An Individual Retirement Arrangement, or IRA, is one of my favorite vehicles to save for retirement because it offers a wide variety of investment choices and lots of tax savings. But when you don’t follow the rules, an IRA comes with hefty penalties. A common mistake is contributing too much to an IRA.
What Happens If You Contribute Too Much to an IRA?
In this article you’ll learn about traditional and Roth IRA contribution limits, IRA contribution deadlines, and how to correct an excess IRA contribution so it costs you as little as possible. (If you’re interested in learning more about all the different types of retirement accounts that can help you accumulate an impressive nest egg, be sure to read my new book, Money Girl’s Smart Moves to Grow Rich.)
When Is the IRA Contribution Deadline?
The deadline to contribute funds to an IRA for the 2010 tax year is April 18 of 2011. So if you didn’t max out an IRA last year, there’s still time to contribute more money for 2010! The maximum allowable contribution for a traditional or Roth IRA is $5,000 if you’re under age 50 and $6,000 if you’re age 50 or older. If you have more than one IRA, you can contribute to both of them as long as the total amount doesn’t exceed your allowable limit. For example, you could contribute $2,500 to a traditional IRA and $2,500 to a Roth IRA.
What are the Income Limits for Roth IRA Contributions?
If you contribute to a Roth IRA and end up making more money than you expect, you might have to withdraw all your contributions. That’s because contributions to a Roth IRA are allowed only if your modified adjusted gross income doesn’t exceed the following IRA contribution limits:
- $120,000 for taxpayers who file as Single, Head of Household, or Married Filing Separately (if you didn’t live with your spouse during the year)
- $10,000 for taxpayers who file as Married Filing Separately (if you did live with your spouse during the year)
- $177,000 for taxpayers who are Qualifying Widow(er)s or Married Filing Jointly
What If You Contribute Too Much?
But what happens if you overloaded an IRA by mistake? It’s not uncommon for people to realize at the end of the year that they contributed more than their allowable limit. The good news is that excess contributions can be corrected without penalty if handled in a timely manner.
Let’s say Polly is 30 years old, earned $40,000 in 2010, and contributed a total of $6,000 to her traditional IRA. Since her allowable limit is only $5,000, she has an excess of $1,000 in the account. If Polly withdraws the excess plus any earnings it made, on or before the due date of her tax return, it’s like it never happened!
If she can’t complete the necessary paperwork for an IRA withdrawal before taxes are due, she can file for a tax extension using Form 4868, Application for Automatic Extension of Time. Filing for an extension will give Polly until October 17, 2011 to file—plenty of time to correct her IRA goof.
How to Correct an IRA Contribution Mistake
I mentioned that Polly has to withdraw both her excess contribution and the earnings it made. The excess contribution can be withdrawn without any tax or penalty, but that’s not the case for income she made on the excess. Let’s say she made $50 on the additional contribution of $1,000. Because she wasn’t supposed to earn that additional money, withdrawing it is considered an early distribution.
Distributions you take from an IRA before you reach age 59½ are subject to a hefty 10% penalty. So Polly has to make things right with the IRS by paying ordinary income tax plus the 10% penalty on the $50 she made from her excess contribution of $1,000.
What Happens If Excess IRA Contributions Are Not Corrected?
Once you realize that you contributed too much to an IRA, contact your IRA custodian or tax professional right away. An excess contribution that isn’t withdrawn by the deadline is subject to a 6% tax penalty each year that it remains in your IRA. It’s important to try to prevent excess IRA contributions from occurring in the first place, but it’s even more important to get them corrected on time to avoid significant taxes and penalties.