What Happens When You Over Contribute to Your Roth IRA?

My thanks for Natalie Choate for analyzing and pointing out the following information.  Ms. Choate is truly a rock star in the world of IRA law, and much gratitude is owed to her by those of us in the financial community for her thorough analysis and commentary that she provides on such matters as this.

If you live long enough, you’re liable to see just about anything… the following is an example of the most extreme example I’ve ever heard of for using the tax law to your own advantage, deliberately flaunting the law for purposes of evading tax.

The Facts

If you intentionally over-fund your Roth IRA, above the amount that you’re allowed to contribute for the tax year.  The tax law allows you to remove the excess contribution by October 15 of the year following the year of contribution.  If you do not remove the excess contribution (and the gains associated with it) by that point, you will be subject to a 6% excise tax on the excess contribution until the situation is rectified.

The situation can be rectified by either crediting the excess contribution to a future years’ contribution, or by withdrawing the excess amount prior to the deadline for the following year.  Each year that you do not rectify the over-contribution you will be subject to the excise tax.

The Anomaly

If you do not remove the excess contribution and the growth associated with it by October 15 of the year following the year of contribution, once you’ve been assessed the excise tax, your rectification is only required to the extent of the excess contribution – not the growth associated with it.  The growth is no longer considered (under present tax law).  In other words, you can rectify the excess contribution at that point by simply removing the excess, but the growth doesn’t have to be removed.

If you’re following the way this is working, you’ve probably figured out the gist of the “idea” we’re talking about here.

The Terrible, Terrible Idea

Here’s an example of the bad idea in play:

Let’s say you have no Roth IRA at all, but you have $20,000 that you’d like to invest.  Furthermore, you don’t have compensation that would make you eligible to contribute anything to a Roth in the first place.  Ignoring all convention, you open an IRA and contribute the $20,000, investing it in the latest hot stock.  October 15 the following year rolls around, and your hot stock has doubled in value.  (It should be noted that if your hot stock didn’t do so well, such as losing money, you could pull it out now and walk away with no consequence.)

Under the normal conventions, you could withdraw the entire $40,000 (your contribution plus your gain), but you’d have to pay ordinary income tax on the gain of $20,000.  Doing this, you’d avoid the excess contribution 6% excise tax, $1,200.

However, in this terrible, terrible idea, you decide to wait until after October 15, and pay the excise tax on the over-contribution.  Now you have three choices:

  • If you’re otherwise eligible for contributions to the Roth in the current year, part of the excess contribution can be used (credited) as a regular contribution.  You would then be subject to the excess contribution tax on the remainder of the over-contribution until it’s been used up by future credits (this is one of the right things you could do).
  • If you’re not eligible for the contributions, you could withdraw the excess contribution at this point, along with the growth in the account, paying ordinary income tax on the growth.  This is the other right thing you could do.
  • If you’re up for a challenge (and possibly jail time), you could withdraw only the excess contribution and leave the growth in the account to grow tax free for the rest of your life.  It probably won’t do you a lot of good in Alcatraz, though.

The Reason This is a Terrible Idea

The IRS is never in favor of kooky tricks like this that don’t work as the law intended.  So what might happen?  Well, the IRS could review your IRA account and disqualify it completely, on the basis that the custodian should never have allowed the excess contributions in the first place.  In this manner, you’d be subject to tax on the growth in the account and the whole account would be null and void.  Your IRA custodian is likely to be in hot water as well, as this would be a violation of the basic rules of IRAs.

Since the entire concept of the ability to withdraw the excess contribution is designed to help taxpayers resolve an honest mistake, abusing this provision is likely to be soundly disallowed.  If the facts were known, (which they would be discovered eventually), the IRA is likely to be disallowed completely, and the abuse is likely to carry with it severe penalties.

The IRS doesn’t presently have remedy for the situation – and in the case where you honestly make a mistake and elect to leave the funds in the account (crediting against the current year, as in the first bullet point above) – it wouldn’t be too much of a leap for the IRS to disqualify distributions from the gains.  This would become especially so if the activity I’ve described becomes a rampant abuse.

It’s best to follow the rules as intended and leave well enough alone.

About the author

Jim Blankenship, CFP®, EA

Jim Blankenship is the founder and principal of Blankenship Financial Planning, Ltd., a financial planning firm providing hourly, as-needed financial planning and advice. A financial services professional for over 25 years, Jim is a CFP professional and has earned the Enrolled Agent designation, a designation that qualifies him as enrolled to practice before the IRS. Jim is also a NAPFA-registered financial advisor, which designates him as a Fee-Only Financial Advisor.

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11 Comments

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  • Over funding sounded like a good idea to me. It would (if contributing to a Roth) effectively change your capital gains rate to 6%. If the government gets 6 percent, why should they care? Paying the penalty is complying with the law. Isn’t it? As long as your rate of return exceeds 6 percent, wouldn’t you be better off over funding? I haven’t done this, but the caps for Roth 401k + Roth IRA are pretty high already. Can you re characterize current contributions for years without contributions? Limiting contributions in the first place seems rather un-American to me. I am complying with the law, but the law is stupid.

  • So, if a person maxes out their Roth IRAs and then unexpectedly goes over the contribution limit, how does one go about “uncontributing” their money – it seems most brokerages only expect you to take a distribution.

  • Hi Jim,
    I over contributed to roth ira in 2010, and 2011. I had a little taxable income in 2010 as $3450.I miximized the contribution for 2010 and 2011 for each year $5000. I’m unemployed since 2010 and cannot carry over the excess contribution to future year.
    Therefore, I removed immediately the excess contribution of 2010 in march of 2012 for the amount of $1550 and the excess contribution and earning of 2011 were removed on February 2012 before the due date of filing.
    The situation is this, the excess contribution of 2010 was returned to me without earning. The institution stated that the request of removing the earning is past due according to IRS guideline I’m subject only to pay penaltey of 6% for 2010 and 2011. I’m puzeled to the situation of 2010, I informed the institution to remove the earning in order to report as income in my tax return of 2011. Still the institution insist I pay only penalty without removing earning.

    Please clarify how do I approach the situation of 2010 in my tax return of 2011, what am I supposed to tell IRS for the earning and what should I expect from the irs. Also How do I amend the tax return of 2010. please respond asp because I din’t file my taxes yet.
    Thank you very much.

  • Cee –

    1) In 2012, if your modified adjusted gross income (yours and your spouse’s) is more than $173,000 your ability to contribute to a Roth IRA is limited. If your MAGI is greater than $183,000 you cannot make regular contributions to a Roth IRA.

    2) There are no income limits on Roth IRA conversions. Keep in mind that a conversion is different from a contribution – a conversion comes from a traditional IRA or a qualified retirement plan, while a contribution is money coming from outside all other retirement plans.

    Hope this helps –

    jb

  • Hi Jim,

    I have two questions:
    (1) When I was single, I converted a Traditional IRA to a Roth IRA a few years ago. When I became married, our joint income was over contribution limits so I figured I could no longer contribute to my Roth IRA. Is that correct?

    (2) I have read that in 2011 and 2012 anyone can convert a Traditional IRA to a Roth IRA regardless of their income. Currently I have a Traditional IRA. If I convert that to a Roth IRA, will I be able to contribute to it even though my spouse and I make more than the adjusted gross income limit?

    Thank you so much for your time and attention,
    Cee

  • Dee,

    When you remove the excess contribution, you will also need to remove the gains that are attributed to the excess contributions. The gains will be subject to tax and penalty (since you’re under 59.5) unless there is an exception that applies (medical, first home purchase, etc.). All of this is reported on Form 8606, ensuring that your excess contribution distribution is accounted for. As you likely already know, the excess contribution tax is calculated on Form 5329.

    If you withdraw the funds and gains before 12/31 you won’t owe the excess tax (6%) for 2011.

    Hope this helps –

    jb

  • Hi Jim,

    I am in a similar situation as the one described by Aaron. I am under the age of 59-1/2. I will not be able to use the excess Roth contribution from prior years to count for current or subsequent years in the near future. The 6% penalty on carry-forward of my excess contribution is getting costly year after year, and I would like to remedy the situation by withdrawing the excess. If I withdraw the excess contribution amount then (1) what happens to any income, my excess contribution have generated? Do I have to calculate and remove it too, or, can it continue to stay in my Roth account without any future tax/penalty hits? (2) How/where can I ensure that this withdrawal counts towards correction of excess contribution, and not just a penalty/tax free withdrawal of my legitimate contributions. (3) If I withdraw the excess contribution by 12/31/2011, would I still have to pay 6% penalty for 2011?

    Thanks.

  • Aaron, did you have income in 2009 and 2010? If so, you can use the over-contribution from 2008 as a contribution for 2009 (up to the income or $5,000 limit) and any extra would still be subject to the excise tax of 6%. If there was any extra (above income for 2009) it could be considered your contribution for 2010. If there was still some left over it would again be subject to the 6% excise tax.

    For example, if you made a contribution of $5,000 to your Roth IRA in 2008 and your income disallowed it, and you had income of $3,000 in 2009, you could indicate that $3,000 (from the over-contribution) was your contribution for 2009. That would leave $2,000 of over-contribution subject to 6% excise tax in 2009. Then in 2010 if you had at least $2,000 of income, the remainder of the over-contribution could be indicated as a 2010 contribution.

    If you had no income or less than the amount of the over-contribution, you’ll continue to be hit with the 6% tax until it’s used up by annual contributions (with appropriate income) or you withdraw it from the account.

    Hope this helps –

    jb

  • Hi Jim,

    In 2008, I had a high-income year and overcontributed to my Roth IRA. I paid the 6% tax but didn’t know to withdraw/recharacterize anything. In ’09 and ’10 I have been a student in the zero-bracket. In those years I have not made any contributions. Do I need to worry about withdrawing my excess that remains from 2008?

    Thanks for the help,

    Aaron

  • Hi, Steve –

    The financial institution will maintain records showing that you withdrew the excess contribution and the earnings. I would suggest that you also maintain your records of these transactions as well, in case you would ever need to prove the transactions occurred.

    jb

  • Hi Jim,

    Thanks for the good article. My wife and I did exceed the limit to the ROTH based on our MAGI which was over the $177,000 limit. If I want to just withdraw that excess, I assume I just need to contact my financial institution, and they should also be able to figure out what gains were made on that excess?

    How does the IRS get notified I had made those withdrawals and am now under the limit?

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