Tuesday, February 26, 2008

What if You Contribute Too Much to a Roth IRA?

I've had a couple of comments from people saying I should be careful not to contribute too much to a Roth IRA. For 2007, I contributed the full $4,000, but that maximum only applies to people whose income was below $99,000. My total income in 2007 was just above $100,000-- so did I screw up?
Fortunately, the answer is NO! The income limit for Roth IRA contributions refers not to your gross income, but to your "Modified Adjusted Gross Income," abbreviated hereafter as MAGI. Maybe I should have called this post "The Gift of the MAGI..."

As I learned from the "Ask Encore" column in this past weekend's Wall Street Journal, you can figure out your MAGI by going to www.irs.gov and using a worksheet in Publication 590. They say it's on page 61, but I didn't see any page numbers-- I just found it by searching the table of contents for Roth IRA contribution limits.
The worksheet asks you to enter your adjusted gross income from line 38 on form 1040. Then you have to add back in a bunch of other lines, none of which applied to me. Below is the 2007 worksheet:

1. Enter your adjusted gross income from Form 1040, line 38; Form 1040A, line 22; or Form 1040NR, line 36 1.
2. Enter any income resulting from the conversion of an IRA (other than a Roth IRA) to a Roth IRA or a minimum required distribution from an IRA (if figuring MAGI for conversion purposes) 2.
3. Subtract line 2 from line 1 3.
4. Enter any traditional IRA deduction from Form 1040, line 32; Form 1040A, line 17; or Form 1040NR, line 31 4.
5. Enter any student loan interest deduction from Form 1040, line 33; Form 1040A, line 18; or Form 1040NR, line 32 5.
6. Enter any tuition and fees deduction from Form 1040, line 34, or Form 1040A, line 19 6.
7. Enter any domestic production activities deduction from Form 1040, line 35, or Form 1040NR, line 33 7.
8. Enter any foreign earned income exclusion and/or housing exclusion from Form 2555, line 45, or Form 2555-EZ, line 18 8.
9. Enter any foreign housing deduction from Form 2555, line 50 9.
10. Enter any excludable qualified savings bond interest from Form 8815, line 14 10.
11. Enter any excluded employer-provided adoption benefits from Form 8839, line 30 11.
12. Add the amounts on lines 3 through 11 12.
13. Enter:
  • $166,000 if married filing jointly or qualifying widow(er),

  • $10,000 if married filing separately and you lived with your spouse at any time during the year, or

  • $114,000 for all others


Is the amount on line 12 more than the amount on line 13?
If yes, see the note below.
If no, the amount on line 12 is your modified adjusted gross income for Roth IRA purposes.

My MAGI was only $86,606, which is basically wages, interest, business income, and capital gains. The reason it's lower than my gross income is those lovely pre-tax deductions: my 401k, maxed out at at $15,500, plus little things like my monthly Metrocards, and health insurance.

For 2008, the MAGI limit for contributing the maximum $5,000 to a Roth IRA is $101,000 for individuals. (Yeah, it's different for you over-50 people and married-filing-jointly types, see the IRS link for details while the young swinging singles read on!) I plan to continue to max out my 401k contributions so hopefully it will still be a couple of years before I have to start limiting my Roth IRA amounts. But I will be using that worksheet each year from now on, just in case.

Fortunately, having a too-high income doesn't necessarily disqualify you from participating in a Roth IRA-- the contribution limit is lessened and eventually phased out as your income gets higher, it's not all or nothing. The IRS provides a worksheet with which you can calculate your correct maximum amount.

Here's an example of the 2007 worksheet for someone whose MAGI is over the limit, showing how to calculate the reduced contribution amount:

1. Enter your modified AGI for Roth IRA purposes 1. 100,000
2. Enter:
  • $156,000 if filing a joint return or qualifying widow(er),

  • $-0- if married filing a separate return and you lived with your spouse at any time in 2007, or

  • $99,000 for all others

2. 99,000
3. Subtract line 2 from line 1 3. 1,000
4. Enter:
  • $10,000 if filing a joint return or qualifying widow(er) or married filing a separate return and you lived with your spouse at any time during the year, or

  • $15,000 for all others

4. 15,000
5. Divide line 3 by line 4 and enter the result as a decimal (rounded to at least three places). If the result is 1.000 or more, enter 1.000 5. .067
6. Enter the lesser of:
  • $4,000 ($5,000 if you are age 50 or older, or $7,000 for certain employer bankruptcies), or

  • Your taxable compensation

6. 4,000
7. Multiply line 5 by line 6 7. 268
8. Subtract line 7 from line 6. Round the result up to the nearest $10. If the result is less than $200, enter $200 8. 3,740
9. Enter contributions for the year to other IRAs 9. 0
10. Subtract line 9 from line 6 10. 4,000
11. Enter the lesser of line 8 or line 10. This is your reduced Roth IRA contribution limit 11. 3,740

So what happens if you accidentally contribute more than you are allowed for your income level? You have to pay the IRS a 6% excise tax on the excess contribution amount. If you leave the money in the Roth IRA account anyway, it will reduce the amount, if any, which you are eligible to contribute the next year. If you aren't eligible to contribute anything the next year, then you'll keep getting dinged that 6% penalty each year the over-contribution remains in your account. Ouch!

Remember, all this tax stuff is serious business, and I am not a professional-- make sure you check the IRS website to do your own research for your own situation, and stay up to date on any changes in the laws!


Mase said...

Actually, if you contribute to a Roth and discover your MAGI income is too high, you can avoid the 6% ding by recharaterizing your contribution to a traditional IRA. You'll need to contact your IRA administrator to do it, but as long as its done before April 15th, you'll be in the clear. This is what I had to do.

Here's an article from Kiplinger's on this:


Now, you many will wonder whether it makes sense to even have a traditional IRA if your income prevents contributions to a Roth. Right now, in 2010, the income limits for Roth are set to expire. Thus, you can contribute to a traditional IRA for tax years 2007, 2008, 2009 and, in 2010, convert it to your Roth (either existing or new). You'll have to pay taxes on the earnings, but not the principal. Plus, the IRS will allow you to have those earnings be spread out over tax years 2010 and 2011.

- Mase

Anonymous said...

Since this did happen to me this year, this is how I fixed it.

If you don't want to re characterize into a tradition ira, which I think makes no sense, you will have to pay taxes on all gains associated with your over contribution along with removing the contribution and gains. There is a fine of 10% on the gains. So you if you made $100 on your $4,000, you will need to pay taxes on the $100 along with 10% or $10. The tax will be around $35 dollars. Its not the tax that is usually the problem. Try figuring out how to fill out the 1099-r, your brokerage company won't mail you the 1099 until 2009. But you owe taxes on this for 2007, you'll have to fill out an explanation form for the IRS as well.

RacerX said...

This is a good area to talk to your tax person about! Seems tricky.

Andrew Stevens said...

Mase, don't count on that 2010 thing to actually happen. It seems to me that it was pretty clearly unintentional and I expect Congress to change it before anyone takes advantage of it. The income limits for the Roth are not set to expire in 2010; only the income limits for Roth conversions. (If both were set to expire, then it's likely it was intentional.)

However, even a non-deductible traditional IRA is probably a good gamble just in case Congress does allow income-unlimited Roth conversions and stranger things have happened.

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Filing Old Tax Returns said...

Just pull it out

Anonymous said...

Mase, you can do that, but just remember that your total contributions to both a Traditional IRA and a Roth IRA when added together can still not exceed the $5000 hard maximum.