What To Do When You Over Contribute to an IRA
Updated: Jan 26
In the Financial Independence and Personal Finance community, we frequently talk about taking advantage of tax advantaged accounts first, like 401Ks and IRAs (Individual Retirement Accounts), but we also have to remember that these accounts are "advantaged" for a reason. The IRS sets rules and limitations around these accounts to prevent people (typically high income earners) from using these accounts as tax havens.
While a raise or big bonus is almost always a good thing, it could also mean that it pushes you into an ineligible income bracket for some of these tax advantaged accounts, particularly IRAs.
When it comes to the rules around eligibility for tax advantaged accounts, it is important to remember,
Just because you were eligible to contribute in previous years, does not mean you will be eligible in the current (or in future) year.
How do I know if I am eligible (or ineligible) to contribute?
If you received a raise or a bonus this past year, it is important to check your year end pay statement, as well as your spouse's if you file your taxes as married filing jointly or separately, to make sure you did not "phase out" of contribution eligibility.
This is particularly important for Roth IRAs, which can have additional taxes and penalties associated with over contributing or contributing when ineligible.
If you contribute more than the Traditional IRA or Roth IRA annual contribution limits, the IRS imposes a 6% tax penalty on the excess amount for each year it remains in the IRA. This means that if the annual contribution limit that you are eligible for is $6,000 in 2020 and you contributed $7,000 in 2020 to your IRA, you will not only pay income tax on the overage amount ($1,000), but an additional 6% excise tax for each year that money remains in your IRA.
There is also the case where you may have been eligible for the full annual contribution (e.g. $6,000 in 2020), but due to raises, bonuses, starting a new job with a higher salary, or even getting married and changing your filing status, you are no longer able to contribute the full amount (if any) to a Roth IRA or receive the tax deduction for a Traditional IRA.
For Traditional IRAs, rather than set an income limit on who can contribute, the IRS sets a limit on who can receive a tax deduction from a Traditional IRA. Depending on your tax filing status, your modified adjusted gross income (MAGI) must be below a certain threshold to receive either the full or partial tax deduction. See our article, So What's a Traditional IRA Anyway, for more information on income levels and eligibility.
Roth IRAs are different, and have an income limit on who can contribute based on your tax filing status, as well as restrictions on how much you can contribute. The limit is based on your MAGI (Modified Adjusted Gross Income), which in most cases, can be estimated based on the MAGI from your previous year’s AGI (Adjusted Gross Income). However, if you received a salary increase or bonus this year, you could no longer be eligible to contribute the full amount, or at all, to a Roth IRA. See our article, So What's a Roth IRA Anyway, for more information on income levels and eligibility.
So what are you to do if you over contribute?
If you over contribute to an IRA, or contribute more than you are eligible for, and don’t fix the mistake, you will owe the IRS a 6% tax penalty each year the excess remains in your account.
If you have over contributed to an IRA and the error is caught early enough (i.e. before the tax year has closed -- typically April 15th of the filing year), you may be able to remove the excess amount with limited or no additional penalties. Contact the IRA brokerage or custodian and ask for at least the excess contribution to be returned. The custodian will return to you the amount of the contribution that you requested, plus any gains or losses that are attributable to that contribution.
While there may be no additional taxes or penalties on the return of the contribution, you will owe income taxes on any gains made on that excess amount. For example, if you contributed $1,000 in excess to a Roth IRA in 2020 and made a $120 gain on that excess, then requested a return of the excess ($1,000) in January of 2021, you would receive the $1,000 excess contribution plus $120 gain, but only owe taxes on the $120 gain. This would be included when you file your 2020 taxes.
In the case that you had a loss on the excess contribution, you would not receive any benefits on the losses of the contribution (i.e. you will not be able to deduct any capital losses to lower your overall tax liability). So in the same example of a $1,000 excess contribution, if you had a loss of $120, you would still need to request the full $1,000 excess contribution, but not be able to write off the $120 loss when you file your 2020 taxes.
While you have until the tax return filing deadline to do this, typically April 15th of the tax filing year, the sooner you do it, the better.
If you believe you have over contributed in previous years (i.e. after the tax year has been closed) or are unsure if you have over contributed and what your tax liabilities may be, be sure to check with a tax professional as soon as possible to determine the best course of action and to minimize penalties.
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