## 2013-10-24

### Correcting Roth IRA Overcontributions

Like most things in life, it's best to be proactive about tax return errors.  If you've made an error, correct it before Uncle Sam comes knocking with additional fees and interest.  You can file an amended return to correct tax errors up to three years ago.

### IRA Contribution Limits

As mentioned in previous IRA articles, IRAs (Individual Retirement Agreements) have an annual contribution limit.  In 2013, this limit is the lower of $5,500 or your taxable compensation for the year. There are several situations that can raise or lower this limit: 1. You're over 50: you may make a 'catch-up contribution' of an additional$1000 per year.
2. You're married, and your spouse makes more than you: you may add your spouse's taxable compensation, minus their IRA contributions, to your taxable compensation for the purpose of calculating your contribution limit.
3. You earn over $110k (filing single) or$173k (filing joint), your limit is reduced:

4. Rollovers from an old IRA or employer-sponsored retirement plan: not subject to any limits.
As mentioned in the article about graduate students and the Roth IRA, taxable compensation for IRA purposes does not include scholarships and fellowships unless you are issued IRS Form W-2 and the scholarship or fellowship amount appears in Box 1 if that form.  It also doesn't include earnings from real estate, interest and dividend income, deferred compensation, pension or annuity income, or anything that you exclude from income (other than combat pay) in your tax returns.

A single brokerage will never allow you to contribute to an IRA past the hard annual contribution limit, but this could occur if you contribute to IRAs held at multiple brokerages.  The brokerages won't keep track of how much you've contributed overall, so that is your responsibility.

If you contribute over your limit and the IRS finds out, especially if the overcontribution was in a previous year, the resulting fees and taxes can be significant.  The sooner an overcontribution is corrected, the less onerous the consequences.

### Overcontribution Scenarios

Due to the rules above, there are two common scenarios in which Roth IRA overcontributions are made:
1. You make more taxable compensation than you expected, pushing you into the income range in which maximum contributions are reduced.
2. You make less taxable compensation than you expected (or you discover that your income isn't counted due to one of the rules above), and you contribute more than your total qualified taxable compensation or more than the annual hard contribution limit of $5,500. Most advice online is for dealing with Scenario #1, which is simple to fix and probably a lot more common than Scenario #2. Fixing Scenario #1 While Roth IRA contribution limits fall off for incomes above$110k (filing single) or $173k (filing join), Traditional IRAs don't have this limitation. All you need to do is contact your brokerage and have them 'recharacterize' your Roth IRA contributions as Traditional IRA contributions. This must be done by October 15th of the year following the contribution. You'll need to file IRS Form 8606 ("Nondeductible IRAs") and, if you've already filed your tax return, you'll need to file an amended return with IRS Form 1040X. The following articles cover recharacterization in significant detail: http://www.bogleheads.org/wiki/IRA_recharacterization https://personal.vanguard.com/us/insights/taxcenter/rothira-conversions http://www.kiplinger.com/article/retirement/T046-C001-S001-recharacterize-a-roth-ira.html http://www.irs.gov/publications/p590/ch01.html#en_US_2012_publink1000230671 Fixing Scenario #2 This one isn't quite so easy. If you overcontributed because your qualified taxable compensation was too low or because you contributed more than the hard annual limit (currently$5,500), that overcontribution needs to be:

A) withdrawn from the IRA, or
B) transferred to the following year.

In either case, you will owe some combination of:

α) a penalty tax on the earnings portion of the early withdrawal
β) a penalty tax on the overcontribution itself.

You'll need to file IRS Form 8606 ("Nondeductible IRAs") and IRS Form 5329 ("Additional Taxes on Qualified Plans Including IRAs and Other Tax-Favored Accounts"), and in some cases you may need to amend previous year(s') returns with IRS Form 1040X.

### Correcting Before You File Taxes, or After?

Your options, and the fees you will pay, depend on whether you catch the error before you file your taxes.  The sooner you catch the error, the less painful the process.

Scenario #2.1 - Catching an overcontribution before you file taxes
If you catch an overcontribution before you file your taxes for the contribution year, the situation isn't too terrible.  Contact your brokerage and ask for a form "to request withdrawal of excess IRA contributions," then fill it out and send it in.  Your brokerage will return to you the total amount of your overcontribution plus any earnings the overcontribution has accrued.  The overcontribution itself is tax- and penalty-free in this situation, but you will be charged income tax plus a 10% early withdrawal penalty on the earnings portion.  If April 15th is coming up and you need more time to get things sorted out, file IRS Form 4868 for a no-cost six-month extension through October 15th.

On IRS Form 8606, you'll fill out Part III, "Distributions From Roth IRAs."  Enter the earnings portion of your withdrawal on Line 19, and unless you had qualified homebuyer or higher education expenses, this value will end up on Line 25 and transfer to Form 1040 line 15b.

On IRS Form 5329, you'll fill out Part I, "Additional Tax on Early Distributions," and Part IV, "Additional Tax on Excess Contributions to Roth IRAs."  Enter the earnings portion of your withdrawal on Line 1, and unless you had qualified homebuyer or higher education expenses, this value will end up on Line 3 and trigger a 10% tax on Line 4, which will then transfer to Form 1040 line 58.  On Lines 18, 23, and 24, you'll enter '0'.  Because you caught this overcontribution before your filed your taxes for the contribution year, the 6% Excess Contribution Tax on Line 25 is zero.

Scenario #2.2 - Catching an overcontribution after you file taxes
If you catch an overcontribution after you file your taxes for the contribution year, there will be more pain involved.  As above, you must contact your brokerage and ask for a form "to request withdrawal of excess IRA contributions" and pay income tax and a 10% penalty tax on the earnings the overcontribution has accrued.  In addition, you must pay a 6% penalty tax on the total value of the overcontribution for each year the overcontribution has persisted.

On IRS Form 8606, you'll fill out Part III, "Distributions From Roth IRAs."  Enter the earnings portion of your withdrawal on Line 19, and unless you had qualified homebuyer or higher education expenses, this value will end up on Line 25 and transfer to Form 1040 line 15b.

If your uncorrected overcontributions only occurred in the tax year for which you just missed the filing deadline, you will fill out Part I, "Additional Tax on Early Distributions," and Part IV, "Additional Tax on Excess Contributions to Roth IRAs" of IRS Form 5329.  Write '0' for Line 18 and the amount of your excess contributions on Lines 23 and 24.  This will trigger a 6% tax on the total value of the overcontribution — or the total value of your IRA on the last day of the previous year, if it's lost money — on Line 25, which will then transfer to Form 1040 line 58.

If your uncorrected overcontributions occurred in a tax year before the tax year for which you just missed the filing deadline, write the sum of those overcontributions in Line 18.  Line 24 will now contain the sum of all of your overcontributions, minus recent tax year undercontributions (Line 19) and distributions (Line 20).  You will need to use Form 1040X to amend previous years' tax returns to acknowledge and pay the required fees if you missed them the first time.

Amending your taxes is no fun, but fix these problems today and you won't have to worry about penalties if errors are uncovered in an audit.  If you have doubts about your ability to do this correctly, see a tax professional for assistance.