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How to Correct Excess IRA contributions and Avoid the Excise Tax

Alli Thomas

If you have an IRA, you’re probably aware that the IRS limits on how much you can contribute each year. But you may not be aware of the consequence of exceeding that limit, which is set at $6,000 for those under age 50 and $7,000 for those 50 or older for 2021.

Unsurprisingly, that consequence is a tax penalty. In this case, it’s a 6% excise tax on any excess contributions and any earnings from those contributions. More significantly, this tax has to be paid each year until the excess contributions (and for Roth IRAs, the earnings on those contributions) have been removed from your account.

It’s possible to avoid paying that 6% tax even if you’ve already filed your taxes, but you have to take action by October 15 – the tax extension deadline.

Let’s dig in.

How Can an Excess IRA Contribution Occur?

There are a few common causes of excess IRA contributions. These include

  • Your modified adjusted gross income was too high and reduced the amount you can contribute to a Roth IRA.
  • You made a contribution to a traditional IRA and you’re 70 ½ or older.
  • You have multiple IRAs with different custodians. It’s easy to forget that the annual IRA contribution limit applies to ALL IRAs you own—not on an account-by-account basis.
  • You use an automatic investment plan—and your recurring contribution amount is too high.
  • You forgot that you already made a contribution to your IRA. This can happen if you used a tax refund earlier in the year, and then added more later.
  • You rolled your Required Minimum Distribution over into an IRA.

 

What to Do to Correct an Excess IRA Contribution

No matter how you wound up making excess contributions, you’re not the first person to have done it. So let’s talk about how to correct it. If you found out about it:

  • Before April 15 and you haven’t filed your return: Complete IRS Form 5239 and include it when you file your taxes. If you earned money on the excess contribution, you’ll need to remove it and include it in your gross income. Done properly, you will not have to pay the 6% excise tax.
  • Before April 15 but you’ve already filed your taxes: You’ll need to file an amended tax return by October 15. Write a note at the top of IRS Form 1040x that says “Filed per section 301.9100-2.” If you earned money on the excess contribution, you’ll need to remove it and include it in your gross income. Again, if you follow this process, you will not have to pay the 6% penalty.
  • After October 15: you’ll have to pay the 6% excise tax each year that the excess contribution is in your IRA as of December 31, until you remove it.

 

Other Ways to Handle Excess IRA Contributions

If you have an excess contribution from last tax year, you can carry it forward to this year by reducing your current IRA contribution by the amount of the overage. While that means you’ll still pay the 6% penalty for the previous tax year, you won’t have to pay it again.

If you’ve made an excess contribution to your Roth IRA, you can recharacterize it by moving the excess contribution and any earnings on that contribution to a traditional IRA. If you choose to take this route, you must complete the recharacterization by October 15.

The Fine Print

  • When calculating earnings on excess IRA contributions, you must account for the performance of your entire IRA—not just the performance of the excess amount. This is often misunderstood or overlooked.
  • As mentioned above, if you remove excess contributions and earnings by the filing extension deadline (October 15), they will be treated as ordinary income. If you’re under age 59 ½, you’ll have to also pay the 10% early withdrawal excise penalty on them.
  • If you contributed to both a traditional IRA and a Roth IRA in the same tax year and had excess contributions, you must remove the excess from the Roth IRA first.

Questions about handling excess contributions (and preventing them from happening again)? One of our financial advisors can help! Get started with a complimentary, no-obligation consultation. 

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