In almost all cases, the penalties for violating IRS rules end up overriding any potential value derived from the transaction. The one exception may be the act of making excess Roth IRA contributions.
With a Traditional IRA, contributions are tax deductible and earnings grow tax-deferred until they are distributed. If a distribution is taken before the IRA holder reaches the age of 59 1/2, a 10% early distribution penalty applies in addition to tax on the amount of the distribution. Moreover, a Traditional IRA is subject to required minimum distributions when the IRA holder reaches the age of 73. Whereas, in the case of a Roth IRA, contributions are after-tax and not tax deductible, but so long as the Roth IRA holder is over the age of 59 1/2 and the Roth IRA has been open and funded for at least five years, all Roth IRA distributions are tax-free and are not subject to the required minimum distribution rules.
In general, an excess Roth IRA contribution occurs if one:
- Contributes more than the contribution limit.
- Makes a regular IRA contribution to a traditional IRA at age 73 or older.
- Makes an improper rollover contribution to an IRA.
The taxation on excess contributions differs if the excess contribution is made to a Traditional or Roth IRA.
Over Contributing to a Roth IRA
In the case of a Traditional IRA, excess contributions would be subject to a 6% tax per year as long as the excess amounts remain in the IRA. In addition, if the IRA holder is under the age of 59 1/2, a 10% early distribution penalty would apply to the amount of the excess contribution. Furthermore, the excess contribution would be subject to income tax, although the earnings generated from the excess contributions would remain in the Traditional IRA.
For a Roth IRA, excess contributions would be subject to a 6% tax per year as long as the excess amounts remain in the Roth IRA. However, unlike a Traditional IRA, there would be no 10% early distribution penalty or tax on the excess contribution amount. Moreover, the earnings from the excess Roth IRA contributions would remain in the Roth IRA.
The tax on an excess IRA contribution cannot be more than 6% of the combined value of all IRAs as of the end of the tax year. In other words, the 6% tax is payable each year that the excess contribution has not been withdrawn or applied toward an allocable contribution for a future year.
Learn More: Converting a Traditional IRA to a Roth IRA
How to Avoid the Roth IRA Excess Contributions Tax
Withdraw the excess contributions from the IRA by the due date of the individual income tax return (including extensions); and withdraw any income earned on the excess contribution.
In addition, an individual can apply an excess contribution to a traditional IRA to a later year by the amount that the maximum deductible amount for the later year exceeds the amount contributed to an IRA (including a Roth IRA) for that year. However, an individual cannot reduce an excess contribution by applying it against an earlier year for which less than the maximum amount allowable was contributed.
Read This: What You Need To Know Before Establishing A Roth IRA For Your Kids
The Strategy
A strategy that has been gaining some popularity as of late surrounds the concept of making excess contributions to a Roth IRA in order to generate additional tax-free returns in the Roth IRA. Since the 6% excise tax only applies to the amount of the Roth IRA excess contribution and no 10% penalty or income tax would apply to the amount of the excess contribution, in addition to the earnings on the excess contribution remaining in the Roth IRA and able to grow tax-free, the idea is that the 6% excise tax on the excess Roth IRA contribution will end up being considerably less than if the investment was made with personal funds subject to the individual income tax rates.
Hence, the excess Roth IRA contribution strategy is based on the notion that paying a 6% tax on excess contributions to a Roth IRA, while gaining the tax advantage of having the earnings from the excess contribution remain in the Roth IRA so it can grow tax-free, is a great deal compared to making the same investment with personal funds and having to pay income tax on the earnings and gains.
The IRS has not yet publicly commented on how they will specifically attack the Roth IRA excess contribution strategy, but it is conceivable that the IRS could end up imposing additional penalties. The IRS would receive notification of the IRA excess contributions through its receipt of Form 5498 from the bank or financial institution where the IRA or IRAs were established.
Making inadvertent excess contributions to an IRA occurs frequently and is typically corrected before the filing of the individual’s income tax return. However, purposely violating the IRA excess contribution rules to receive a tax benefit is not advisable and could lead to an IRS audit.
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If you feel you have made excess Roth IRA contributions, please contact us @ 800.472.0646 so we can help you correct the mistake!
