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One of the downsides of the Roth IRA is that there are income limits that preclude high income earners from contributing directly to these accounts. But for people on the cusp, or for those who unexpectedly end up earning more than they planned, (or who get married during the year and only discover after the fact that they now exceed the limits) it’s actually quite common to find out after you file your income taxes that you were actually ineligible to contribute the year before.
Luckily the IRS understands that this can happen, so there are ways to fix it, but you have to take certain steps to minimize the tax consequences and avoid penalties.
Here are your choices if you contributed to a Roth IRA then found out later that you were ineligible for the contributions because you made too much money in the year of contribution.
1. Do nothing and pay the 6% penalty. Per year. Not the best option.
2. Withdraw the money. This is the simplest, but obviously not the best since withdrawing the money negates your efforts to save it for retirement. And a potential complication would be figuring out if the money you contributed grew in value at all if you already had money in the account from prior year contributions — you have to withdraw the contributions AND associated earnings in order to avoid the penalty.
The biggest downside is that any earnings would be taxed as income and also subject to the 10% early withdrawal penalty if you’re under the age of 59 ½, making this not a very desirable option.
3. Re-characterize the money. In other words, transfer the money out of the Roth and into a traditional IRA and call it a contribution to the traditional instead of the Roth for the year. If you have a workplace retirement plan such as a 401k or 403b available, you won’t be able to deduct this contribution as there are even lower limits that apply here, but it will spare you the hassle of figuring out the earnings and any penalty, while also still allowing you to save for the future.
The tricky part with this option is that you will need to keep a record of this non-deductible contribution so that when you do make withdrawals in retirement, you’ll be able to avoid double taxation of the original contribution. You can do that by completing Form 8606.
Using the ‘back door’
The thing is, there is actually a loophole that, when used properly, can get money into a Roth even when you exceed the income limits. It’s been affectionately coined the “Back Door Roth IRA.” This method isn’t the greatest if you already have traditional IRA money due to account aggregation rules, but if you’re just entering IRA territory, it’s a great way to build your Roth IRA even as your earnings grow.
Keep in mind that in order for the Back Door Roth method to work, you actually have to start out putting the money in a traditional IRA first then convert it to a Roth. So if you find yourself with a contribution directly to a Roth that needs to be re-characterized to a traditional, you can’t just turn around the next day and say, “OK, now I’m ready to convert that traditional IRA back to a Roth!” Specifically, the rule says that you must wait the later of 30 days or the year after the year you re-characterized.
In other words, for people who are discovering this issue as they are preparing their taxes and decide to re-characterize, you’d have to wait until the following calendar year to convert the money back to the Roth. It’s still doable, but you’ll just have to be prepared to pay income taxes on any growth of the re-characterized money in the meantime.
If you want to try this method, here’s the best way to make it work while minimizing the tax consequences: The re-characterization rules give you until the date your tax return is due to make it right, which includes extensions, so you could extend the date your return is due until October 15th (keep in mind you still have to pay any taxes due by the April filing deadline), then make the transfer to a traditional IRA in early October. Then on January 2nd, convert the money back to your Roth IRA. Unless there’s a huge run in the stock market during the 3 months in between, the tax consequences should be minimal.
Avoid this hassle next year.
If you want to continue contributing directly to your Roth each year, the best way to avoid the need to wait so long would be to run a quick income projection around December 1st of each year to see if you’re in danger of exceeding the income limits. If you think you’ll be close, just do a quick re-characterization by transferring any Roth deposits from that calendar year to a traditional IRA. Then after 30 days has passed, you’ll be in the year after the year of the re-characterization and can convert the money back to the Roth in January.
I believe that the true meaning of financial security is the ability to make decisions without having to worry about money. There are both factual and psychological aspects of this belief and my mission is to help people find that intersection in their own lives according to their personal values and goals.
I hold the CPA/PFS license and am a CFP® professional, but I don’t sell any products or manage any money. When I’m not writing, I’m working one-on-one with people through my coaching business, Financial Bliss with Kelley Long. I’m also a member of the AICPA Consumer Advocate Council and am frequently quoted in the press on financial literacy issues facing Americans.
I love to apply my own money lessons to my writing as well as break down some of the more complicated financial planning techniques into plain English. My goal in life is for all people to feel able to make their own financial decisions with confidence, being fully aware of the pros and cons of the actions they take.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.