What To Do When You Over Contribute to an IRA
Updated: Jan 26, 2021
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.