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.
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Correcting an excess contribution requires the use of a specific formula that determines the amount that must be removed. To help taxpayers determine these amounts, the IRS provides guidelines and regulations that must be followed. Here we look at the penalties that apply if excess contributions are not corrected and the ways in which excess contributions can happen.
Excess Contribution Defined
An individual may contribute amounts up to a certain limit that is designated for the year ($5,500 for 2013 or $6,500 if age 50 or older by year end). To avoid penalties, 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 2013 is $50,000, and her contribution limit is $5,500 for 2013 or $6,500 if she is age 50 or older by year-end 2013. Contributions to Jane\'s IRAs in excess of $5,500/$6,500 are therefore excess contributions.
Jim\'s compensation for 2013 is $2,000, so his contribution limit is $2,000 for 2013. Contributions to Jim\'s IRAs in excess of $2,000 will be excess contributions.
An individual who makes little or no compensation may receive a spousal IRA contribution, 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 2013 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 $5,500 ( $6,500 if at least age 50 by year-end) on his behalf.
When Correction Is Not Timely
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 April 15. But if you miss the April 15 deadline, you may still be able to make the correction, as individuals who file tax returns by April 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 2013 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 2013 is an excess contribution. In November 2013, Tim learned that he was not eligible to contribute to his IRA in 2012. Because Tim failed to remove the excess amount by his 2012 tax-filing deadline, he must pay the IRS a penalty of $300 ($5,000 x 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. For 2013, these limits are as follows:
- $188,000 for individuals who file as married filing jointly
- $127,000 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 $5,500/$6,500 limit. For 2013, these MAGI ranges are as follows:
- At least 178,000 but less than $188,000 for individuals who are married and file a joint return
- At least $112,000 but less than $127,000 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 special formula ( available at www.irs.gov) to determine the maximum amount they are eligible to contribute to a Roth IRA.
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 $5,500/$6,500. An individual may choose to split his or her contributions for reasons which include the following :
- Because of the income cap placed on Roth IRA contributions, an individual may only be eligible to contribute an amount less than $5,500/$6,500 to a Roth IRA. To benefit from contributing the full allowable amount for the year, 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. 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. (To learn why, see Traditional IRA Deductibility Limits.)
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 or her Traditional IRA 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 5
Jim is 55 years old and eligible to contribute $6,500 to his IRA. He contributes $2,500 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.
The Bottom Line
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 professionals to prevent excess contributions and to ensure required corrections are made on time should excesses occur.