Roth Individual Retirement Accounts let eligible taxpayers contribute to an after-tax savings account. However, not everyone is allowed to participate. If you're over the modified adjusted gross income limit for Roth IRAs, you're not allowed to contribute, so any money you put in your account is treated as an excess contribution.
Excess Contribution Penalty
You must pay an excess contribution penalty equal to 6 percent of the amount you contributed to your Roth IRA when you contribute even though you're not eligible. For example, if you contribute $5,000 when your contribution limit is zero, you've made an excess contribution of $5,000 and would owe a penalty of $300. You pay the penalty when you file your income tax return, and it counts as taxes you owe.
The penalty for excess contributions continues every year that you don't correct the excess contribution. For example, if you contributed $5,000 too much last year, and you're still not eligible to contribute this year, you'll owe another $300 penalty when you file your income taxes. However, you can use your current year contribution limit to reduce or eliminate your excess contribution that carries over from a prior year. Suppose you contributed $5,000 last year when you made too much to contribute and paid the excess contributions penalty. If you're eligible this year, you can count that $5,000 toward your contribution limit so you won't owe the penalty again.
Correcting Excess Contributions
To avoid an early withdrawal penalty, you must withdraw the excess contribution before your tax return is due, including any extensions. In addition, you have to withdraw any earnings on the excess contribution. For example, if you contributed $5,000 too much, and that $5,000 grew to $5,500 by the time you corrected this distribution, you would also have to withdraw the $500 in earnings. If instead the $5,000 had declined to $4,600, you would only have to withdraw $4,600.
Tax Treatment of Earnings
If you withdraw earnings to correct your excess Roth IRA contribution, you must include them in your taxable income for the year. In addition, if you're not allowed to take a qualified distribution from your Roth IRA and don't qualify for an exception, you also must pay a 10 percent early withdrawal penalty. Exceptions include if you're over 59 1/2 years old, permanently disabled, have significant medical expenses or are paying higher education expenses.