Maximum Roth IRA Contributions, and Dealing with Excess Contributions
The maximum Roth IRA contributions vary from year-to-year, and typically, they get higher as the years go by.
For example, in 2007, the maximum contribution for a Roth was only $4,000. Whereas in 2008, the maximum contribution is $5,000.
Nobody knows for sure yet what the maximum Roth contribution will be in 2009. We’ll have to wait until the IRS announces it, or publishes it in the latest version of IRS Publication 590.
If you exceed the maximum Roth IRA contributions, here’s what happens
You have a choice to either remove it, or re-characterize it.
If you remove it, any earnings will be subject to taxes, but contributions come out tax-free as they always are in a Roth.
So in 2007, let’s say you accidentally put in $5,000. By the time you realized that you exceeded the maximum Roth contribution, your $5,000 had increased by 15% and your balance is $5,750.
2007 Contributions = $5,000
2007 Earnings = $750
Clearly you have to take out the $1,000 that you over-contributed. This is tax-free (i.e. you get the whole $1,000, no strings attached).
But you also have to take out a portion of the earnings (1/5th), and this is taxable.
Since you earned $750 on $5,000, if you do the math, each $1,000 earned $150 ($750 divided by 5). So you take out $1,000 (tax-free) and $150 (taxable). Not too big of a deal, but still costs you money.
Another way to figure out how much you have to take out (if all this math stuff isn’t for you), is to just figure how much you would have if you hadn’t exceeded the maximum Roth IRA contributions.
In our example, you’d have a 15% gain on $4,000, which would leave you with $4,600. (Same answer we got before)
When you remove excess contributions, you get a choice of where you want it to go. You can choose to have a check sent to you, or you can most likely invest the funds in a taxable account with the same company.
For instance, if you’re with T. Rowe Price, you could just say, “Hey, T. Rowe, take the excess contributions and open me up a taxable account with it.”
(Remember, in a taxable account, you get to choose investments just like an IRA (stocks, bonds, mutual funds, etc.) but all gains are subject to taxation.)
Re-characterizing it means to label it as a contribution for the next year. If you don’t feel like going through the process of removing it, you can just say, “Hey, T. Rowe, put that toward my 2008 contribution.”
This way seems easier to me.
One way or the other though, if you exceed the maximum Roth IRA contributions, you must take action by tax-filing time, or else you’ll get taxed and penalized. If you leave it in there for more than a year, you’re subject to a yearly 6% penalty.
Then, if you’re under 59 and-a-half, the earnings are still subject to taxes when you finally do take it out. The longer you leave it in there, the more earnings, and thus more taxes you’ll probably have.
Moral of the story–Take care of business. ASAP.