What happens if you contributed more to your IRA than allowed? Often, excess IRA contributions are caught around the time you’re preparing your taxes. Hopefully, you catch the error in time to make adjustments that may ease the 6 percent penalty the IRS levies if you deposit more into your IRA than yearly contribution limits allow. And that penalty accumulates every year relevant to the excess amount remains in your plan.
Contribution Limits for IRAs
Annual contribution limits are in place for every retirement plan. The amount you can contribute is determined by the plan you have. So, you must know your plan’s limit and make sure you don’t exceed that in any given year.
For example, for 2022, the annual contribution limits for both traditional and Roth IRAs is $6,000 or $7,000 if you’re age 50 and older. In 2023, those limits increase to $6,500 and $7,500 if you’re 50 or older. You are prohibited from making annual contributions that exceed those amounts.
But it does happen. And it happens to the best of us. Maybe you forgot you already reached your limit and made another deposit that put you over the max allowed.
Or if you use a Roth IRA and got a raise that pushed your modified adjusted gross income over the threshold that allows you to directly contribute the maximum limit to your account and didn’t adjust your contributions to the account, you probably exceeded the limits of your plan for the year.
How to Correct Excess IRA Contributions
Fortunately, you can limit your exposure to the penalty for excess IRA contributions and avoid being taxed twice. If the oversight is caught early enough, the IRS might even waive the penalty. Below are three options to consider.
1. If you haven’t filed your tax return yet, you can take a corrective distribution.
Withdraw the excess cash—and any income generated by that excess amount—as soon as you can. This move, if performed before you file your taxes (including extensions), saves you from the 6 percent excess contribution penalty. You’ll add those earnings to your current income and pay tax on it, but the rest of the overage is free and clear once it’s withdrawn.
2. You can also reassign some of your overage to the following year.
For example, let’s say you contributed $2k more than you should have in 2022. Before filing your taxes (including extensions), you can designate that $2k to go towards 2023 contributions. You’ll still owe the 6 percent penalty, but you’re coming out better than paying tax twice on the excess contribution.
3. Roth IRA Owners Can Recharacterize the Account
Roth account owners who made excess IRA contributions have a third option. You can recharacterize your Roth IRA to a traditional IRA. In the example mentioned earlier in this article, if your MAGI reaches a certain limit, you’re unable to contribute to a Roth account. So, if you made an excess IRA contribution in these circumstances, recharacterizing those funds into a traditional IRA may benefit you—especially if you want to continue socking away retirement savings. Work with your accountant here, because your excess contribution to the Roth cannot exceed that of the traditional IRA limit.
You Must File IRS Form 5329 to Report the Excess Contribution
This is a fact many taxpayers don’t know, and before 2023, the oversight was costly. In the past, filing Form 5329 started the clock for the statute of limitations for the excise taxes and penalties you incur on excess contributions. But if you didn’t know about the form and failed to file it, you were hit with additional interest and penalty charges, which could be financially devastating for many taxpayers.
Beginning in 2023 and beyond, you must continue to report excess IRA contributions using Form 5329. But the SECURE Act 2.0 passed in late 2022 provided leeway in Section 313. This section deems an automatic 6-year timeframe of the administration of these taxes, starting the day you file your individual tax return (Form 1040) in the year the excess IRA contribution was made.
The above moves apply to both conventional IRAs as well as self-directed IRAs. Please contact Advanta IRA if you have questions about this article or would like more information about how you can use self-directed plans to build wealth using alternative investments.
Additional reading about IRA rules: