2023. Instead of taking the money out, you could carry the $500 difference over and limit your additional contributions next year to $6,500 (instead of taking the 2024 increased contribution amount of $7,000).
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).
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.
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.
Photo credit: ©iStock.com/Spydr, ©iStock.com/Nuli_k, ©iStock.com/Mikolette
Rebecca Lake, CEPF®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, CreditCards.com 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. Rebecca also holds the Certified Educator in Personal Finance (CEPF®) designation.
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