If I pour too much water into a glass, removing liquid from a different glass does not correct the problem. The excess water must be removed from the “offending” receptacle. Such is the case with excess IRA contributions. If too much money is deposited into a particular IRA, those excess funds must be removed from the same over-flowing IRA to avoid penalties.
Excess IRA contributions can occur in a number of ways. A few examples include:
Regardless of how the excess got into the IRA, it must be removed from that same IRA. But what if the “offending” IRA no longer exists? For example, what if an excess contribution is made to a Roth IRA, but that Roth IRA is subsequently transferred to a new custodian before the excess is identified? Or, what if an excess is made to a traditional IRA, but the entire account is converted to a Roth IRA?
The IRS does not give us direct guidance on how to handle such occurrences. But logic tells us that an honest effort must be made to remove the excess from the offending account. We must “follow the dollars.” If the IRA was transferred, we should remove the excess from the account at the new custodian. If the IRA was converted, the excess should come from the converted Roth. While we follow the dollars and make a concerted effort to remove the excess from the offending IRA, we do not have to withdraw the exact same dollars.
Example: Jerry, a single tax filer, has an annual income that is well over the 2024 Roth IRA phaseout levels ($146,000 – $161,000; or $230,000 – $240,000 for those married, filing joint). Nevertheless, Jerry makes a $7,000 contribution to his existing Roth IRA. Jerry immediately invests the $7,000 within the Roth IRA into an illiquid financial product. Soon after, Jerry realizes his excess contribution mistake. Since he is before the correction deadline (generally October 15 of the year after the excess) he can avoid penalties by removing the excess, plus “net income attributable” (NIA). There will be no early distribution penalty, but the NIA is taxable. But the $7,000 is tied up in an illiquid investment. What to do? Jerry has other items within this same brokerage Roth IRA. He sells enough of a mutual fund within this same Roth IRA to cover the $7,000 excess, plus NIA, and takes an excess contribution withdrawal. All is well.
In the example above, Jerry properly removes the excess contribution from the same Roth IRA. It does not matter that it was “different dollars” from that account. The key is that the distribution came from the offending IRA. If Jerry had another Roth IRA (or a traditional IRA) – even if that other IRA was held at the same custodian – he could not correct his excess contribution problem by withdrawing from one of these different accounts.
Specializing in private wealth management, we provide education, guidance, and strategies to help you achieve a tax-efficient retirement income.
Specializing in private wealth management, we provide education, guidance, and strategies to help you achieve a tax-efficient retirement income.
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