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03/06/09 - Excess Roth Contributions

By: Jeremy Carpenter, MBA

Many people are aware that an IRA is a great tool to save for retirement and most people know the general maximum allowable contribution ($5,000 plus $1,000 catch-up if over age 50) in any given year.  However, most people don't stop to confirm how much they are permitted to contribute or whether they are eligible at all.  This article, which will be one of a few additional ones on the broader topic of IRAs, will examine the requirements that must be met in order to contribute to a Roth IRA and how to rectify an excess contribution if one is made.

Roth contribution eligibility:

• Income eligibility. This is the first limit in being able to contribute to your Roth IRA.  Roth IRAs are meant for the working class, not wealthy individuals, and therefore the maximum contribution allowable is phased out based on your modified adjusted gross income (MAGI).  The table at the end illustrates this.

For example, if you are married and file jointly and you made over $159,000 (let's say you made $163,001), then you would only be able to contribute $2,500.  If you are over 50 years of age, you are eligible for a catch-up contribution of $500 meaning your total contribution can be $3,000.

• Contributions must be made based on taxable compensation.  This includes wages, salaries, tips, professional fees, bonuses, and other amounts received for providing personal services. It also includes commissions, self-employment income, and taxable alimony and separate maintenance payments.  You can only contribute the lesser of the maximum contribution allowed or your total taxable compensation for the year.

Looking at another example, we'll say you are over 50 and are semi retired so you only received a salary of $4,000.  Even though you would normally be eligible to contribute up to $6,000, in this instance, you are capped at your $4,000 taxable compensation amount.

• Your total contribution to your IRAs can't exceed your maximum allowed contribution for the year.

For example, if you have multiple IRAs, Traditional and/or Roth, the combined contributions can't exceed your maximum allowed for the year.  Let's say you are single, 30 years of age and make $90,000.  You already contributed $3,000 to a traditional IRA.  This means that you can only contribute $2,000 to a second traditional IRA or a Roth IRA because you can't exceed the total maximum contribution of $5,000 allowed to you.

Another example would be if you made $110,000, are single and under 50.  In this scenario, you could only contribute $2,000 to your Roth IRA, but you can make up the difference between $5,000 by contributing a maximum of $3,000 to your Traditional IRA.  In this example you couldn't contribute to a second Roth because of the phase out rules.

People commonly over contribute because they didn't earn any income, contributed more than they earned, earned too much and were restricted, invested in more than one IRA or even miscalculated their MAGI.  So what should you do once you've realized that you've made an excess contribution?  You have a few options depending on when you caught the mistake.

• Removal of excess contribution - A removal of excess contribution from a Roth can only be done penalty free when the error is caught and corrected before the tax filing deadline (plus extensions) of the year the contribution was made and reported on your tax return.  For example, if you made a contribution on February 2, 2008 for the tax year 2007 you would have until April 15, 2008 (plus any filing extensions) to correct it.  On the contrary, if you were to have made the contribution on April 16, 2008, you would have to recognize it as a 2008 contribution but would then have until April 15, 2009 (plus extensions) to correct it.  Any earnings from the contribution must be calculated and withdrawn as part of the excess distribution as well.
• Recharacterize the contribution - If you over contributed to your Roth due to the phase out rules, you should still be eligible to make that contribution to your Traditional IRA.  As long as you catch this mistake in the same tax year you can recharacterize the excess money and move it to your Traditional IRA.
• Distribution - If the tax filing date has passed, you will be charged a 6% excise tax for each year the excess portion of your funds remains in your Roth account.  You must take a distribution of the principle amount of the contribution (adjusted for any earnings or loss) to rectify the problem.  Only the earnings portion will be penalized 10% for an early withdrawal, if applicable.

If you find yourself in one of these situations, please contact your financial advisor to correct the problem.  Your advisor will be able to calculate any earnings or loss on the excess and will supply you with a simple distribution form for the withdrawal or recharacterization.

** The limit may become $8,000 if you participated in a 401(k) with an employer who went bankrupt in an earlier year.
*** You can find modified adjusted gross income by adjusting your gross income on your tax return as follows:

• 1. Subtract the following:
• a. Conversion income. This is any income resulting from the conversion of an IRA (other than a Roth IRA) to a Roth IRA.
• b. Minimum required distributions from IRAs, (for conversions only).
• 2. Add the following deductions and exclusions:
• a. Traditional IRA deduction,
• b. Student loan interest deduction,
• c. Tuition and fees deduction,
• d. Domestic production activities deduction,
• e. Foreign earned income exclusion,
• f. Foreign housing exclusion or deduction,
• g. Exclusion of qualified bond interest shown on Form 8815, and
• h. Exclusion of employer-provided adoption benefits shown on Form 8839.

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