Undoing an Excess Roth IRA Contribution

If you work, you can contribute to a Roth IRA, but only if your modified adjusted gross income is below set limits. What happens if you contributed to a Roth IRA during 2015 (for the 2016 tax year) but now that the year is over you discover your income is too high for a full contribution, or perhaps only a partial contribution? Until you take corrective action, the excess contribution plus earnings on it are subject to a 6% excise tax each year. Here are four ways to handle the problem.

1. Timely withdraw the excess

You won’t be penalized if you withdraw the excess contribution, plus any earnings on it, by the due date of the return, including extensions. Thus, if you made an excess contribution for 2015, you can withdraw it penalty free by April 18, 2016 (April 19 if you live in Maine or Massachusetts). If you obtain a filing extension, you have until October 17, 2016, to take corrective action. However, any earnings you have on the excess contribution are taxable (not subject to the 6% penalty but possibly subject to the 10% early distribution penalty if under age 59-1/2).

2. Recharacterize the Roth IRA as a traditional IRA

Here you direct the trustee or custodian of your Roth IRA to retitle the account or deposit the funds into an existing traditional IRA. Recharacterization must also be taken before the extended due date of your return. This action avoids tax on any earnings that may have accrued.

In using the recharacterization option, determine whether the funds will be deductible or nondeductible. For example, if you are an active participant in an employer’s retirement plan, you may not be able to treat the recharacterized funds as tax deductible for 2015 (and this assumes you recharacterize before the April filing deadline).

Note: If you fail to recharacterize before the deadline, you may be able to obtain more time by asking the IRS for an extension. Your request may be granted if, upon discovering the fact that you weren’t eligible for a contribution when you made it, you seek to correct the situation promptly (by asking the IRS for more time to do so). It likely will give you an extension as long as the interests of the government aren’t prejudiced (i.e., you recharacterize to a nondeductible IRA so that government revenue isn’t diminished).

3. Withdraw funds later

If you miss the deadline in 2016 for withdrawing the excess 2015 contribution, the 6% excise tax will apply for 2015. However, you can avoid the excise tax for 2016 by withdrawing the excess contribution by December 31, 2016.

4. Apply the excess contribution toward a future contribution

Maybe you weren’t eligible to make a Roth IRA contribution because of your income in 2105, but 2016 is shaping up to be a different (lower income) year. If so, you can treat the excess contribution that had been made for 2015 as your 2016 contribution (assuming your income permits it). Again, the 6% excise tax applies for 2015, but you avoid it for 2016 and future years.

Conclusion

Saving money through a Roth IRA can be an important retirement strategy. It creates tax-free income and there are no mandatory lifetime distributions. But you must be eligible to make contributions or you’ll be penalized with an annual 6% excise tax…until you fix the problem.