In a prior post, we covered over-contributions into a Roth IRA. Now, let’s look at what the fixes are.
Fix 1: Withdraw the Over-Contribution
This is the fix I see most often, and is usually the best fix. If you catch the over-contribution before you file your tax return, you simply withdraw the over-contribution and it’s as if it never happened. You do need to run an “earnings” calculation, but this is something that the investment platform should be able to handle.
Example: In 2023, Jerry maxed out his Roth IRA with a deposit of $6,500. Unfortunately for Jerry, his AGI was beyond all of the AGI limitations so his allowable Roth contribution was $0. Jerry has made an over-contribution of $6,500. Jerry can withdraw this over-contribution before the due date of his tax return, including extensions, and there is no penalty. Jerry (or more likely, his investment platform) will need to calculate an amount for earnings, and the earnings portion is taxable income on his 2023 tax return (even though the withdrawal happened in 2024).
Note 1: In these situations I always like for clients to file an extension because it buys extra time to get the over-contribution out. An extension means Jerry has all the way til October 15th to make the withdrawal. Many average clients are deathly afraid of the “E” word but I try to explain it as, it’s just buying time to get the withdrawal done properly. It does not mean we will wait til October 15th to file the return.
Note 2: the earnings are taxable in the current year(i.e. the year of the return) — so let’s say the $6,500 over-deposit had $100 of earnings. Jerry will receive a distribution of $6,600, and the $100 earnings portion is taxable on his 2023 return. What if it’s a loss instead of a gain? This is not deductible. So, if Jerry’s calculation shows, say, a $50 loss, he’ll get $6,450 back from his account. This is not taxable, but Jerry also doesn’t get any deductions for his loss.
Fix 2: Leave In, Pay Penalty, Withdraw Later
I’ve had this happen too:
Continuing with Jerry from above, let’s say Jerry is one of those “late arrivers” who doesn’t give his tax pro any of his information until October 13th. The tax pro discovers that Jerry over-contributed to his Roth IRA in 2023 by $6,500, but there’s no way that this over-contribution can be withdrawn by October 15th. The fix here would be, pay a 6% penalty on the $6,500 (so, a penalty of $390). Then, withdraw the excess contribution as a 2024 item. No earnings calculation needs to be done; you simply withdraw the $6,500 over-deposit. It is not taxable, and that is the end of it.
Fix 3: Leave In, Call it a Contribution Later
Let’s say Jerry’s AGI problem was caused by a 1-year blip in his AGI. Maybe he sold some stock or something, or came into a large sum of taxable income but it was one-time only. Or maybe in 2024 he lost his job, or whatever. Whatever the case, his income is way down in 2024. If his AGI in 2024 is lower than the Roth AGI thresholds, he can make contributions again.
In this case, Jerry pays a 6% penalty on his 2023 return on the $6,500 over-contribution. Since he knows his AGI will be BELOW the limits in 2024, he can call this a $6,500 contribution for 2024. No penalty in 2024.
Fix 4: Recharacterize to a Traditional IRA
Jerry can also recharacterize the Roth contribution to a traditional IRA contribution (see the note below for additional info as some types of transactions cannot be recharacterized). This must be done by the original due date of the return (NOT including extensions). Traditional IRA contributions also have AGI restrictions, but that is simply a restriction on DEDUCTING the contribution, not a restriction on MAKING the contribution.
Basically if you want to recharacterize, you must do so by the due date without extension, because the rule is that it must have been a valid contribution to the traditional IRA. Traditional IRA contributions must be made by the due date, without extension, of the return.
(NOTE: the Tax Cuts and Jobs Act prohibits recharacterizing Roth conversions [a conversion from a traditional IRA to a Roth IRA; basically once this type of transaction happens, you can’t undo it. This restriction does not apply to over-contributions.)
Another Option, But Probably Not a Good One
Jerry could also just leave the 2023 over-contribution in his IRA and pay a 6% penalty on $6,500 … but this penalty would apply EVERY YEAR until the over-contribution is withdrawn or until his AGI drops and he can use the 2023 over-contribution as a current-year contribution. Doing this means he would pay a $390 penalty every year, since the money remains “tainted.”
Which Option is Best?
Option 1 is usually the best choice. It avoids penalty and also avoids the hassle of recharacterizing and needing to manage a traditional IRA when really you want a Roth IRA.
Option 2 is best if you aren’t able to make the withdrawal in time before your tax return is due.
Recharacterizing (option 3) is also an option if 1) you can do it by the original due date of the return, and 2) you are okay with a traditional IRA and possibly needing to track after-tax basis in that account.