Client Question: Improper Roth Contribution

May 18, 2023

I onboarded a new client this week, and within minutes of looking at his pre-existing Roth IRA and tax returns for the given years, I realized he had made improper contributions to his account (due to exceeding the income limit).

While he had an advisor helping him, that individual did not confirm my new client’s income before making the contributions. (If you have been reading along to these columns, you will remember that the ability to contribute directly to a Roth IRA is dependent upon your income for that tax year).

Knowing the contributions were made in error, his question quickly became “how do we fix this?”

Luckily, the account was relatively new and the fix should not result in a large financial impact to my new client. However, given the complexity of rules around Roth IRAs and the ability for income levels to vary during any given year, I thought it was worth discussing how to remedy excess contributions in this week’s column.

The proper remedy for fixing excess Roth contributions varies based upon the timing of such contributions and the related tax-year filing. If you made the contribution for a tax year for which you haven’t filed a return yet (or even if you just filed it), the fix is much easier and does not result in any excise penalties.

Timely Correction: This is a contribution made for a tax year for which the tax return is not yet filed (including extensions).

If the contribution was made for a tax year for which the return has yet to be filed, the remedy is seemingly straightforward.

You withdraw the contribution, plus any attributable earnings, from the account and report the earnings as income. The calculation of the related income (referred to as Net Income Attributable) can be a bit complicated but the good news is most custodians can assist with the “math.”

For timely corrections, there is no 6% excise penalty since the error was caught in time. However, if you are under 59.5 years old, in addition to income tax on the earnings, you will also have to pay 10% excise penalty on any earnings (since it’s being withdrawn prior to retirement). (Note that if there has been a loss in the ensuing time period, this would reduce the amount of the withdrawal (ie: offset contribution reversal) and avoid any tax/excise on income since there isn’t any).

Even if the return has been filed, you have six months after due date (excluding extensions, so October 15) to avoid the excise penalty. However in this case, you will need to amend your tax return and include any earnings on the excess contribution.

Untimely correction: – if the contribution relates to prior years (returns filed over 6 months ago), this is deemed to be an untimely correction.

You still need to remove the contribution and you will also be subject to a 6% excise penalty per year on the excess contribution amount. However, you no longer need to remove the associated earnings. Why is this the case? Many assume that the 6% penalty is meant to be equivalent to the likely return over time, but the IRS doesn’t explain the rationale.

Given the variance in treatments for timely/untimely, some individuals attempt to evaluate whether it’s better to wait over a year to fix a mistake (to avoid taking out earnings) and pay 6% penalty – or if it would be best to fix sooner and remove earnings (without 6% penalty). This is a complex evaluation and should be carefully considered with the help of your tax and financial advisors. My advice would be fix the error when discovered (as I am now doing for this client).

Please note there are also other ways to fix excess contributions – either via recharacterization or allocating the excess to another year’s contribution amount. Again, both of these can become complicated and will depend on the specifics of the situation, so these are best handled on a case by case basis with your advisors.

Hopefully the need never arises for you to correct an excess contribution but if it does, I trust this brief explainer will be of use to you!

Note: All commentary above is as of the date of this post and is for education and informational purposes only. Windermere and its principals do not intend for this to serve as investment advice and are not responsible for any actions taken based on this article. Consult your tax and/or financial advisor before taking any actions as it relates to your own investment portfolio

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