Contributing to a Roth IRA is an attractive option for clients of all different income levels—the tax-free income source can prove invaluable to many during retirement. Despite this, the IRS imposes strict income-based limitations that determine which clients are actually eligible to contribute to a Roth IRA in any given year.
For this reason, clients may find themselves in a position where they have contributed to a Roth, and later discovered that they were actually ineligible to make the contribution—whether because of higher-than-expected income levels or otherwise.
In these situations, it’s important to know that the client still has options available to correct the mistake—and potentially avoid imposition of steeper penalties in the future.
Roth Contribution Limits
A variety of reasons exists to explain why a client might make a Roth IRA contribution and later discover that he or she has violated the Roth contribution rules. First, in 2015, the ability to make contributions to a Roth IRA begins to phase out for married clients with modified adjusted gross income (MAGI) over $183,000 ($116,000 for single clients). Roth contributions are completely blocked for married clients who earn over $193,000 and single clients who earn over $131,000.
A client could easily expect that his or her income would fall below the applicable thresholds, make a Roth contribution early in the year and later discover that he or she earned more than expected, thereby becoming ineligible to contribute. Further, married taxpayers filing separate returns are almost always ineligible to contribute if MAGI exceeds only $10,000—a rule that could cause an uninformed client to improperly contribute to a Roth.
Also, contributions are always limited to $5,500 ($6,500 for clients age 50 or older) per year in 2015. Any contributions in excess of this amount will be improper even if the client otherwise falls below the income thresholds discussed above.
Correcting an Excess Roth Contribution
Regardless of the reason for the excess Roth contribution, the client will likely need to remove the excess Roth contribution amount from the account. There are a few options that can be used, depending on the date that the excess contribution is discovered.
If the client realizes that the contribution was improper before October 15 of the year after the year of contribution (or Roth conversion), he or she can recharacterize the contribution by removing the funds to a traditional IRA.
The client must inform both the Roth IRA custodian and the traditional IRA custodian of the recharacterization (the amount contributed, plus or minus any gains or losses, must be recharacterized). In this case, the funds are simply moved back to the traditional IRA—but the mistake must be caught before the October 15 deadline.
The client can also withdraw the funds as an excess contribution (whether before or after the October 15 deadline) by notifying the IRA custodian of the transaction and simply removing the excess funds from the account. Only the amount contributed must be withdrawn, though a 6% penalty tax applies (and will continue to apply for each year that the excess contribution remains within the Roth IRA).
If the client believes that he or she will be eligible to contribute in the following year, he or she can also choose to leave the funds in the account and count them against the contribution limit for future years. However, this option also carries the imposition of the 6% penalty tax on excess contributions for each year that the funds remain in the account as an excess contribution.
If a client discovers an excess Roth IRA contribution, it’s important to realize that options do exist for correcting the mistake—however, it is equally important to note that the applicable penalty tax will be imposed for each year that the funds remain excess contributions within the account, so this is one area where timing does matter.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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