Most of us can agree that Roths are great. Whether it be your Roth TSP or a Roth IRA, these accounts provide tax-free income in retirement, the opportunity to limit the taxation of your Social Security benefits, and they don’t have Required Minimum Distributions – while this last one only applies to Roth IRAs.
But as we discussed in last week’s article, not every federal employee is eligible to contribute to a Roth IRA directly.
And while Feds can utilize a Backdoor Roth strategy to contribute to a Roth IRA, some may not realize that they are ineligible until they have already made direct contributions.
So, what happens if you inadvertently make ineligible contributions to a Roth IRA? That’s the question we will answer this week.
What Are Ineligible Contributions
First, let’s review what ineligible contributions are.
As discussed last week, both the Roth TSP and Roth IRA share many similarities, such as being tax-advantaged, accepting after-tax contributions, and allowing tax-free distributions.
However, they also have significant differences, the most critical of which is the one that catches many federal employees off guard, which is the Modified Adjusted Gross Income (MAGI)* limit of Roth IRAs.
What this means is that if your MAGI is too high, you may be ineligible or only eligible to make a partial contribution to a Roth IRA.
For tax years 2021 and 2022, if your tax filing status was MFJ and your MAGI exceeded $208k and $214, respectively, you were not allowed to contribute to a Roth IRA. See the table below for the MAGI ranges.
What If You Contributed When Ineligible?
If you’ve contributed to a Roth IRA when ineligible, you’ll owe a 6% penalty on the amount each year until you fix the mistake.
Depending on when you discover the ineligible contributions, you may be able to remove them and avoid the penalty.
Before Your Taxes Are Due
If you spot this mistake before your taxes are due, you’ll have the following options to avoid the 6% excise (penalty) tax.
Option 1: Withdraw the Excess Contribution
You can contact your bank or investment company to request the withdrawal of the contributions and earnings for the tax year on or before the due date for filing your tax return.
If you file an extension, you have until the October 15 deadline to make the withdrawals. Make sure you include Form 5329 with your filing to reflect that the withdrawal was the removal of excess contributions.
If you also removed earnings from the contributions, you’ll need to include them in your gross income, and if you’re under 59 ½, you’ll have to pay a 10% early withdrawal penalty.
Option 2: Recharacterize the Contributions
Another way of undoing a contribution to a Roth IRA is called a recharacterization. You have until your tax filing deadline (April 15 or October 15 with extension) to recharacterize the disallowed contribution to a traditional IRA rather than withdraw it.
In other words, you are reclassifying the contribution as if you made it to a traditional IRA, to begin with.
To do this, you will tell your financial institution to transfer the amount of the contribution plus earnings to a traditional IRA either at the same institution or if at a different firm then via a trustee-to-trustee transfer.
Likely, your traditional IRA contribution will be nondeductible. Meaning the contribution will give you basis in your IRA so that future distributions will be partly nontaxable.
In which case, you may want to consider a Backdoor Roth strategy, which is a technique for contributing to a Roth IRA by first contributing to a nondeductible IRA and then converting the contributions to a Roth IRA.
Note: Be sure to complete Form 8606 to report the nondeductible contributions.
After the Extended Due Date of Your Return
Unfortunately, if the extended due date for your return has passed, you will be subject to the 6% excise tax for each year the excess remains in the account.
While Roth IRAs are an effective way of supercharging your retirement savings, making ineligible contributions can be surprisingly easy.
Hence, the easiest way to avoid the headache and penalty is to pay attention to your Modified Adjusted Gross Income, especially once you start to near the income limit.
Because tax planning and saving for retirement require ongoing attention to detail and knowledge of the rules, it’s important that you consult a qualified financial planner if you are ever unsure about your retirement saving strategy.
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2023 Legislative Change Notice
The SECURE ACT 2.0 passed and impacted many of the articles on this website. While the articles were correct when written, it’s impossible to re-write every article. Please consult a qualified professional (i.e., CFP®, CPA, or attorney) before implementing any strategy.