How to Avoid a Penalty on Your Excess IRA Contribution

Did you make your IRA contribution for 2016? If you did, you may want to take some time now during tax season to be sure your contribution is an allowable contribution and not an excess contribution.

What is an excess IRA contribution?

Excess contributions to IRAs can happen for a wide variety of reasons. No one can contribute more than $5,500 if under age 50 in 2016. Those who are 50 or over in 2016 cannot exceed $6,500. If you contributed to an IRA for 2016 and you or your spouse did not have taxable compensation from an employer or self-employment income, you have made an excess IRA contribution.

For Roth IRAs, there are income limits. For 2016, the income phase-out range for contributions if you are a single filer is between $117,000 and $132,000. If you are married filing jointly, it is between $184,000 and $194,000. Making a Roth IRA contribution when your income is too high will result in you having an excess contribution. There are no income limits for traditional IRA contributions, but there are age limits. You may not contribute to a traditional IRA in a year when you are age 70 ½ or older.

6% Penalty

If an excess contribution is not corrected in a timely manner, a 6% excess contribution penalty will apply. This penalty is not a once and done thing. It will apply each year the excess remains in the IRA. That is why it is important to correct your excess contribution as soon as possible. It is not a problem that will necessarily go away on its own.

Correcting an Excess without Penalty

How can you avoid the 6% penalty? Well, you must correct the excess contribution by the deadline. The deadline for correcting a 2016 excess IRA contribution without penalty is October 16, 2017. You will have two potential strategies for how you do the correction.

You may choose to withdraw the contribution and the earnings or loss attributable from the IRA. The contribution amount is not taxable or subject to penalty. However, any earnings would be taxable and may also be subject to the 10% early distribution penalty if you are under age 59 ½.

Your other option would be to recharacterize your contribution. When you recharacterize your contribution, plus the earnings or loss attributable the funds would be directly transferred from a traditional IRA to a Roth IRA or vice versa. Recharacterizations are not taxable or subject to penalty.

Which method of correction should you use? Well, it will depend on the facts of your situation. For example, if you have an excess traditional IRA contribution because you were age 72 in 2016, you may consider recharacterizing that contribution to a Roth IRA where there are no age limits. However, if you made a traditional IRA contribution and you have an excess contribution because you have no taxable compensation, recharacterizing will not help you. You will need to correct your excess by withdrawal.

Act Now

While you still have some time before the October 16, 2017 deadline to correct your excess 2016 IRA contribution and avoid a penalty, it makes sense to take care of it now during tax season. By doing so, you can be sure that you don’t miss the deadline and you may be able to avoid the hassle of having to file an amended tax return. The excess IRA contribution rules are complicated. You may want to seek the advice of a knowledgeable tax or financial advisor.