Excess Roth IRA Contributions: Does My Brokerage Keep Track of Income Limits?

According to the IRS’s Roth IRA income limitations, if you plan to file married filing jointly and make $183,000 or over in Modified Adjusted Gross Income (MAGI) in 2012, then you cannot make contributions to a Roth IRA.

Many dual income households are now staring down this Roth IRA limit. Such is the case of this PT Money reader who asks:

I am considering opening a Roth IRA account with an online broker, but I have a few tax questions first. If I make some stock trades in my Roth IRA account, what happens to those trades if my wife and I end up making over the income limit (married filing jointly) of 173K or phased out 183K?

Since it is after tax funds, will the trades just get kicked out of the Roth IRA status and become regular trades that are taxed at the traditional capital gain rates? Is their a penalty for doing so?

Great question. The good thing is that you have not started making contributions yet. So you will not have to reverse anything at this point.

Here’s the deal, your broker does not know how much you make. So, your broker will not do anything but put the money into the Roth IRA each time you make a purchase trade.

Some brokers might notify you if you reach your annual contribution limits. But none to my knowledge keep track of your annual income, and therefore, would have no way of knowing if you breached your limit.

The onus is on you to keep track of your income limitations.

To extend this conversation though let’s say you did contribute to your Roth IRA already or let’s say you might take a chance on contributions later in the year only to find out that you made too much. Here’s what would happen…

The Penalty on Excess Roth IRA Contributions

If you do nothing (i.e. leave the contributions and earnings in the Roth IRA), then you will be charged a 6% penalty (on the excess contributions) each year that you have not corrected this.

The IRS won’t let this go. They will continue to charge you 6% each year that you leave the excess contributions in the Roth IRA.

If you were to contribute $5000 in excess contributions for the year, your penalty would be $300 ($5000 x .06). To calculate and report your excess contribution penalty, you would use Form 5329.

How to Avoid the Excess Contributions Penalty

There are several things you can do to correct this mistake and avoid the 6%.

Shift Your Income or Contribution Date – First, you could make an attempt to reduce your MAGI by deferring income till next year or making additional contributions to your company 401K.

A similar move (that Ryan Guina pointed out in his post on excess contributions) would be to tell your broker to reclassify the contribution as a future year contribution.

Re-characterize – Second, you could request a re-characterization to a traditional IRA before you file your taxes next year. Your broker could help you with this. Just call them up and tell them you have excess contributions.

The broker will then assist you in moving the excess contributions, and the earnings from those funds, over to a traditional IRA. The funds will be considered non-deductible, so at that point you may want to consider a backdoor Roth IRA conversion to bring back a tax advantage.

Pull the Money Out – Third (and probably the least favorable choice), you could take a distribution from your Roth IRA prior to filing your taxes the next year. Again, your broker could help you here.

Just call them up and tell them you made an excess contribution and need to make a distribution of the contributions and the earnings on those contributions.

They will then send you a check and you can do with it what you please. Keep in mind that you will owe taxes on the earnings and you will also face a 10% early distribution penalty on the funds unless it is deemed a qualifying distribution.

If all of this seems confusing, it’s because it is. I’d recommend you visit with your CPA to talk through these options to see which is best.

Have any tips for anyone with excess retirement contributions in their Roth IRA? Leave them in the comment below.

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  1. I realized this year that I’ve been making Roth IRA contributions over the last 5 years when our income does not allow us to make any. I am fairly well versed in my taxes since I do them myself on paper so read up all the instructions (have been doing that for the last 10 years). So I called up my broker (Fidelity) and pulled out my contributions from 2007-2010 (had already recharacterized my 2011 to traditional). However, they mentioned that they will leave the earnings in the IRA and as long as I don’t withdraw that before 59.5 I am OK. I was surprised as I thought that even the earnings should be withdrawn since I was not allowed to make any contributions. Any thoughts?

  2. Avatar machildebrand says:

    I for one will congratulate the people who made this mistake. I certainly hope that you can avoid the 6% penalty through shifting the contribution date or pulling the money out, but at least the ones worrying about this problem are facing a minor mistake of uninformed responsible planning rather than no planning at all. Good to hear people are eagerly planning for the future and seriously contributing to Roth IRA’s.

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