Overcontributing to IRAs

It’s easy to accidentally place more in your IRA than your annual limits permit. If you are not mindful, going over the contribution limit can cost you significant time and money. Fortunately, if this happens, there are ways to fix it.

The so-called “excise tax” due to overfunding an IRA has been a frequent stumbling block for most taxpayers who aren’t aware of the policy. Learning about the penalties for excess contribution early in your retirement planning can save you headaches down the road.

This guide provides a handful of resources to help you make sure you don’t fall into excess contribution tax traps and know what to do if it happens. That said, this is all for educational purposes only and does not constitute advice; for advice, you need to consult one-on-one with a certified financial professional.

What are the limits for contributing to IRAs?

One of the key differences between Traditional, Roth, SEP, and SIMPLE IRAs are their contribution limits. It is one of the critical factors driving how the IRS makes distinctions between IRAs types.

The Internal Revenue Service (IRS) imposes retirement account limits and updates it from year to year to help the average worker. It is generally to prevent high-income taxpayers from benefiting more than the average worker from individual retirement accounts’ tax advantages.

Contribution limits vary by the type of IRA, the age of the plan participant, and for Roth IRAs, by how much the person earns.  The IRS may also update the rules and limits each year, so be sure to check with the IRS for the most recent information.  According to type, here’s a rundown of the 2023 IRA contribution limits based on your filing status.

Source: Table – A Side-By-Side Comparison of Different IRA Types

Roth IRAs have an additional policy on contribution limits. Your modified adjusted gross income (MAGI) determines whether you can contribute up to the limit—or anything at all. Here’s a look at the Roth IRA contribution limits for 2020:

Source: Table – IRS

For additional information about contribution limits according to IRA Types, you can refer to these resources:

• A Side-By-Side Comparison of Different IRA Types -This Birch Gold article provides key distinctions between IRA types, including updated contribution limits.
• IRS – Retirement Topics – IRA Contribution Limits – This IRS page posts general updates on contributions you need to know.
• IRS – Amount of Roth IRA Contributions That You Can Make for 2023 – Roth IRAs have an additional policy on contribution limits. This IRS page provides an updated guide on the Roth IRA contribution limit for 2020.
• IRS – SEP Plan and SIMPLE IRA Plan Limits – The contribution limits for your SIMPLE IRA plan are separate from the limits for your SEP plan. This IRS page answers how much you can contribute to a SEP plan if you participate in your employer’s SIMPLE IRA.

What is the penalty for over-contributing to an IRA?

The penalty for ineligible or excess contribution is 6% of the extra amount. In general, if the excess contributions for a year aren’t withdrawn by the date your return for the year is due (including extensions), you are subject to a 6% tax.

If you incur it, you will need to pay the penalty when you file IRS Form 5329 for your income tax return.

If the excess is not removed, you’ll owe the penalty every year that the excess remains in your IRA. It’s also important to note that if you’re not eligible to take a qualified distribution from your IRA to remove the excess, you’ll have to pay an additional 10% penalty for early withdrawal.

To learn more about the liability for excess contribution and what you can do avoid it, refer to the following resources:

• IRS – Retirement Topics – IRA Contribution Limits – This IRS page posts general updates on contributions you need to know.
• Tax on excess contributions to certain tax-favored accounts and annuities – The Internal Revenue Code Section 4973 stipulates the penalties for excess contributions.
• Contributions To Individual Retirement Arrangements (IRAs) – Starting from Page 34, IRS Publication 590-A provides the limits for IRA contributions, penalties for excess contributions, and general provisions for fixing it.

Why do people over contribute to their IRAs?

In an honest attempt to fund your IRA, you could easily find yourself accidentally making an excess contribution.

Here are some common scenarios that could easily lead to over-contributing:

1. Use of an automatic investment plan: An automatic investment plan is still one great way to meet your retirement goals, but it’s possible that you set it up too high to add to more than your limit.
2. Putting money into an IRA at another company: The annual limit on IRA contributions is the combined total of Traditional and Roth IRAs, not just any one IRA. If you have a Traditional IRA and a Roth, you are still subject to the annual contribution limit. Remember that your annual contribution limit is applied across all of your Traditional and Roth IRAs.
3. Making more than one contribution to your IRA in a given tax year: You might have used a tax refund, for example, to make an IRA contribution earlier and then contributed again later for the same tax year.
4. Contributing beyond what’s allowed for your income level: Keep in mind that Roth IRA contributions may be reduced or possibly ruled out depending on your modified adjusted gross income (MAGI). Consult a Roth IRA calculator to determine how much you can contribute.

What to do if you’ve exceeded your IRA contribution limit

Fortunately, there are several options to fix excess contributions on your IRA and avoid the tax penalty. Methods to correct excess contributions include corrective distribution, carry the excess forward, and recharacterization.

Whichever one you end up choosing, it’s best to act quickly—before additional penalties can accumulate.

Eliminating excess contributions before the tax filing deadline

The excess IRA contribution amount can be removed before the tax filing deadline (generally April 15), which includes an automatic six-month extension (October 15).

This method entails distributing the amount of the excess contribution and any accumulated net income attributable to the excess contribution.

If you remove the excess contribution after you file your taxes, you may need to file an amended tax return.

If you withdraw the excess promptly, you will owe tax and, if under age 59½, the IRS 10% additional tax for early distributions (10% extra tax) on any earnings.

Some additional specialized resources on this corrective redistribution include:

• 2019 Publication 590-A – Pub 590-A “Contributions to IRAs” provides ample information on what and how to deal with excess contributions with corrective distributions.
• IRA Reporting: Excess contributions and recharacterizations – This article examines how to report the removal of an IRA excess contribution and a recharacterization distribution, both of which from a distribution reporting standpoint is dependent on the year the contribution was made vs. the year of issuance.
• How Do I Withdraw Excess IRA Contributions? – . This resource emphasizes the need to quickly discover and remove the excess contribution and possibly avoid penalty taxes.

Eliminating excess contributions by recharacterization

You may be able to treat a contribution made to one type of IRA as having been made to a different kind of IRA. This is called “recharacterizing” the contribution.

Recharacterization can be done to eliminate excess contribution by recharacterizing a transaction instead of making a valid contribution or rollover to a different type of IRA through a trustee-to-trustee transfer.

When recharacterizing a contribution, it will be considered to have been executed for the same taxable year that the contribution was made initially.

Some additional specialized resources on recharacterization include:

• 2019 Publication 590-A – Starting from Page 29 of Pub 590-A, the IRS provides ample information on what and how to recharacterize a contribution, including step-by-step corrective actions to deal with excess contributions through a recharacterization.
• Recharacterization of IRA Contributions – This IRS page answers frequently asked questions regarding recharacterization and pertinent information and concerns around the method.
• Recharacterizing Your IRA Contribution or Roth Conversion – This resource explains recharacterizations to help you understand the mechanics of calculating earnings or losses on the amounts you want to recharacterize, including correcting excess contributions.

Eliminating excess after the tax filing deadline

If you are unable to eliminate the excess contribution before the tax filing deadline, you may eliminate an excess contribution by merely making ordinary distributions. Ordinary distributions are subject to existing distribution policies, penalties, and exceptions.

You would generally prefer to eliminate the excess before the tax filing deadline instead of making an ordinary distribution. A corrective distribution before the tax filing date will help you avoid the excise tax for all years. A regular distribution, however, may be subject to an IRS early distribution 10% additional tax if you are under age 59½.

But if it is too late to make a corrective distribution, an ordinary distribution may be the only feasible solution to remove the excess from your Traditional IRA.

For a Roth IRA, an ordinary distribution is generally more favorable than for a Traditional IRA. The entire amount of an ordinary distribution from a Roth IRA (not just the taxable portion) offsets excess contributions, and a Roth IRA distributes all of its nontaxable investment before taxable earnings.

To learn more about Traditional and Roth IRA distribution tax treatments, you may refer to the following resources:

• A Comprehensive Guide to Tax Treatments of Roth IRA Distributions – Roth IRAs have many benefits compared to Traditional IRAs. Investopedia creates a summary of the tax benefits and consequences of Roth IRA distributions.
• Traditional & Roth IRAs: Withdrawal Rules and Early Withdrawal Penalties – HR Block outlines everything you need to know about the when and how for taking money out of a Traditional and Roth IRAs
• What to Do About an Excess Roth IRA Contribution – You can fix an excess Roth IRA contribution reasonably quickly.

Eliminating excess contributions by carrying forward

According to the IRS, you may be able to apply an excess contribution to a later year if the contributions for that last year are less than the maximum allowed for that year. This means that you can offset the excess contribution by limiting your annual contribution for the next year to the maximum minus the excess.

This “carrying forward” method lets you avoid making a withdrawal. It doesn’t, however, allow you avoid the 6% tax on any excess contributions remaining at the end of a tax year.

Carrying forward an excess contribution should be a last resort.

To learn more about carrying forward, you can consult these additional resources:

• Correcting excess contributions to IRAs – The Tax Adviser compiled several possible conditions and provided examples that lead to excess IRA contributions, how to fix them, and how to avoid the excise tax for future years.
• Deducting an Excess Contribution in a Later Year – IRS Pub. 590-A, starting on page 36, dedicates a section on carrying forward contributions to correct any excess.

Bottom Line

Excess contributions can be a hassle, but it can be avoided entirely. Educating yourself is the first step in ensuring successful retirement planning. Pay attention to earned income, modified adjusted gross income, and stay up-to-date with the annual contribution limit changes.

Most importantly, keep track of any contributions you’ve already made for the tax year, including tax refunds and distributions.

When it happens and if you do make a mistake overfunding your IRA, it’s best to act quickly so you can limit the penalties you’ll owe.