- Exceeding the IRA contribution limit can result in a 6% excise tax on excess contributions and their earnings.
- Common causes of excess IRA contributions include high income, multiple IRAs, automatic investment plans, forgetting prior contributions, and rolling over Required Minimum Distributions.
- Earnings on excess contributions are considered ordinary income and may be subject to early withdrawal penalties.
You probably know the IRS limits your yearly contribution if you have an IRA. But you may not yet know the consequence of exceeding that annual contribution limit.
In 2023, the maximum allowable annual contributions to both traditional IRAs and Roth IRAs are determined:
- If you are under 50, your total contributions each year to your traditional IRAs and Roth IRAs cannot exceed $6,500.
- However, if you are 50 or older, the maximum annual contributions increase to $7,500.
Deducting your IRA contribution
There is a possibility that your contributions to a traditional IRA may be eligible for tax deductions. It’s important to note that the deductibility of these contributions can be subject to certain limitations based on your income and the coverage of a retirement plan at work by either you or your spouse. If your income exceeds specific thresholds and a workplace retirement plan covers you or your spouse, the deduction for traditional IRA contributions may be restricted by income limits. (1)
IRA Deduction Limits
Unlike traditional IRAs, contributions made to Roth IRAs are not eligible for tax deductions. They are made with after-tax funds.
If you or your spouse are covered by a retirement plan at work and your income surpasses specific thresholds, the deduction for your traditional IRA contributions may be limited.
Unsurprisingly, the consequence of excess IRA contributions is a tax penalty. In this case, it’s a 6% excise tax on any excess contributions and earnings from those contributions. More significantly, this tax has to be paid each year until you withdraw the excess contributions (and, for Roth IRA contributions, the earnings on those contributions) from your account.
It’s possible to avoid paying that 6% tax even if you’ve already filed your taxes, but you have to take action by October 15 – the tax extension deadline.
Let’s dig in.
How Can an Excess IRA Contribution Occur?
There are a few common causes of excess IRA contributions. These include:
- Your modified adjusted gross income was too high and reduced the amount you can contribute to a Roth IRA.
- You have multiple IRAs with different custodians. It’s easy to forget that the annual IRA contribution limit applies to ALL IRAs you own, not on an account-by-account basis.
- You use an automatic investment plan, and your recurring contribution amount is too high.
- You forgot that you already made an IRA contribution. This can happen if you used a tax refund earlier in the year and added more later.
- You rolled your Required Minimum Distribution over into an IRA.
Calculate Excess Contributions
To determine the earnings or losses resulting from an excess contribution, the Internal Revenue Service (IRS) provides a specific formula. The net income can be calculated by multiplying the net income attributable to the excess contribution by the difference between the adjusted closing balance (ACB) and the adjusted opening balance (AOB), divided by the AOB.
The adjusted opening balance refers to the previous balance of the Individual Retirement Account (IRA), including the excess contribution and any consolidations or transfers into the account since the contribution was made.
On the other hand, the adjusted closing balance represents the current value of the IRA, taking into account any distributions, consolidations, or transfers that have occurred since the contribution was made.
Example of Excess Contribution
Jill contributed $3,000 to her traditional IRA last year. When filing her taxes, she realized she could only contribute $2,000 because she earned an income of $2,000 for the year. Consequently, she decides to remove the excess amount of $1,000.
Before the contribution, Jill’s IRA balance stood at $12,000, currently at $18,000. There have been no additional contributions or distributions. Applying the IRS formula, Jill calculates her earnings by using an adjusted closing balance of $18,000 and an adjusted opening balance of $15,000 ($12,000 + $3,000).
Jill decides to remove a total of $1,200 from her traditional IRA. This amount includes the $1,000 excess contribution and an additional $200 in earnings attributable to the excess contribution.
What to Do to Correct an Excess IRA Contribution
No matter how you made excess IRA contributions, you’re not the first to do it. So let’s talk about how to correct it. If you found out about it:
- Before April 15, if you haven’t filed your return: Complete IRS Form 5239 and include it when you file your taxes. If you earned money on the excess contribution, you must remove it and include it in your gross income. You will not have to pay the 6% excise tax if done correctly.
- Before April 15 but have already filed your taxes: You must file an amended tax return by October 15. Write a note at the top of IRS Form 1040x that says, “Filed per section 301.9100-2.” If you earned money on the excess contribution, you must remove it and include it in your gross income. Again, if you follow this process, you will not have to pay the 6% penalty.
- After October 15: you’ll have to pay the 6% excise tax each year that the excess contribution is in your IRA as of December 31 until you remove it.
Other Ways to Handle Excess IRA Contributions
If you have an excess IRA contribution from the previous tax year, you can carry it forward to the current tax year by reducing your current IRA contribution by the overage amount. While you’ll still have to pay the 6% penalty for the previous tax year, you won’t have to pay it again.
If you’ve made an excess Roth IRA contribution, you can recharacterize it by moving the excess contribution and any earnings on that contribution to a traditional IRA. If you choose this route, you must complete the recharacterization by October 15.
The Fine Print
- When calculating earnings on excess IRA contributions, you must account for the performance of your entire IRA—not just the performance of the excess amount. This is often misunderstood or overlooked.
- As mentioned above, removing excess contributions and earnings by the filing extension deadline (October 15) will be treated as ordinary income. If you’re under age 59 ½, you’ll have to also pay the 10% early withdrawal excise penalty on them.
- If you made a traditional IRA contribution and a Roth IRA contribution in the same tax year and had excess contributions, you must remove the excess Roth IRA contribution first.
- Correcting the same IRA by removing the excess contribution from the same IRA that initially triggered the excess is crucial. You cannot select a different IRA to rectify the situation if you hold multiple IRAs.
- Last contribution as the excess: If you made multiple contributions to the IRA, the most recent one is considered the excess contribution.
Questions about handling excess IRA contributions (and preventing them from happening again)? One of our financial advisors can help!