On the Excess Contribution to a Roth IRA
In 2007, I contributed too much to my Roth IRA. The max per year is $4000, and I thought I could contribute the max but the year didn’t work out that way. Uh oh, what to do? Well, the IRS can at times be understanding, so there’s a procedure in place, which is outlined in Publication 590:
A 6% excise tax applies to any excess contribution to a Roth IRA.
Excess contributions. These are the contributions to your Roth IRAs for a year that equal the total of:
- Amounts contributed for the tax year to your Roth IRAs (other than amounts properly and timely rolled over from a Roth IRA or properly converted from a traditional IRA, as described later) that are more than your contribution limit for the year (explained earlier under How Much Can be Contributed?), plus
- Any excess contributions for the preceding year, reduced by the total of:
- Any distributions out of your Roth IRAs for the year, plus
- Your contribution limit for the year minus your contributions to all your IRAs for the year.
Withdrawal of excess contributions. For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made.
Applying excess contributions. If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year.
All I see is “blah blah blah”, but at least I know I’m not in some sort of big trouble!
However, all this makes for an interesting point: if you had a good year, then you might as well pay the 6% excise tax. Why? Well, if you withdraw the money, then you’ll have to pay taxes on those earnings, which may be much more than 6%! As long as you expect to be able to apply those excess contributions in the future, then you will likely save/make more money by contributing the max as early as possible to your Roth IRA to give your money as much time as possible to grow tax-free (aside from that possible 6% excise tax).
Am I missing something here???
Also, in case you’re wondering how to calculate the amount to withdraw, then check out this Investopedia article. It explains that it’s simply done on a pro rata basis on the total fair market value of your Roth IRA. Although this may be a pain to calculate by looking at old account statements, I think most brokers have procedures in place to automatically withdraw excess contributions. Mine does. All I have to do is tell them how much the excess contribution is, and they calculate for me what the earnings are on that amount.
February 1st, 2008 at 5:07 pm
I agree entirely. Contribute the full amount regardless of earnings and if you are over the income limit, pay the 6% excise tax.
Assuming an 8% return, you will recoup the tax within the first year and reap the tax free earnings from then on. If you sit down and do the math, you will see that it makes sense to contribute the maximum if you are more than a few years from retirement.
October 3rd, 2008 at 6:47 pm
am i reading that incorrectly…
you have to ADD the excess contributions from the preceding year, so that 6% can compound annually on itself.
so no, you will not get a tax benefit by having excess contributions.