Correcting Ineligible (Excess) IRA Contributions - Part 1

by Denise Appleby,CISP, CRC, CRPS, CRSP, APA (Contact Author | Biography)

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Sometimes, in our eagerness to fund our IRAs, we contribute amounts in excess of the allowable limits. Fortunately, the IRS allows these excess amounts to be corrected without penalty, provided the correction occurs within a certain time frame.

Correcting an excess contribution requires the use of a specific formula that determines the amount that must be removed. To help taxpayers determine this amount the IRS has simplified related regulations. The final version of the regulations, issued in May 2003, is effective for contributions made during 2004 or later. In this first of a three-part series, we look at the penalties that apply if excess contributions are not corrected and the ways in which excess contribution can happen.

Excess Contribution Defined
An individual may contribute an amount up to a certain limit that is designated for the year ($5,000 for 2008 or $6,000 if age 50 or older by year end). To avoid penalties, which we discuss below, individuals need to be aware of and stay within these statutory contribution limits. If a person's taxable compensation is less than the statutory contribution limit, the maximum amount that person may contribute is equal to the compensation he or she received for the year. Here are some examples of excess contributions:

Example 1
Jane's compensation for 2008 is $50,000, and her contribution limit is $5,000 for 2008 or $6,000 if she is age 50 or older by year-end 2008. Contributions to Jane's IRAs in excess of $5,000/$6,000 are therefore excess contributions.

Example 2
Jim's compensation for 2008 is $2,000, so his contribution limit is $2,000 for 2008. Contributions to Jim's IRAs in excess of $2,000 will be excess contributions.

An individual who makes minimal compensation may receive a spousal IRA contribution from his/her spouse, provided certain requirements are met. (For more information, see Making IRA Contributions on Behalf of Your Non-Working Spouse.) Contributions in excess of the regular limits are also considered excess contributions.

Example 3
John's compensation for 2008 is $500, but he files a joint tax return with his wife, and their combined compensation is $40,000. John's wife may make a spousal IRA contribution of no more than $5000/$6,000 on his behalf.

Penalties That Apply When Correction Is Not on Time
To correct an excess contribution, an individual must remove the excess amount and any applicable income from the IRA by the owner's tax-filing deadline, which is generally Apr 15. But if you miss the Apr 15 deadline, you may still be able to make the correction as individuals who file tax returns by Apr 15 receive an automatic six-month extension on the deadline for removing the excess amount. An excess contribution that is not removed by the deadline accrues a 6% penalty for every year it remains in the IRA. As you can see from the following example, this can be a significant amount.

Example 4
Tim is a retiree whose only income for year 2008 is the rent he received from his property. Tim did not understand that rental income is not eligible compensation for the purpose of contributing to an IRA. So the $5,000 he contributed to his IRA for year 2008 is an excess contribution. In Nov 2009, Tim learned that he was not eligible to contribute to his IRA in 2008. Because Tim failed to remove the excess amount by his 2008 tax-filing deadline, he must pay the IRS a penalty of $300 ($5,000 * 0.06). An additional $300 would apply for each year the excess amount remains in the IRA.

Roth IRA Excess Contributions
Unlike Traditional IRAs, Roth IRA contributions are subject to income (compensation) limitations and are allowed only if the individual's modified adjusted gross income (MAGI) falls below certain limits. These limits are as follows:

$160,000 for individuals who file as 'married filing jointly'.
$110,000 for individuals who file as 'single or head of household'.
$10,000 for individuals who file as 'married filing separately'.

Any Roth IRA contributions for individuals with MAGI in excess of these limits will be excess Roth IRA contributions.

Furthermore, contributions for individuals whose MAGI falls within a certain range are restricted to an amount less than the $3,000/$3,500 limit. These MAGI ranges are as follows:

At least $159,000 but less than $169,000 for individuals who are married and file a joint return.
At least $101,000 but less than $116,000 for individuals who file as single or head of household.
More than $0 but less than $10,000 for individuals who file as married filing separately.

These individuals must use a formula to determine the maximum amount they are eligible to contribute to a Roth IRA. (For instructions on how to calculate the maximum contribution amount, see the "Eligibility" section of the Roth IRA tutorial.)

Example 5
Assume that Bill, who is over age 50, files as single and that his MAGI is $112,000. By using the formula in the Roth IRA Tutorial referred to above, Bill determines that his maximum allowable Roth IRA contribution is $1,600. Any contribution in excess of $1,600 to Bill's Roth IRA will be an excess contribution.

Contributing to a Traditional and a Roth IRA in the Same Year
If an individual chooses to contribute to both a traditional and a Roth IRA for the same tax year, the combined contribution should not exceed $5,000/$6,000. An individual may choose to split his or her contributions for the following reasons (besides simply wanting to do so):

Because of the income cap placed on Roth IRA contributions, an individual may only be eligible to contribute an amount less than $5,000/$6,000 to a Roth IRA. To benefit from contributing the full allowable amount, the individual may contribute the difference to the Traditional IRA.
An individual may be able to deduct only a portion of a Traditional IRA contribution. (To learn why, see Traditional IRA Deductibility Limits.) For the amount that is non-deductible, the individual may contribute this to the Roth IRA, since Roth IRA contributions are not -deductible, but are tax-free when distributed.

Excess Applicability When Contributions are Made to both Types of IRAs
According to the final Roth IRA regulations, an individual's IRA contributions for the year are applied first to his/her Traditional and then to a Roth IRA. Therefore, should an individual contribute to both a Traditional and a Roth IRA, any excess amounts would be deemed to occur in the Roth IRA.

Example 6
Jim is age 55 and eligible to contribute $6,000 to his IRA. He contributes $2,000 to his Traditional IRA and $4,500 to his Roth IRA. This is $500 in excess of the allowable limit. Because contributions are applied to Traditional IRAs before they are applied to Roth IRAs, the $500 excess is deemed to occur in the Roth IRA. To correct the excess amount, Jim must distribute the excess amount from his Roth IRA.

Conclusion
When contributing to an IRA, individuals should try to ensure that contributions are within the allowable limits. If there is any doubt, individuals should consult with their tax professional to prevent excess contributions and to ensure required corrections are made on time should excess occur. Unfortunately, in many instances, excess contributions are not discovered until a few years after the occurrence, causing the IRA owners significant penalties. In part 2, we review other transactions that may result in excess contributions, as well as the tax treatment of excess distributions. And in part 3, we look at how to compute the earnings on the excess contributions, which must also be removed in a timely manner.

by Denise Appleby (Contact Author | Biography)

Denise Appleby is a retirement plans consultant, freelance writer and editor. Before starting her own business, Appleby Retirement Consulting, Denise worked for Pershing LLC for almost 10 years. While at Pershing, Denise rose to the rank of vice president, and held many positions including retirement plans product manager, manager of the retirement plans technical assistance group and retirement plans training manager. Appleby Retirement Consulting provides technical assistance to financial institutions and financial professionals; content for newsletters, websites and magazines; and technical editing services for books and other retirement plans material. Denise holds several retirement professional designations.