Roth IRAs are one of the most talked-about investment accounts today, and frankly have been for the last decade that I’ve been in the financial industry. With the rise of social media influencers, more and more people are taking advantage of one of the most powerful wealth-building tools available. That’s great. However, some nuances are often missed when it comes to abiding by the rules set forth by the IRS.
If the title of this post applies to you, you probably already know that Roth IRAs offer tax-free treatment of any interest, dividends, and capital gains inside the account if the account has been open and funded for 5 years, and you are age 59 ½ at the time of withdrawal.
In exchange for this potentially enormous tax benefit, the IRS imposes some restrictions on Roth IRAs:
1. Contributions are not tax-deductible. In other words, you pay taxes on money before it enters a Roth IRA, in exchange for no taxes later (on the gains, contributions can always be withdrawn tax-free).
2. There are income limitations that restrict who can make direct contributions to Roth IRAs, known as a phaseout.
The 2nd part is where people get in trouble, and this post will explain how to get out of it.
For high-income earners, it’s more common to earn inconsistent income throughout the year. Whether it’s monthly commissions, quarterly bonuses, equity compensation or unexpected investment income, it can be hard to predict exactly what your MAGI will be for the year.
As such, it’s common for a problem to arise – you contributed to a Roth IRA earlier in the year, but later realized you are in or above the phaseout income limit shown above. The IRS will penalize you 6% on the overcontributed amount every year until it is corrected.
If you are single, and your modified adjusted gross income (MAGI) – which is the figure that matters when determining your eligibility to contribute to a Roth IRA – is less than $146,000, you can make a full Roth contribution for 2024 ($7000 if under age 50, $8000 if over). If you make over $161,000, you cannot contribute anything.
The $15,000 range in the middle is where it can be confusing – let’s clear that up.
Try to envision your income “filling up” the phaseout range. The amount of phaseout leftover in the range, as a percentage of the total range, is how you determine what you can contribute to a Roth IRA. For example, if your MAGI is $157,250 then you have “filled up” 75% of the phaseout range, with 25% leftover. This means you can contribute 25% of the annual limit of $7000, or $1,750. The graphic below should help visualize this better.
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In the above example, if this person contributed $7000, then $5250 would be deemed an excess contribution subject to a 6% penalty each year until removed.
One of the following fixes must be implemented by the tax filing deadline to avoid paying the penalty.
Your first option, and most common, is to recharacterize your contributions to Traditional IRA contributions. Since Traditional IRAs do not have income limitations for making contributions (only for determining deductibility of said contributions), anyone can contribute to a Traditional IRA, regardless of income.
To recharacterize Roth contributions to Traditional, first open a Traditional IRA if you don’t already have one. Next, contact your IRA custodian (i.e. Fidelity, Charles Schwab, Vanguard, etc.) and request/complete an IRA Recharacterization Form. Once they approve it, the money will move directly from your Roth IRA to your Traditional IRA. Any earnings on your contributions will not be taxed upon recharacterization, since they are staying inside an IRA and not being distributed to you.
Note: The deadline for recharacterizing contributions is Oct 15th of the year after the contribution regardless of whether you file for an extension or not.
From here, you can either leave this money in the Traditional IRA, or convert it back to a Roth IRA, which is essentially the 2nd half of a Backdoor Roth conversion (explained in detail in a previous blog post). Keep in mind the pro-rata rule, which, in short, means that this conversion could be taxable if you have other pre-tax money in this or any other Traditional IRA, SEP IRA, or Simple IRA.
To avoid the 6% penalty, you can also simply withdraw the excess contribution. This may be an appropriate option if you have a significant pre-tax balance in one of the aforementioned Traditional IRA accounts, and don’t want to pay taxes on the conversion back to Roth or comingle after-tax and pre-tax money.
Any earnings on your excess contributions will subject to taxes and an early withdrawal penalty upon withdrawal from the Roth IRA.
With good planning, you can actually reduce your modified adjusted gross income with “above the line” deductions such as pre-tax 401(k) contributions. Note that above the line deductions can be utilized regardless of whether you take the standard deduction or itemized deductions (which are “below the line”).
Example:
You expect to earn a $140,000 salary in 2024, safely below the $146,000 lower phaseout limit, so you decide to contribute $7000 to your Roth IRA early in the year. However, your boss promotes you later in the year and tells you part of your promotion is a $10,000 bonus, to be paid this year (woohoo!). However, since this now puts you at an expected $150,000 for the year, you are solidly in the phaseout range, which means you overcontributed to your Roth IRA (boo!).
Solution:
If your budget (and remaining 401(k) contribution limit) allows, you can contribute $4000 or more to your Traditional 401(k) to reduce your MAGI down to $146,000 or less, and your Roth IRA contribution is allowed again without the need to recharacterize.
Other above-the-line deductions include:
· Unreimbursed expenses for educators who work in schools
· Business expenses of reservists, performing artists, and fee-based government officials
· Contributions to a health savings account (HSA)
· Moving expenses for members of the Armed Forces.
· The deductible part of self-employment tax.
· Contributions to self-employed SEP, SIMPLE, and qualified retirement plans.
· Health insurance premiums for self-employed people
· Penalties on early withdrawal of savings
· Alimony payments (for divorce agreements dated before Dec. 31, 2018)
· Contributions to a Traditional IRA (if eligible to deduct)
· Student loan interest
The process of correcting excess Roth IRA contributions, while not the end of the world, can still be a bit of a headache that’s worth avoiding in the future. A few options:
1. Wait until the end of the year, or even the following year to make contributions.
Since you can make prior year contributions to IRAs up until the tax deadline, you can avoid this problem by simply waiting until you know your full year income before contributing.
2. Backdoor Roth contributions
Backdoor Roth contributions allow you to get money into a Roth IRA by way of a Traditional IRA. Because anyone can make a non-deductible contribution to a Traditional IRA regardless of income, you can essentially bypass the income limits of a Roth IRA. However, as previously stated, the pro-rata rule could cause part of the conversion step to be taxable. More details on the backdoor Roth strategy in this post.
3. Contribute to a Roth 401(k) instead
A common misconception is that anything labeled “Roth” is subject to the phaseout limits mentioned earlier. Employer-sponsored Roth accounts like 401(k)s, 403(b)’s and 457 plans do not have income limitations. Only Roth IRAs have income phaseouts/limitations!
As always, speak to a tax advisor or financial advisor familiar with these concepts and your unique financial situation to determine the best path in correcting excess Roth contributions.
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