IRAs are the cornerstone of most people’s long-term retirement plans. In the best of circumstances, they offer tax-deferred growth and either tax-free distributions at retirement or a major tax-deduction when contributions are made.
Savvy investors fund their IRAs to the maximum amount allowed by the IRS. However, if you are not careful, it’s actually possible to OVER fund your IRA.
Known as an “excess contribution”, adding too much to your IRA could result in significant penalties and quite a mess to untangle.
Below are 5 ways you can end up with an excess IRA contribution.
Exceeding the maximum contribution limits. The IRS says that anyone with earned income may contribute up to 100% of their income or $5,500 to an IRA for that year. If you are 50 or older, you can even contribute an extra $1,000 as a catch-up contribution bringing your contribution limit to $6,500.
It’s easy to get this one wrong especially since you can contribute to your IRA up until April 15th (or your tax filing deadline not including extensions) of the following year. When you make that contribution between January 1 and April 15, be sure it gets coded for the correct tax year by your IRA custodian.
Exceeding the earnings limit. The IRS says that anyone with earned income may contribute to an IRA. True enough. However, there is always the fine print.
Roth IRA contributions are limited to those with adjusted gross incomes below $120,000 for single filers or $189,000 for married taxpayers who file a joint return. People with higher incomes may qualify for a partial contribution. If your income exceeds the maximum income limit, you will not be eligible to contribute any amount to a Roth IRA. Those income limits are $133,000 for single filers; $199,000 for married filing jointly.
If you contribute to a traditional IRA and wish to deduct your contributions from your taxable income, there are income limits as well. The specific limits for deducting your IRA contribution vary based on your income and whether you participate in a retirement plan at work.
For more detailed info about IRA income limits, click here.
Failing to have earned income. Earned income is the key. The definition of “earned income” generally includes wages, tips and other income earned from a job or self-employment. Social Security payments, interest and dividend income, unemployment benefits and alimony do NOT count as earned income for purposes of your IRA contributions.
Another trap – your earned income for the year is less than what you added to your IRA. For example, perhaps you only have $3,000 of earned income for the tax year. Your contribution limit is 100% of earned income or $5,500 whichever is less. In this case, your IRA contribution would be limited to $3,000.
If you made a lump sum contribution early in the year or make monthly contributions throughout the year based on the $5,500 cap, but you stop working before you earn that much, you could be at risk of making a excess contribution to your IRA.
For the IRS’s definition of earned income and a list of they types of income that does and does NOT qualify, click here.
Making contributions after age 70 ½. IRAs were created as part of the Employees Retirement Income Security Act of 1974. At that time, Congress probably never imagined that people would still be working in their 70’s. Today, however, things are different. Many retirees work part-time for several years after traditional the retirement age of 62-65.
To be clear, this rule only applies to traditional IRAs. As long as you have earned income and are under the age of 70 ½ you may contribute to a traditional IRA. If you turn age 70 ½ at any time during the year, you may not do an IRA contribution for that year.
For example, let’s say you turn 70 on May 15th of 2018. You may NOT contribute to an IRA this year because 2018 is the year you will turn age 70 ½ (November 15th you will turn 70.5).
Contributions to Roth IRAs may be made regardless of your age as long as you meet the earned income and other requirements of Roth IRAs.
Contributing to the wrong IRA. It’s not unusual to have more than one IRA. You may have a traditional, non-deductible IRA, a rollover IRA, one or more inherited IRAs, a Roth IRA, etc. On top of that your husband have a portfolio of IRAs as well. It can get confusing in a hurry.
Adding money to the wrong IRA will count as an excess contribution even if you were eligible to make an IRA contribution to the correct IRA. The key to avoiding this mistake is to be sure that your financial advisor and/or IRA custodian know exactly which IRA you are contributing to, then to review your confirmation statements to be sure that your money went where it was supposed to go.
An expensive mistake. Excessive IRA contributions are an expensive mistake. The penalty is 6% of the contribution amount. On the surface that doesn’t sound too bad: 6% of $6,500 is less than $400. Not exactly pocket change, but it’s not going to ruin you.
The trouble is that the 6% excess contribution penalty applies for EVERY year in which that money was in your IRA. And in some cases the clock never stops ticking.
Those penalties add up.
If you believe you have contributed too much to an IRA talk to your financial advisor, tax professional or your IRA custodian right away. Taking action now will minimize your penalties and put you back on track to having a clean IRA without an IRS problem hanging over your head.