Q. My wife and I contribute to our Roth IRAs every year through a monthly automated draft from our checking account. In the past this has been great since we don't have to think about it and at the end of the year our Roth IRAs are fully funded. I just started working on our taxes and due to a rather large bonus my wife received late last year it appears that we are over the limit to make the full contribution. So, what do we do to remove the amount we shouldn't have contributed, is there any penalty and if so, a way to avoid one, what do we do with any earnings and could you please provide an example of what we can contribute based on a modified adjusted gross income of $190,000?
A. Just in the nick of time! Investing via auto draft is great but I'd encourage taxpayers that anticipate being near the income limits for full Roth IRA contributions to wait until your income is known and make any allowed contribution in a lump sum. As I'm sure you know, you have until the typical tax filing date of April 15, regardless of extensions, to make an IRA contribution for the previous tax year. You have until your filing date including extensions to remove an excess contribution from a Roth IRA and avoid a 6 percent excess contribution penalty tax. The 6 percent tax applies to your excess contribution for each year the excess contribution remains in the Roth IRA. It's important to correct this since the 6 percent tax can add up to more than your contribution if left uncorrected for several years.
Since you have time to act before your filing date, including extensions, you have two options to correct this and avoid the 6 percent penalty tax.
The first is to withdraw the excess contribution and earnings from your IRA. You will need to report and pay tax on the earnings on your 2014 tax return since the contributions were made for 2014. If you are under the age of 59 1/2, you will also owe a 10 percent early withdrawal penalty on the earnings unless an exception applies. Contact your IRA custodian and request that the excess contribution and any earnings on that amount be distributed.
The second option is to recharacterize the excess contribution and any earnings from the Roth IRA to a traditional non-deductible IRA. You won't pay any tax on the earnings since the transfer will be from one IRA to another. If at a later date you wish to convert this IRA to a Roth IRA, you will owe income tax on the earnings but there will be no 10 percent early withdrawal penalty. You must wait 30 days or until the next calendar year, whichever is later, after a recharacterization before making a conversion. You would need to wait until January 2016 to convert the non-deductible IRA to a Roth IRA. For this option, contact your IRA custodian and request that a direct transfer in the amount of the excess contribution and any earnings be made from the Roth IRA to a traditional IRA.
To determine the amount of Roth IRA contributions you can make you begin with your modified adjusted gross income (MAGI). For tax year 2014, if married filing jointly and MAGI is under $181,000 the full contribution can be made ($114,000 if filing single or head of household). If MAGI is $181,000 and less than $191,000 a reduced amount can be contributed ($114,000 and less than $129,000 if single of head of household). Based on a married couple with MAGI of $190,000 the maximum contribution limit if under age 50 is $550. See IRS publication 590-A for a worksheet to calculate reduced contributions to IRAs.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624