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Correcting an Excess Roth IRA Contribution

A reader writes in, asking:

“Way back in January, I maxed out my Roth for the year. Income-wise it turned out to be a better year than I expected and now, barring an immediate layoff, my income for 2013 will be too high to actually be eligible for Roth contributions. I’ve read that it’s a 6% tax if I just leave the money there. That doesn’t sound so bad actually. Thoughts?”

Yes, there is a 6% penalty on (uncorrected) excess IRA contributions. A key point to understand, however, is that it’s a 6% penalty per year for each year in which the excess contribution remains in the account.

So how do you fix the problem? You have a few options.

Option #1: Recharacterize the Contribution (and Earnings)

Often, the best way to deal with the situation is to contact your brokerage firm to ask them to “recharacterize” the contribution (and any associated earnings) as a traditional IRA contribution rather than a Roth IRA contribution. They will then remove the excess contribution and earnings from your Roth IRA and move it to a traditional IRA. If you do this by the due date of your tax return for the year (including extension, if applicable), it will simply be treated as if you made the contribution to the traditional IRA in the first place.

For example, if you contributed $5,500 to your Roth IRA in 2013, but turned out to be ineligible to make a Roth IRA contribution, you have until April 15, 2014 (or October, 15, 2014 if you file for an extension) to recharacterize the contribution by having your brokerage firm move the $5,500 and associated earnings to a traditional IRA.

Some taxpayers will find that, after recharacterizing the contribution as a traditional IRA contribution, they will then want to convert it to a Roth IRA as a part of a “back-door Roth” strategy.

Unfortunately, recharacterization is not a solution in cases in which the excess Roth contribution would be an excess contribution even if it was made to a traditional IRA instead (e.g., because you contributed $4,000 at each of two different brokerage firms, thereby exceeding the $5,500 limit or because your contribution was in excess of your compensation for the year).

Option #2: Withdraw the Excess Contribution (and Earnings)

A second way to avoid the 6% penalty is to simply take the excess contribution (and associated earnings) back out of the account. As with a recharacterization, you have until the due date of your return (including extensions) to withdraw the excess contribution in order to avoid the 6% penalty for the year.**

One drawback of this approach is that the earnings that you take out of the account will be taxable as income and (unless you’re over age 59.5 or you meet one of the other exceptions) subject to the 10% penalty for early distributions of earnings from a Roth IRA.

Option #3: Do Nothing

If you are confident that your income next year will be such that you’d be allowed to make a Roth IRA contribution, you can simply leave the amount in the account this year, and under-contribute next year by the appropriate amount.

Example: Samantha contributes $5,500 to her Roth IRA in 2013, but, due to unexpectedly high income, she turned out to be ineligible to make a Roth IRA contribution. In 2014, however, her income is significantly lower, and she is eligible to contribute the full $5,500. If she contributes nothing in 2014, that unused $5,500 contribution limit can count toward rectifying the prior $5,500 excess contribution. As a result, she’ll have to pay the 6% penalty in 2013, but not in 2014.

Drawbacks of this approach are that it results in an avoidable 6% penalty (for the year of the excess contribution), and it sets you up to potentially have to pay the penalty next year as well, if your income once again turns out higher than expected.

**In years after the year in which the excess contribution was originally made, you only have until 12/31 to withdraw the excess contribution in order to avoid the 6% penalty for the year. (For example, if you make an excess contribution in 2013 and do not correct it in 2013, in order to avoid the penalty for 2014, you have to correct the excess contribution by December 31, 2014.)

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