The tax laws don’t limit how much your IRA investments can grow each year or how much you can roll over into your IRA from another tax-qualified account, but they do limit how much you can deposit as an annual contribution. Most IRA owners understand these limits, but excess contributions often happen inadvertently. Fortunately, you have multiple options for correcting an excess contribution.
Step 1: Determine if you have an excess in your IRA.
You have an excess for 2021 if you contributed more than
- $6,000 to your Traditional and Roth IRAs in aggregate if you’re under age 50, or
- $7,000 to your Traditional and Roth IRAs in aggregate if you’re 50 or older.
These types of excesses can happen when contributing to multiple IRAs in a year, or when a spousal IRA contribution gets deposited into the working spouse’s IRA. Also, if you complete more than one IRA-to-IRA rollover in a 12-month period or deposit an indirect rollover after the 60-day deadline, you have an ineligible rollover in your IRA. An ineligible rollover is generally deemed to be a regular contribution. If it exceeds your contribution limit, it creates an excess.
Excesses can also occur if your modified adjusted gross income exceeds the income limit for contributing to a Roth IRA, or you did not have sufficient “earned income” to make an IRA contribution.
Step 2: Understand the consequences.
The deadline for timely correcting an excess is your tax-filing deadline (including extensions) for the year for which the contribution was made. If your 2021 tax-filing deadline is April 15, 2022, and you timely file your tax return, you have until October 15, 2022, to correct the excess and avoid the 6% tax.
If an excess contribution is not corrected timely, you will be subject to a 6% tax on the excess amount each year it remains in the IRA. If you correct your excess contribution after you filed your tax return for the year, you may need to file an amended return.
Step 3: Pick a correction method based on your timing and tax strategy.
Your options for correcting an excess depend on when you complete the correction. If you correct the excess BEFORE your tax-filing deadline plus extensions, your options are…
- #1 – Remove
You can avoid the additional 6% tax if you timely remove the excess contribution from your IRA, along with any investment earnings associated with the excess amount. You will not owe tax on the excess you remove, but any earnings withdrawn must be included in your taxable income and are subject to the 10% early distribution tax if you are under age 59½. Your IRA custodian may be able to help you calculate the earnings attributable to the excess when you request a distribution of an excess.
- #2 – Recharacterize
If your excess is a result of not being eligible to contribute to a Roth IRA, or you have simply changed your mind about the type of IRA contribution you want to make, you can recharacterize a current-year contribution to the other type of IRA and avoid the additional 6% tax on a true excess. For example, if you contributed to a Roth IRA, you could treat that contribution as if it were made to your Traditional IRA by requesting a recharacterization and transfer from your IRA custodian and filing documentation with your tax return. Any investment earnings related to the excess must also be moved to the other type of IRA. This is an option only if you are eligible to contribute to the other type of IRA and the deadline for correcting an excess has not yet passed. There are no tax consequences for a recharacterization except that you must follow the tax rules for the type of IRA that receives the recharacterized contribution. For example, you cannot take a deduction for an IRA contribution that you recharacterize to a Roth IRA.
If you correct the excess AFTER your tax-filing deadline plus extensions, your options are…
- #1 – Remove
If you missed the deadline to correct an excess, you will owe the 6% tax on the excess for the tax year for which the contribution was made. You can avoid paying another year of additional tax by removing the excess. With this option, the investment earnings stay in the IRA. The withdrawal will be tax-free if made from a Roth IRA. It is also tax-free if made from a Traditional IRA if the excess contribution did not exceed the contribution limit for the year and you do not take a deduction for the contribution. If the Traditional IRA excess was caused by a contribution that exceeded the annual limit, the excess amount distributed will be taxable and subject to the 10% early distribution tax.
- #2 – Redesignate
Instead of removing the excess, you may choose to leave the excess in the IRA and redesignate, or carry over, the excess to “use it up” as an IRA contribution in a following year. You will owe the 6% tax for each year an excess amount is not used up, but you do not have to remove any money from your IRA. To use this correction method, you must be eligible to contribute to the IRA in the year you claim the contribution. The redesignation is handled on your tax returns, not with your IRA custodian.
If you have made an excess IRA contribution, contact your tax or financial advisor or STRATA Trust to review your options and tax consequences for correcting your excess.