It’s normal for me to get a few texts from friends & family throughout tax season looking for help. Something I’ve seen more this year than others is people making excess Roth IRA contributions. This is generally a fantastic problem to have because it generally means income went up!
It tends to sound like this, “I was preparing my taxes and the software told me I can’t make Roth IRA contributions anymore. And I owe a penalty! Did some rule change?! I put the money in the account back in January 2023, how do I fix it?”
The person I’m talking to is usually surprised to hear there is a household income limit where you can make too much money to contribute to a Roth IRA. Without getting into all the details, the IRS uses something called your Modified Adjusted Gross Income (MAGI) to determine if your household made too much earned income for Roth IRA contributions.
For 2023, if your MAGI is over $138,000 as a Single or Head of Household filer, you will not be able to contribute the full amount to your Roth IRA. For those filing Married Filing Jointly, the phase-out range begins at $218,000. And lastly, if you are filing Married Filing Separately, the phase-out starts at $0!
When you make Roth IRA contributions above the income limit, you will pay a 6% penalty this year and every year moving forward until the excess contributions are removed from the account. So if someone maxed out their 2023 Roth IRA contribution at $6,500 but wasn’t allowed to, that is a $390 penalty every year until that $6,500 is removed!
There are several ways to fix this issue; however, assuming the taxpayer is going to be above the income threshold every year hereafter, I think the best way to fix the issue is through Recharacterization. Recharacterization is when you tell your custodian, i.e. Fidelity, Vanguard, Schwab, etc. that you would like to change your IRA contribution from Roth to Traditional. The best time to do this is before you file your taxes.
Your custodian will help you do the following:
- Make sure you have a Traditional IRA for the funds to move to.
- Recharacterize the Roth contributions to your Traditional IRA. This means the funds will actually leave your Roth IRA and go into your Traditional.
- Lastly, they will calculate the ‘Net Income Attributable’ which is the earnings/losses on those excess contributions and move those to the Traditional IRA as well.
And there you have it! The ineligible Roth contributions, along with the earnings/losses attributable to them, are moved to a Traditional IRA. No 6% penalty, everybody is happy. But wait, everyone isn’t happy because the reason they contributed to the Roth IRA in the first place is for tax-free growth and distributions in retirement! And now they are stuck with Traditional Contributions moving forward?
Not so fast! Next month, we’ll look at a fictional case study of a high-income household and how they continue to get funds into their Roth IRA, without penalty, despite being above the income limits.
Please note that this blog is for educational purposes only and Kotys Wealth Professionals does not prepare taxes. Always consult your accountant about your personal tax situation.
Mark Rosinski, CFP®, CPA
Wealth Advisor