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As we move towards the end of the year, you should have a good idea of what your income for the year should be.  For those who have contributed to an IRA or a Roth IRA throughout the year, you will want to make sure that your final income does not make those contributions ineligible.  For the 2018 income phaseout limits for both traditional and Roth IRAs and the rules around them, please take a look at a previous blog I wrote here. 

What Makes a Contribution to a Traditional IRA Ineligible and Subject to the Excess Contribution Penalty?

Excess contributions to an IRA generally fall into two categories; a contribution for the year that is more than the smaller of $5,500 ($6,500 if over 50) or the amount of your taxable compensation for the year.  Additionally, if you are over 70 ½, any contribution to a traditional IRA, whether deductible or non-deductible is also considered an excess contribution.     

Even if you do not fall into any of the two categories above, if you make a deductible contribution to a traditional IRA when your income exceeds the phaseout limits, that will also qualify those contributions as excess.

What Makes a Contribution to a Roth IRA Ineligible and Subject to the Excess Contribution Penalty?

Roth rules are similar to the traditional rules, with one major exception.  There is no restriction on making contributions to a Roth IRA after reaching the age of 70 ½.  However, you still have to be within the income phaseout limits for a Roth IRA, have taxable compensation for the year equal to or in excess of the amount you contribute, and that contribution can not exceed $5,500 ($6,500 for those age 50 and over) for the year.

How do Rollovers Factor Into the Excess Contribution Penalty?

Properly executed rollovers will not result in an excess contribution, however, if executed improperly, they could subject you to the excess contribution penalty.  Common mistakes that could make the rollover improper include, waiting more than 60 days between withdrawing the funds from your IRA and depositing them into a Roth IRA, and withdrawing one type of security and depositing a second type.  The result of an improper execution results in the deposit into the Roth IRA being treated as a contribution instead of a rollover, and if that contribution puts you over the contribution limit or exceeds your taxable compensation for the year, then it will be treated as an excess contribution and subject to the IRS penalty.

What is the Excess Contribution Penalty, and How Do I Avoid it?

If the IRS deems the contribution to be in excess, the taxpayer is subject to a 6% penalty tax, applied for every year that the contribution remains in the account.  If you realize at the end of the year, that you have made an excess contribution, don’t panic, there are ways to fix this and avoid the penalty.  To avoid paying the 6% penalty, you must withdraw the amount of the excess contribution, including any interest or growth that the excess contribution has generated in the account.  You have until the due date of your taxes to complete the withdrawal, which for most people will be 15 April, but could be up to 15 October if you apply for a 6-month extension.  Your IRA custodian should have a form to assist you with requesting the withdrawal and calculating the interest or growth associated with the excess contribution amount.  As long as you complete this prior to the due date for your taxes, you will not be subject to the 6% excess contribution tax.

Avoiding Making an Excess Contribution

Rather than trying to avoid the excess tax, there are some steps you can take to avoid making the excess contribution first.  Let’s look at the common mistakes and what your options are to avoid them in the first place.

Common Mistake:  Contributing over the allowed limit of $5,500 ($6,500 for those over 50).

How to avoid this:  Make sure you have a system for tracking how much you have contributed, to include both your and your spouse’s contributions.  While this sounds easy enough, if you and your spouse have multiple IRAs, it can start to get confusing on how much has been contributed to each one.  Make sure you have a system in place, monitor it, and avoid contributing over your allotted limit.  If you do exceed your limits, your only option is to withdraw the amount over the limit before your tax due date.

Common Mistake: Contributing more than your taxable income for the year.

How to avoid this:  Know what counts toward taxable income and what doesn’t.  If you have exceeded this amount, even if you are under the $5,500 limit, you will still need to withdraw the excess to avoid the 6% penalty being assessed.

Common Mistake:  Made a contribution to a traditional IRA when over 70 ½.

How to avoid this:  Regardless of your eligibility when it comes to income, you are not able to contribute to a traditional IRA after 70 1/2, even if you are not deducting that contribution.  Fortunately, this is an easy fix.  Instead of making a traditional contribution, make the contribution to a Roth IRA, which does not have the 70 ½ age restriction.

Common Mistake: Income was too high for a deductible traditional or Roth contribution.

How to avoid this:  If your income was high enough that you exceeded the phase-out limits for both the deductible traditional IRA and a Roth IRA, don’t fret, you can still make what is called a non-deductible IRA contribution.  With a non-deductible contribution, you contribute to a traditional IRA, but you do not claim a deduction for that contribution when you file your taxes.  Instead, with your taxes, you file a Form 8606, which establishes your tax basis in the contribution, and will help you avoid paying taxes on that contribution when you withdraw it in retirement.  If the original contribution was made to a Roth, you will have one additional step, you will need to work with your Roth IRA custodian to recharacterize that contribution from a Roth to a traditional IRA in order to then treat it as a non-deductible contribution.

Don’t let these rules scare you from contributing towards your retirement.  Just make sure you understand them or are working with a professional who can help explain them to you.  Planning for retirement is one of the best things you can do for your future self, but do it in a planned, educated, and thoughtful way in order to avoid giving additional money to the IRS that could be used for yourself and your family.

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