How to fix a Roth IRA Contribution Mistake

Photo by Mikhail Nilov

I don't have to tell you that Roth IRAs are a great tool. For small savers, it offers the ability to make contributions as you can, up to an annual maximum. For big savers, it is a way to stack additional savings on top of their employer retirement plan. And, of course, there is the tax advantage: pay tax now, and as long as you meet certain conditions, you can pull the money out tax-free, no matter your future tax rates. 

In fact, the Roth IRA is so valuable that the IRS limits who can contribute, both on the low end and the high end, and running afoul of these rules can lead to headaches. 

Who is eligible to contribute? 

For starters, you must have earned income. The IRS details what it considers earned income here and in Publication 590. The bottom line is that your income must be earned from employment or self-employment. Passive income does not count. I recall a memorable situation with a client when I worked in the brokerage world, insisting that his rental income allowed him to make an IRA contribution that year. Well, he made the deposit and then showed up a few months later, letting me know he needed to take the money out because his accountant told him rental income was not countable for IRA contribution purposes. 

On the other hand, you can not earn too much income either. The IRS sets maximum thresholds on your Modified Adjusted Gross Income (MAGI): your Adjusted Gross Income (AGI) with a few items added back. The income limits typically change every year, but for 2024: 

• Single and Head of Household taxpayers' contributions are phased out from $146,000 to $161,000 in AGI. You can not contribute with AGI over $161,000. 
• Married Filing Jointly taxpayers see a phase-out from $230,000 to $240,000 in AGI. If AGI is over $240,000, they are ineligible to contribute.
• Married Filing Separately taxpayers have their contribution phased out between (*gasp*) $0 and $10,000 and can not contribute at all over $10,000. 

Identifying the excess contribution

Typically, taxpayers find out they overcontributed when they do their taxes. That's when you determine your AGI for the previous year, which is essentially all of your income minus the "above the line" deductions. (Note that the standard deduction does not reduce your AGI as it is a "below the line" deduction. AGI is, in essence, "the line"). You'll get everything plugged in, and then your accountant, tax software, or maybe even your financial planner will give you the bad news that your income was outside of the parameters in some form. What do you do now?

Removing the Excess Contribution

You could ignore it, of course. The IRS won't like that, and since they get copies of tax forms, too, there is a good chance they'll catch it. And to prove they're serious, they will tack a 6% penalty on the excess contribution for every year the contribution is in the IRA (subject to limitations put in place by SECURE Act 2.0). Paying that is bad enough. Spending the time calculating it is probably even worse. 

So, you should go through a process to remove the excess contribution. Now, I wish it were as easy as withdrawing the contribution, but there's more to it than that. You see, while the money was improperly in the IRA, it may have earned interest and gained or lost money. You (or your brokerage firm or your accountant) will have to calculate the amount of earnings or loss attributable to your contribution from when it was contributed until the day it is removed and then distribute that amount. 

This calculation is easy to understand if you start with a brand new, $0.00 balance IRA. Let's say you open an IRA and contribute $7,000, only to find out you are ineligible to contribute. By the time you notice it's been a few months, the stock market has gone up, and the $7,000 turned into $7,500. You will have to remove the full $7,500 as an excess contribution because the earnings are also ineligible to stay in the IRA. I bet you're thinking, "That stinks and is totally unfair!" (at least, that's what a few depositors have told me). 

Let's take a look at the opposite scenario. You make a $7,000 contribution, buy the hot stock your dentist recommended, and it loses half its value and is only worth $3,500 by the time you realize the mistake. Do you want to have to withdraw the original $7,000 total? Of course not, and it would be impossible anyway. Instead, you withdraw your contribution, minus the loss attributed to the contribution, and distribute the lower $3,500 value. While it's pretty straightforward when the account's beginning balance is $0.00, it can get rather complicated in an established IRA that contains other investments.

Deadlines: Correcting this before the tax filing deadline for the year of the excess contribution is crucial to retaining the best options for fixing this and avoiding penalties. So, for a 2024 contribution, you have until April 15th, 2025, to remove the excess, or you can file an extension and remove it by the extension deadline of October 15th, 2025. 

If you miss that deadline, heaven help you. Please get support from a tax professional. There are a couple of wrinkles in the rules that change the amount you need to distribute, or you can consider applying the overage to next year's contribution (if you are eligible). The 6% penalty will also apply.

More advanced options if you're working with a tax professional

There are some more advanced strategies that I won't go into detail on here, mainly because I don't think they are suitable to employ without the help of a tax professional or your financial planner (or ideally, both). I hesitate even to mention them, but I do want you to know that there are multiple ways to deal with this to add value to your long-term financial planning. These options involve more profound knowledge of the IRS rules around retirement accounts, the ability to communicate the correct instructions to your IRA custodian (the firm holding the IRA or Roth IRA), and the ability to complete the appropriate corresponding tax forms. Congress and the IRS can also change the rules on us, rendering specific strategies obsolete. Frankly, they can be more trouble than they're worth if you don't know what you're doing. Other options include:

• Recharacterizing the Roth IRA to a non-deductible IRA contribution. 
  
  • This would treat the contribution as if it were made to a Traditional IRA.
  • Anyone can make a non-deductible Traditional IRA contribution, regardless of income. The income limits determine whether you can deduct it or not. 
  • Non-deductible IRA contributions create a concept called "IRA basis" because your contribution is after-tax, while the earnings and other money in the IRA are pre-tax. It can be a mess when it comes time to distribute from the IRA. 
  • Like the excess contribution removal, this must be done before the tax filing deadline (plus extension) and involves moving the contribution plus or minus any gain or loss. 
• Backdoor Roth IRA
  
  • Recharacterization has the potential to lead to then implementing a "Backdoor Roth IRA" strategy to get the money back into the Roth account.

Avoiding the issue in the first place

The moral of the story here is to avoid the issue in the first place. That is part of why the IRS gives you until your tax filing deadline (without extension) to make the previous year's IRA contribution. Sometimes, you just don't know where your income will shake out from a tax perspective until your taxes are done. Many people get end-of-year bonuses that are unknown until they are paid out, while others who work on commission might have income that can vary widely from year to year. If you expect to be close to the thresholds, it's OK to wait. Better to hold off and contribute in February or March of the following year than to put your money in early and to have to unwind things in a rush. While you pass the time to make that contribution, set the money aside in a high-yield savings account so you can get paid to wait, and it is there when you're ready.

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