It would be best if we could collect as much cash as we want in a Roth IRA, but unfortunately, that isn’t the case. The government forms the rules and limits how much we can contribute to this account annually.
Moreover, because rules are complicated, it is strangely easy to overcontribute to Roth IRA.
It can happen to anyone who didn’t understand the rules or who didn’t pay enough attention, today we are talking about:
- Roth IRA essentials.
- What are Roth IRA contributions excess?
- Ways to avoid Roth IRA contribution tax.
- Is the excess contribution worth the risks?
- How you can withdraw the excess contribution.
- What is an alternative to Roth IRA that doesn’t have a contribution limit?
- How to be financially independent.
It’s a lot of work. Let’s started!
Basics of Roth IRA
A Roth IRA is an Individual Retirement Account where you can contribute after-tax dollars. Contributions and earnings are growing tax-free, and the account owner can withdraw it after a year of 59½ tax-free and penalty-free (if the account has been open for five years).
This type of account is popular because it doesn’t have age restrictions and has no required minimum distributions (RMDs). In a traditional IRA, if the person is 70 1/2 or older, they can’t make a regular contribution.
Usually, people who expect to be in a higher tax bracket in the future choose Roth IRA for their saving plan.
An advantage of this retirement account is the opportunity to leave your money in the account for as long as you want. On the other hand, many people don’t prefer this option due to income limitations.
Even though Roth IRAs are similar to traditional IRAs, the most significant difference is how the two are taxed. With Roth IRAs, the contributions are not tax-deductible, but when you start withdrawing funds, the money is tax-free.
On the other hand, with Traditional IRA, there are no income limits, although the income can affect the extent to which contributions will be tax-deductible.
Unlike traditional IRAs and 401 (k), there are no required minimum distributions during the account holder’s lifetime.
After contributing funds with Roth IRA, everyone has various investment options, including mutual funds, stocks, bonds, exchange-traded funds (ETFs), money market funds, etc.
How to Open a Roth IRA?
Usually, individuals open their IRAs with brokers. Only a financial institution that has IRS approval can offer IRAs.Generally, these financial institutions are banks, brokerage companies, federally insured credit unions, and savings and loan associations.
A Roth IRA can be opened anytime, but it’s important to make contributions for a year by the tax-filing due date. It is usually around the 15th of April the following year.
Roth IRA providers are quite different, with different investment options. Some offer an extensive list of investment opportunities, while others are more limiting.
Also, almost every provider has a different fee structure for Roth IRAs, which can have an enormous effect on investment returns.
Everyone should choose a Roth IRA provider depending on their risk tolerance and investment preferences.
When it comes to contributing to an account, the IRS dictates how much money individuals can deposit in a Roth IRA and the type of money. Only earned income is allowed for contribution to a Roth IRA.
Compensation includes salaries, bonuses, wages, commissions, and others for people working for an employer. For self-employed people or a partner, or members of a pass-through business, taxable compensation is the net earnings from their company.
Alimony, investment income, rental income, child support, and unemployment benefits are not included.
If someone’s annual income is above a certain amount, which the IRS changes periodically, they become unqualified to contribute.
Who is Qualified For a Roth Individual Retirement Account?
Every person that has earned income is qualified for this account, as long as they meet specific requirements concerning filing status and modified adjusted gross income.
Roth IRA Contribution Limits
Roth IRA contribution limit in 2022 is $6,000 for most people. People older than 50 can contribute an additional $1,000 a year (the total contributions are $7,000). Or the taxable compensation for the year if the compensation was less than this dollar limit.
”Excess contribution” means overcontributing your earned income, more than the contribution limit, or making an improper rollover contribution to an IRA. Roth IRA contributions might be limited if your income exceeds a certain level.
Modified adjusted gross income (MAGI) and filing status can reduce contributions.
To keep up with inflation, these annual limits periodically increase.
For people that have a maximum contribution of $6,000 (or $7,000 if over 50) in the tax year 2022 and their adjusted gross income (AGI), the contribution limits are:
- Less than $129,000 if they are single, applying for the head of household filing status. Or, if they are married, file separately but didn’t live with their spouse.
- Less than $204,000 if they are married and file a joint return with their spouse.
When these income thresholds are met, the IRA contribution limit starts decreasing. They go to zero for incomes of $214,000 for married filers of joint returns in 2022. In another case, for single people, head of household, and married filers of separate returns who didn’t live with their spouses is $144,000.
There is a phaseout for the married filers of separate returns who lived with their spouses and earned less than $10,000.
So, if their AGIs are $10,000 or more and remain the same in the current year, their contribution limit is zero.
These contribution limits involve traditional IRAs as well.
If someone maintains both types of accounts, they can’t contribute $6,000 to one and $6,000 to another account. Also, they cannot contribute $6,000 each to multiple Roth IRAs. $6,000 (or $7,000) is the total Roth IRA contributions that cannot be exceeded.
Excess Roth IRA Contributions
Generally speaking, an excess IRA contribution occurs if one:
- Contributes over the contribution limit.
- Makes a regular IRA contribution to a traditional IRA at age 70 1/2 or older.
- Makes an improper rollover contribution to an IRA.
The taxation on excess Roth IRA contributions depends on the type of the account. It’s not the same for Roth and Traditional IRA contributions.
Penalties For Excess Roth IRA Contributions
Excess Roth IRA contributions would be conditional on a 6% excise tax per year with the Traditional IRA. This will last as long as the excess amounts remain in the traditional IRA.
Moreover, if the account owner has less than 59 1/2, an early distribution penalty of 10% would affect the amount of the excess contribution.
Additionally, the excess contribution would be subject to income tax while the earnings would remain in the Traditional IRA.
With the Roth IRA, excess contributions will be subjected to a 6% tax per year as long as excess amounts remain in the account.
In contrast to Traditional IRA, there wouldn’t be a 10% tax on early distribution or the excess contribution.
Furthermore, the earnings from the excess Roth IRA contributions will stay in the Roth IRA.
The maximum tax on an excess IRA contribution is 6% of the combined value of all IRAs as of the end of the tax year.
Specifically, everyone with remaining excess contributions that aren’t withdrawn or applied toward an allocable contribution for the following year must pay the 6% tax each year.
What To Do If You Overcontribute to Roth IRA?
Now let’s go through possible solutions for this problem and learn how to avoid paying taxes on excess Roth IRA contributions.
Roth IRA Excess Contribution Removal
When someone notices their overcontribution mistake before the year’s tax filing deadline, the best option for them is to remove the excess Roth IRA contributions and attributable earnings before filing taxes.
Unfortunately, it is not as simple as it might sound.
Accounts’ owner has to remove excess contribution and any earnings attributable to that excess contribution.
Everyone who goes over the contribution limit probably knows how much the excess Roth IRA contribution is. But if not, it would be easy to figure it out by checking how much it was contributed during the year. To consider how much someone has earned on the excess contribution is necessary to use the net attributable income formula (NIA).
”Net income attributable‘ formula is’:
Net income = Excess contribution x (Adjusted closing balance – Adjusted opening balance) / Adjusted opening balance
The adjusted opening balance (AOB) is the Roth IRA balance before excess contribution, plus all contributions, including the excess contribution, consolidations, and transfers.
The adjusted closing balance (ACB) is the current value of the Roth IRA minus any distributions the account owner has taken or any consolidations or transfers they made since the excess contribution.
Here is an example to be easier to follow.
Let’s say Mark accidentally contributed $7,000 to their Roth IRA. Since he was eligible to contribute the maximum contribution of $6,000 this year, he made an excess Roth IRA contribution of $1,000. His AOB was $10,000 and ACB is $12,000.
So, when subtracting AOB ($10,000) from ACB ($12,000) you get $2,000. Following the formula, now divide this buy AOB, leaving us with 0,2.
The last step is to multiply this by the number of your excess Roth IRA contributions of $1,000. That’s how we got the net attributable income, which is, in this case, $200.
Thus, if Mark wants to avoid the 6% penalty on the excess contribution, he needs to remove the $1,000 contribution itself and the $200 he earned because of that contribution. Perhaps Mark goes through the preceding calculations and finds that he has taken a loss instead of earning money on the excess contribution.
Then we need to subtract this loss from the amount he must withdraw. In our example, if Mark’s loss is $200, he has to withdraw only $800.
Removing the Roth IRA excess contribution before the tax deadline will help avoid the 6% excise penalty. But unfortunately, the individual still needs to pay income tax on that money.
If Mark is under 59 1/2, the government will charge him a 10% penalty for early withdrawal on any earnings portion in his taxable income that he withdraws.
In this example, he would owe $20 of his $200 earnings to the government, plus income tax.
If Mark doesn’t remove his excess contribution before the tax deadline, there is an option to file an amended return tax after removing the funds. Although, he must do this by October because then is the tax extension deadline.
The government will review that and refund any penalties that are taken out if it’s necessary.
Recharacterizing Excess Roth IRA Contribution
Another method to fix the mistake is transferring excess contribution and any attributable earning from a Roth IRA to a traditional IRA.
If someone hasn’t realized their high-income limits how much they could legally contribute, it can correct it with this transfer, but it must be done in the same tax year.
In case they don’t do that, the 6% excise tax penalty needs to be paid. Additionally, they also have to be able to contribute more to a traditional IRA, or nothing will change.
A trustee-to-trustee transfer is when the distribution is not paid directly to the account owner, nor does the account owner receive a check made payable to the new account.
A taxpayer who decides to make a characterization must transfer the contributed funds in a trustee-to-trustee transfer from the first IRA to the second IRA.
For example, redesignating a Roth IRA as a traditional IRA is equivalent to a trustee-to-trustee transfer of the entire balance of the first IRA to the second IRA.
Any earned income on the funds while sitting in the first IRA must be included in the transfer to the second IRA.
An individual must characterize excess contributions no later than the due date of the individual income tax return (including extensions) for the tax year of the contribution without being treated as a taxable distribution. It usually is the 15th of October, the following year of the excess contributions.
Even if the individual didn’t need or obtain a filing extension, it would be the same.
Still, if the individual did not file a timely return for the year of the excess contributions, they must do the characterization earlier. The regular due is the 15th of the April of the calendar year following the contribution year.
If an individual is a retiree and misses the due date for characterization, the IRS may allow additional time to complete it. But it is possible only if the retiree shows that they acted reasonably and in good faith. The point is to prejudice the interest of the government.
Assign the Excess Contribution to the Next Year
The mistake can be solved by reducing the contribution this year by the excess amount.
We recall our example with Mark once again to be easier to understand. Mark contributed too much for this year, $7,000 instead of $6,000. More precisely, he exceeded the dollar limit of $1,000.
He can fix it by contributing only $5,000 the following year. That is, he will contribute $1,000 below the contribution limit.
Still, he will have to pay the 6% excise tax for one year when the excess contribution remains in the account.
The mitigating circumstance is that he doesn’t have to bother with withdrawals.
Thus, the excess amount is being pushed toward the next year as a regular contribution.
But, he would need to fill out and submit Form 5329 with the next tax return.
This Form calculates how much tax a person has to pay on the excess contribution.
The IRS will know about the excess IRA contributions by receiving the Form from the bank or financial institution where the IRA or IRAs were established.
Withdrawing
Another solution for people who didn’t fix their mistake before the tax due date in the year they have made an excess contribution is to withdraw it next year.
People who decide to do this have to take out only the contribution, without any earnings.
They still have to pay the 6% excise tax for the year when the excess contribution was in their account, but they will prevent this tax in future years.
The government charges the ordinary income tax when someone withdraws these excess Roth IRA contributions, despite already paid taxes on this income in the year the account owner earned it.
They also charge an additional 10% for early withdrawal if the account owner is under 59 1/2. Thus, it is a pretty expensive way to fix the problem.
Are the Excess IRA Contributions Worth the Risks?
Simply put: no. Even though there are options to fix going over the limit, we think it’s not worth it. It is not beneficial because it is expensive or complicated and requires hiring a professional to help.
Usually, people contributed too much because of their improvidence or insufficient understanding of the rules.
Despite that, some people think they can hack the system and benefit from it. It’s not the case because the IRS sees every excess contribution very well.
We think there is a much better option for your retirement account where you couldn’t overcontribute.
If you have high earnings and plan to retire early or have everything you need in retirement, this option will be perfect for your personal finance.
How to Withdraw the Excess Contribution?
In case someone decides to withdraw the excess amount of contribution, here is an explanation of how to do it.
Withdrawal means the removal of assets from a retirement account. So, the money withdrawn doesn’t count toward an account owner’s contributions for that particular tax year.
According to the IRS, the deadline for withdrawing excess contributions is on or before the due date for filing a tax return. It was on Monday, April 18, 2022.
But, there is also an option to request an extension of time to file the tax return. If individuals request it, they can withdraw excess contributions from a Roth IRA until October 17, 2022.
We need to distinguish between withdrawals and distributions. It is not the same.
Withdrawals are like a function for a new start, and the result is like the contribution was never made in the first place.
If the money person contributed earns any interest or dividend while sitting in the Roth IRA, the account owner must withdraw those earnings along with the underlying principle.
If the Tax Return Is Filed
Even if the person didn’t file for an extension, a specific rule allows withdrawing excess contributions until the 17th of October.
A person who made excess contributions can withdraw some or all their Roth IRA contributions up to six months after the original due date of their return.
It is the 17th of October for most people. People need to file an amended federal tax return after withdrawing the funds from their Roth IRA.
In some cases, people need to amend their state tax returns, but the best is to check that with a local tax professional.
If You Do Nothing
A person who doesn’t take any action about their excess IRA contribution will simply owe a tax of 6%. This cost is known as an excise tax.
The excise tax involves the contribution amount that exceeds the person’s limit for that year. It’s reported on Form 5329.
Many people think that a 6% excise tax isn’t too much. This is usually the reason why they choose to leave the money parked in the Roth IRA.
Maybe 6% isn’t that bad for a one-time tax hit, but it isn’t the case with an excise tax. But even if a person avoids the 6% penalty, they still have to pay income tax on the money – the tax of 6% kicks in every year that the excess contributions remain in the IRA.
Leaving your excess money in this account is like throwing it through the window.
Taxes Payment
Let’s turn to another example for a better illustration.
Olivia contributed $8,000 to her Roth IRA. Her actual maximum limit was $2,600. Thus, Olivia contributed $5,400 more than she was allowed. She didn’t fix the excess contribution by the 17th of October.
Since 6% excise tax on her excess Roth IRA contribution, she owes $324.
The following spring, she works on her taxes and finds out the mistake she made last year.
For this new year, Olivia is eligible to contribute $3,200 to her Roth IRA, but she decided not to make any additional contributions.
So, $3,200 of her $5,400 in excess contributions is carried over and absorbed into the new year. Thus, Olivia’s new excess amount drops to $2,200. The corresponding 6% excise tax is now $132.
That means that Olivia would pay $456 in excise tax over two years. The excess Roth contribution will have been corrected by not contributing additional money to her Roth IRA.
An excess contribution can be absorbed as a regular contribution for a later year if the individual is eligible to make a contribution for such a year later and doesn’t use up their Roth contribution limit for that year.
The excess contribution has been fixed by the third year, and there is no additional excise tax she should pay to the IRS.
An Alternative that Doesn’t Have a Contribution Limits
We promised to present an alternative where you can stash as much money as you want. Get ready because it’s much better than you can imagine!
Whole Life Insurance Policy
One of the most significant benefits of whole life insurance is building cash value that can be used later in life for any financial purpose. It refers to retirement as well.
Whole life insurance is a permanent life insurance policy that builds up cash value with tax benefits. One part of each premium is allocated and invested in the cash value policy, which can be used for savings.
We highlighted the benefits of whole life insurance:
- Permanent life insurance benefit
The contrast of permanent life insurance is term life insurance policies that only last for a specific period (term). The problem with that is while you are aging, the cost of that policy becomes more expensive. More often than not, impossible to pay.
Since the permanent life insurance policies often stay in force through age 100 or even higher, the full death benefit is paid out. So, in any case, your family will receive a lump sum cash benefit as long as the policyholder keeps the policy in effect and premiums are paid.
- The premium is always the same
The monthly premium doesn’t rise after the policy owner takes out their whole life insurance policy. Due to that reason, it is more beneficial to take out a whole life insurance policy when you are younger (and healthier) because the insurance rates are lower.
- You have control over guaranteed cash value
After every policy premium payment, one part of that premium covers the insurance and administrative costs. After that, the rest goes toward gaining tax-deferred cash value that grows to a helpful sum over time.
- Dividends
If you buy a whole life insurance policy from a mutual company, you become an owner of the company and get dividends when there are profits.
Your cash value grows at a guaranteed rate with a whole life insurance policy. Additional dividends allow you to use them later to withdraw or borrow against for future expenses, including retirement.
So, not just that you get the death benefit protection, but you get the opportunity to fix your personal finances and achieve all of your goals.
The best way to use the whole life policy is to supplement your retirement income stream. It would be best to get a whole life insurance policy by age 45 or even earlier. Of course, you can get it later, but an earlier start gives you more time to grow cash value and lower premiums which will never increase.
A perfect strategy for your retirement would be to contribute to your traditional IRA, 401 (k), or Roth IRA, and the remaining money put towards the whole life policy.
Because whole life builds guaranteed cash value, it is a fantastic wealth-building vehicle that can be used for retirement income.
Instead of paying a 6% excise tax for excess contributions, you will have a vehicle to improve your retirement plan.
Retirement savings are one of the key financial goals in everyone’s life, but certainly not the only one. We recommend whole life insurance because it is tied to Infinite Banking and allows you to gain complete financial freedom while also saving for retirement.
Here is how!
Gain Financial Freedom
The Infinite Banking Concept or over-funded life insurance began thanks to Nelson Nash’s book Becoming Your Own Banker.
In the book, Nelson Nash explained how whole life insurance supports policy owners to borrow money from themselves without eliminating the growth of their policies.
You will need just a whole life insurance policy to start an over-funded life insurance strategy. As we mentioned, whole life insurance policies have a savings component besides the death benefit.
After activating your policy, its value can be borrowed against. Money can be taken out of the policy, making it excellent collateral due to the provider’s guarantee.
Borrowing and repaying funds from your insurance provider help you pay huge expenses in your life – kid’s education, new car, home, or anything you want.
You will never again have to take a loan from the bank, pay them high fees, and depend on them.
As Nelson Nash says, you will become your own banker. Thanks to Infinite Banking Concept, you will be imitating the process of traditional banks, but you will be financially independent.
Final Thoughts
We hope this article has helped you understand the importance of avoiding excess Roth IRA contributions and shown you how Whole Life Insurance can be a valuable investment for your future.
Here at Wealth Nation, we teach people about personal finance and provide support so they can make informed decisions about their money. Good luck on your journey to financial freedom!