Individual retirement accounts (IRAs) encourage workers to save for their retirement by providing valuable tax breaks. In a traditional IRA, your contributions are deductible and grow tax-deferred. Roth IRAs don’t provide a tax-deduction, but growth and withdrawals are tax-free if you follow the rules. If you contribute too much to your IRA, you must take corrective steps and may have to pay a penalty. One solution is to carry forward an excess contribution to the next tax year.
Read More: Differences Between IRA & Non-IRA Accounts
Limits on Contributions
The amount you can contribute to IRAs is the lesser of your annual taxable compensation and the IRS limit for the year. If you file a joint return, you can include your spouse's taxable compensation minus contributions to your spouse’s IRA. In 2021, the IRS limit is $6,000, or $7,000 if you are age 50 or older. These limits apply to the total contributions you make each year to all your IRAs.
Roth IRAs have additional limits based upon your modified adjusted gross income (MAGI). In 2021, those limits kick in when your MAGI exceeds the following thresholds:
- For joint filers: $198,000
- For single filers: $125,000
- For married filing separately: $10,000
If your MAGI exceeds the Roth IRA thresholds by a set amount, contributions for the year are not allowed.
Excess contributions can come about for various reasons. You might have contributed before the end of the year and overestimated your income. Perhaps you forgot about a contribution you made earlier in the year, or you made an improper rollover to your IRA.
Correcting Excess Contributions
The penalty for excess contributions is 6 percent of the excess amount for each year the problem goes uncorrected. You have until the due date of your return (including extensions) to withdraw the excess amount, including any income earned on the excess, and avoid the 6 percent penalty for the tax year.
Alternatively, you can address the problem by carrying forward your excess contribution to a later tax year. However, you will still have to pay the 6 percent penalty for any excess remaining in the IRA at the end of the current tax year. The amount you can carry forward must be no greater than the contribution limit for the later year, minus any other contributions you make for the later year.
Reporting Your Excess Contribution
You use IRS Form 5329 to report the additional 6 percent tax on excess contributions and any income they generated. You also use the form to report a 10 percent penalty on early withdrawals of income tied to your excess contribution. The 10 percent penalty applies to income you earned on the excess contribution for the year that you withdraw before age 59 1/2.
You must withdraw this income to avoid the 6 percent excess contribution penalty in the current year, even if you withdraw the entire excess contribution. Also, you must include the withdrawn income in your gross income for the year.
Read More: Penalties for a Mistake on Federal Taxes
Figuring Your Deduction
You cannot deduct excess contributions to you traditional IRA in the year the excess was contributed. However, if you carried forward an excess amount in a traditional IRA for one or more prior years, you can figure how much of the excess you can deduct in the current year by following these three steps:
- Calculate your maximum IRA deduction for the current year.
- Subtract your actual IRA contributions for the current year.
- The deductible amount is the lesser of the difference calculated in the previous step and the excess contributions in the IRA at the beginning of the year.
Carry Forward Excess IRA Contribution
Imagine that Pat, age 30, was entitled to deduct $2,000 for her traditional IRA contribution in 2019 and $2,500 in 2020. However, in 2019, she contributed and deducted $2,400, a $400 excess subject to the penalty of 6 percent tax. She could avoid the 6 percent tax if she withdrew the excess $400 plus the $20 it earned before the due date of her 2019 return.
Instead, she carried the $420 forward to tax year 2020, and had to pay a $25.20 penalty (6 percent of $420) for 2019. She can avoid the 6 percent tax in 2020 as long as she does not contribute more than $2,080 (i.e., $2,500 - $420) to her IRA in 2020.
She mistakenly deducted the $400 excess contribution in 2019 and had to file an amended 2019 return accordingly. She was able to deduct the $400 contribution in 2020.
Read More: Filing Your Income Tax Return
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.