The Internal Revenue Service sets limits on how much you can contribute to Roth IRAs. If you miscalculate and add too much money to your Roth IRA, you are supposed to remove the excess contributions. IRS rules allow you to take excess contributions out of your IRA without paying large penalties provided you do so in a timely manner.
You cannot contribute more than $5,000 a year to a Roth IRA, or $6,000 once you reach age 50. You also can’t add more than your adjusted gross income. In either case, adding too much is called an excess contribution by the IRS. The amount you may contribute is also reduced, and then eliminated, when your adjusted gross income is greater than the annual limits. If you make an improper rollover from another retirement plan, the IRS defines this as an excess contribution as well.
The IRS assesses a penalty of 6 percent of the amount of an excess contribution each year until the money is removed from your Roth IRA. Suppose you miscalculate because your income was more than the IRS annual limit and put in $2,000 too much. You’ll have to pay $120 in penalty tax each year the money stays in your Roth IRA. The penalty cannot be more than 6 percent of the total balance in all of your IRA accounts.
Removing Excess Contributions
When you make an excess contribution, you have until your tax return is due, including extensions, to remove the extra money and avoid the penalty tax. If you discover the error after you file, you can take the excess contribution out and file an amended return, again by your filing deadline including extensions. You must take out any earnings attributable to the excess money. These earnings are taxable and must be reported on your income tax return.
Later Year Removal
If you have not acted in time to keep from paying the penalty tax for previous years, you can avoid it for the current year by withdrawing the excess funds during the current year. For example, if you made an excess contribution in 2011 and the money was still in your account in 2013, you would pay the penalty tax for 2011 and 2012. However, if you were to remove the excess by December 31, 2013, you wouldn’t pay the penalty for 2013. For these subsequent year removals, you may either withdraw the excess funds or reduce your current year contribution by enough to offset the excess amount.
Recharacterization means changing your excess Roth contribution into a traditional IRA contribution. The IRS says that it’s as if you never made the excess contribution in the first place. All you do is instruct your Roth IRA trustee to move the excess funds, including earnings, into a traditional IRA account. You must do this by your filing deadline, including any extensions. The good thing about recharacterization is that you don’t have to pay taxes or penalties on the earnings stemming from the excess contribution. However, you can only use this strategy if it won’t cause an excess contribution to the traditional IRA.