While contributing money to a Roth IRA can help individuals save for retirement, over-allocating to these accounts can trigger substantial tax penalties. Fortunately, there are ways to reduce this concern.

Key Takeaways

  • Individuals may discover that they've contributed too much to their Roth IRAs if their incomes took an unexpected jump, making them ineligible for a full contribution.
  • There are several remedies, but action must be taken before tax filing deadlines.
  • Those who fail to fix the problem will face a 6% tax penalty every year until they do.

Three Ways to Deal With Contributing Too Much

The annual contribution limit to a Roth IRA is $6,000 for 2020 and 2021. Those who are aged 50 and over can contribute an additional $1,000, which is called a catch-up contribution.

There are three chief ways to remedy excessive contribution to Roth IRAs, but these solutions must be applied prior to tax-filing deadlines to avoid penalties. Since individuals typically discover these issues while doing their taxes, they'll need to act quickly.

It is important to know the term “net income attributable” or (NIA), which refers to any income over-contributed funds have earned since they were deposited in the Roth IRA. The NIA must be withdrawn along with the contribution itself in order to finalize the correction.

It's also important to remember that if your income allows a partial contribution, you are not obligated to remove everything from your Roth IRA, just the overage.

The Three Corrective Actions

1. Recharacterize your contribution

One potential option is to recharacterize your excess contributions and any NIA as contributions to a traditional IRA. This assumes you qualify to contribute to a traditional IRA for that tax year. Following the passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, if you plan on working into your 70s, you can still put money into a deductible IRA. In other words, the age limit for contributions to an IRA has been eliminated.

Prior to the SECURE Act, 70½ was the cut-off age, after which no individuals could contribute any new funds to their traditional IRA, even if they were able to contribute to their Roth IRAs, which have no age limits.

This legislation essentially means that couples over 70½ would be allowed to save to an IRA over $14,000 in 2020 if both spouses are contributing the maximum of $7,000 a year. 

Please note that the Tax Cuts and Jobs Act banned recharacterizing Roth contributions from a traditional IRA or other tax-advantaged accounts, starting in 2018.  This ban does not apply to recharacterizing excess cash contributions that don't come from one of these sources.

2. Withdraw your contribution overage

If you don’t qualify for a traditional IRA (and thus cannot recharacterize your overage), you can simply withdraw the extra contribution and any NIA. You must do this by the date your tax return is due for that year.

3. Apply your contribution to a future year

You can also apply the excess contribution and NIA to a future year's Roth IRA. You may have to pay a 6% tax penalty to the IRS to be able to do this. If you choose to do nothing, you will have to pay that 6% tax penalty every year until you've fixed the problem.

Why Excess Contributions Happen

The main reason people accidentally over contribute to their Roth IRAs is an unexpected increase in income. This can affect the amount individuals are eligible to contribute, which they may not realize until they do their taxes for the year. By then, they may have already funded their Roth IRAs to the max.

Contributions to Roth IRAs are limited and can be phased out, depending on how much income you earn and your tax-filing status. For those who file their taxes as single, contributions cannot be made to a Roth if your income exceeded $139,000 in 2020 and exceeds $140,000 in 2021. Contributions get phased out if your income was between $124,000 to $139,000 in 2020. The income phase-out range is $125,000 to $140,000 in 2021.

For those who file their taxes as married filing jointly, the Roth income phase-out range for 2020 was $196,000 to $206,000, and for 2021, it's $198,000 to $208,000. In other words, the maximum amount you could contribute in 2020 was $206,000, and for 2021, is $208,000.

For example, if you’re married and your income is around $170,000 a year, you normally would not need to worry about hitting the limit. But suppose you received a substantial bonus at the end of the tax year and it pushed your income over $196,000 in 2020. Now your Roth IRA contribution limit would be lower, or you wouldn't be eligible to contribute at all. If you already made your Roth contribution for the year, you'd have an excess contribution.