How to Manage Excess IRA Contributions - Tax Professionals Member Article By Abundant Wealth Planning LLC
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How to Manage Excess IRA Contributions

How to Manage Excess IRA Contributions

Maximizing your Individual Retirement Account each year is smart when you're focused on increasing your retirement fund. But contributing excess money can result in a tax penalty. Many taxpayers use a financial advisor to avoid excessive contributions and optimize their retirement strategies. If you have a lot of money in your IRA, here's what you can do about it.

The IRS sets IRA earnings and contribution limits each year. For fiscal years 2021 and 2022, you can contribute up to $6,000 ($7,000 if you're over 50) to traditional and Roth IRAs.

The IRS has set an additional limit for the Roth IRA based on modified adjusted gross income. So if you are a co-filer, married taxpayer, or qualified widow in 2022, you must earn less than $204,000 to contribute up to the IRA limit. If you claim to be a single individual, head of household, or married filing separately, you are expected to earn less than $129,000 to contribute to the maximum limit. And if you're a married taxpayer filing separately and living with your spouse, you are expected to earn less than $10,000 and can only contribute a small amount.

Please note that if you exceed your income limit or part of your IRA contribution exceeds IRS rules, you may have to pay a 6% penalty.


How to Fix Excess IRA Contributions

1. Withdraw extra money

The IRS allows you to withdraw excess IRA contributions without penalty, as long as you do so before the tax filing deadline. You have until the April tax deadline to withdraw your money for contributions made in the current fiscal year. If you usually apply for an extension, you have until the deadline to receive the extra money.

You will also need to withdraw any earnings from the money generated while in the IRA when you withdraw your contributions. The profits must then be entered in the tax return as ordinary income. In addition to paying tax on the money, if you are under 59.5, you will also be charged a 10% withdrawal penalty.


2. Carry the Excess Contribution Forward

A second option is simply applying the excess contributions to your IRA savings for the next fiscal year. For example, suppose you saved $6,500 in the Roth IRA this year. The annual contribution limit is $6,000 (for fiscal years 2021 and 2022) and $7,000 for those over 50). Instead of withdrawing the money, you can carry the $500 difference over and limit additional contributions to $6,000 for next year's tax.

Carrying the excess contribution forward is a little easier, but that doesn't rule out a tax penalty. The IRS imposes a 6% penalty for excess contributions that are not corrected each year. If you carry forward a contribution of $500, you will have to pay a tax penalty of $30 (6% of $500 = $30).


3. Re-characterize your Roth

Your ability to put money in a Roth IRA is based on adjusted gross income for the year. If you run out of Roths and then find that you don't qualify because your income is too high, all that money will be considered too much of a contribution. However, you can avoid the 6% penalty by converting your account to a traditional IRA.

When you recharacterize a Roth, the IRS treats you as if you were making your first contributions to a traditional IRA. This means that any sanction is waived as long as the amount does not exceed the annual contribution limit. If you plan to go this route, you must do so before the tax filing deadline.

You will also need to verify your eligibility to contribute to a traditional IRA. If you are over 72, no additional contributions to a Traditional IRA are permitted.


Bottom Line

When you plan to eliminate excess IRA contributions, it's a good idea to do so as soon as possible. Ideally, you'd like to resolve the issue before the end of the current fiscal year rather than waiting for the tax filing deadline.

If you file your return without noticing your mistake, the 6% penalty will automatically apply, and you will not be able to retroactively recharacterize a Roth IRA at that time. In this scenario, you would be stuck at paying the penalty for at least a year until you figure out what to do with the excess contributions.


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