You can have too much of a good thing. While it is a good strategy to contribute to an IRA, some contributions are not allowed. When a contribution is not permitted in an IRA, it is an excess contribution and needs to be fixed. Some excess contributions are pretty easy to understand. Others are a little more complicated. Here are 5 ways an excess IRA contribution can happen:
1. Exceeding the Limit
If you contribute more than the annual limit to an IRA, that will be an excess contribution. For 2023, the limit is $6,500 for those under age 50 and $7,500 for those who are age 50 or over. This may seem like an easy rule to follow. You may wonder who is going around contributing tens of thousands of dollars to IRAs in violation of the contribution limits and, in fact, most IRA custodians will not accept contributions over the yearly limit. However, an individual with multiple IRAs with different custodians could exceed the limit by contributing to each of them.
2. Not Enough Earned Income
A more frequent occurrence is an IRA owner not having sufficient earned income or taxable compensation to fund an IRA contribution for the year. While you can use a spouse’s taxable compensation to fund your IRA, you may not use a multitude of different income sources including Social Security, rental income and investment income. You may have a high income, but not be eligible to fund an IRA. If you go ahead anyway, the result is an excess IRA contribution.
3. Income Is Too High for Roth Contribution
A common cause of excess Roth IRA contributions is contributing in a year when income is too high. If your income fluctuates or you have unexpected income in the year, you are particularly vulnerable. Watch out for the annual income limits. For 2023, the ability to make a Roth IRA contribution will begin to phase out when Modified Adjusted Gross Income (MAGI) reaches $138,000 if you are single and $218,000 if you are married filing jointly. For traditional IRAs, there are no income limits for eligibility to contribute, so this is never a problem.
4. Failed Rollovers
You may be surprised to know that a failed attempt to make a rollover can result in an excess contribution. How can this happen? Well, there are a variety of ways you can end up in this position. One possibility would be the violation of one of the rollover rules. If you mistakenly attempt a rollover after the 60-day rollover period has already expired or if you violate the once-per year rollover rule, you will end up with an excess contribution instead of a rollover in your IRA.
If you are older, you may be at greater risk of excess contribution due to rollover mistakes. This is because of the rule that says that the required minimum distribution (RMD) for the year cannot be rolled over. In fact, the RMD for the IRA must be taken before any of the funds in the IRA are eligible for rollover. For example, an RMD must be taken before doing a Roth IRA conversion. If you mistakenly roll over your RMD, you will end up with an excess contribution.
5. Inherited IRA Mistakes
If you inherit an IRA from someone who is not your spouse, you may not contribute to that inherited IRA or combine it with your own IRA. If you do, you will have an excess contribution.
Fixing Excess Contributions
Knowing what can cause excess IRA contributions is the first step in avoiding them. If despite your best efforts, an excess contribution occurs, the bad news is that the problem will not fix itself. An excess contribution will be subject to penalties each year it remains in the IRA. The good news is that excess contributions can be corrected and often without penalty.
By Sarah Brenner, JD
Director of Retirement Education
Ed Slott and Company, LLC
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Christian Cordoba, founder of California Retirement Advisors, has been a member of Ed Slott's Master Elite IRA Advisor Group since 2007.