Tax season is here and the deadline is quickly approaching. Scores of Americans are gathering their documents in preparation and accountants are working overtime to make sure that everything is in order for their filings. It is during this preparation that investors often find out that their IRAs have contribution limits and exceeding those limits can be a costly error.
Wait, there’s a Limit?
Many investors are surprised to discover that their retirement accounts have limits and restrictions that vary based on their income, age and type of retirement account they have. For example, the contribution limit of an IRA for a person under the age of 50 in 2017 is $5,500 ($6,500 for those 50 and over.) What happens though if an excess contribution is made over the account limit? The short answer is potential IRS penalties and a major headache until the issue is resolved. The long answer is a little more nuanced.
Once an excess contribution is made to an IRA the client has until October 15 of the following tax year from the contribution to remove it plus the net income attributable, which is accounting lingo for plus or minus the earnings. For example, if an investor was to make an excess IRA contribution in 2016, they would have until October 16, 2017 to correct the excess contribution in order to avoid a penalty (October 15 is a Sunday in 2017.) If the excess contribution is not resolved by the deadline, then those contributions will be subject to a 6% penalty each year until the issue is resolved, plus potentially late filing fees and interest charges.
So I made an excess contribution, now what do I do?
There are a number of different ways people end up with excess contributions. The most straightforward fix is to simply withdraw the excess contribution. Depending on the type of contribution you made, (Roth, after-tax, or traditional) will determine how that withdrawal is treated in tax terms. Also, make sure that the IRA custodian is alerted that you are withdrawing excess contributions, so they issue the 1099-R with the correct coding for your return filling, as the IRS needs to be notified properly.
Another option is to apply your excess contribution as a future annual IRA contribution. This type of solution typically works well with small excess amounts. Rather than remove the excess contribution just to add it back in, you can just carry it forward to satisfy the new tax year’s contribution. Be careful though, as penalties could still apply for any additional excess amounts not covered by the new tax year’s contribution limit as well as penalties from the previous year.
Navigating Difficult Waters
Keeping up with the ever changing tax code is not easy, especially when it comes to retirement, and unfortunately sometimes things fall through the cracks. For example, even though traditional IRAs phase out the tax deductibility at higher income levels they do not have income limits for contributions themselves, unlike a Roth IRA that does restrict your contributions based on your income. However, traditional IRAs do restrict contributions by age. An investor can no longer contribute to a traditional IRA once they turn 70 1/2. If an investor makes a contribution in that year or any year afterwards, this is not allowed and considered an excess contribution. It is subtle mistake that is often overlooked. However, while a Roth IRA does have income restrictions for contributions, contributions are not restricted by age, further adding to the account confusion.
Another common mistake investors make is that in order to contribute to a traditional IRA or Roth IRA, you need to have earned income, such as wages or self-employment income. If an investor is living solely on their pension and wants to save money in an IRA they would be in violation, as they do not meet the compensation requirements to contribute to an IRA in the first place. This is another common mistake that could lead to an excess contribution.
As many investors unfortunately learn the hard way, an excess contribution situation must be addressed as soon as possible. The longer this problem is left unattended, the more costly it can inevitably become.