The Essential Guide to Roth IRA Overcontribution: Preventing, Fixing, and Optimizing

Key Takeaways:

• The IRS levies a 6% excise tax for each year the overcontribution remains in one’s Roth IRA.

• There will be no penalties if the investor simply withdraws their excess contribution, in addition to any income it has earned in the interim, by the tax return due date.

• Avoiding overcontributing is typically a matter of keeping track of all IRA contributions made throughout the year and understanding rules about income limits.

Those who have a Roth Individual Retirement Account (IRA) or are considering such an investment must be careful to not overcontribute to it. Such an event can happen, usually by accident. The problem is that penalties and taxes can be assessed by the Internal Revenue Service (IRS).

The good news is that there are ways to avoid and fix an overcontribution; along with other actions one can take after maxing out their Roth IRA. With that said, here is the essential guide to Roth IRA overcontribution: preventing, fixing, and optimizing.

What is a Roth IRA Overcontribution?

A Roth IRA account provides tax-free growth and tax-free withdrawals in retirement. Overcontribution occurs when contributions exceed annual limits.

The federal government frowns on excess contributions, although most are just mistakes. Perhaps the investor did not realize that both Roth and Traditional IRA contributions count toward the annual IRA contribution cap, for example. Whatever the case, it is important to follow established limits.

Consequences of Overcontributing to Roth IRA

Overcontribute to Roth IRA can have repercussions:

• Tax implications of overcontributing. The IRS levies a 6% excise tax for each year the overcontribution remains in one’s Roth IRA.
• Penalties for excess contributions. If an investor overpays their account by $1,000, for example, they must pay the government $60 annually until the issue is resolved.

How to Fix Overcontributions

There are steps one can take to remedy overcontributions:

Options for Correcting Overcontribution

Here are the options to consider.

• Withdraw the excess contribution. There will be no penalties if the investor simply withdraws their excess contribution, in addition to any income it has earned in the interim, by the tax return due date. The earnings portion, however, must be included as part of taxable income for the year.
  
  The investor must file an amended form with the IRS stating “filed pursuant to Section 301.9100-2” at the top of the form. Note that those who have already filed their annual tax return may still withdraw their Roth IRA contribution within six months of their tax return’s due date.

• Move excess contributions into a traditional IRA. This option involves recharacterizing an overcontribution by transferring the overage, in addition to any accumulated income, into a traditional IRA. If this occurs by the tax return due date, it can take the place of the contribution to the first IRA.

• Apply the Excess Contribution to a Future Year’s Roth IRA. With this option, the overcontribution and its earnings can be applied to a Roth IRA in the future – if the investor follows contribution limits for that year.
  
  For example, if an investor is permitted to contribute up to $6,000 to their Roth IRA last year but accidentally contributed $7,000, they could correct their mistake by contributing just $5,000 this year. In so doing, the $1,000 overage is no longer deemed an excess contribution, but rather a legitimate one.
  
  The investor still must pay the 6% excise tax for the year the excess contribution remained in the account, but withdrawals will not be necessary. They must file Form 5329 with their next tax return. The form calculates the amount of tax that must be paid on the excess contribution.

Preventing Overcontribution

There are steps investors can take to prevent excessive Roth IRA contributions.

• Understanding annual contribution limits. Last year, Roth IRA contribution limits for most people was $6,000, $7,000 for those age 50 or older. For 2023, limits increase to $6,500, or 7,500, respectively. Limits depend on one’s filing status and modified adjusted growth income (MAGI). Those who make too much to contribute to a Roth IRA may want to consider a backdoor Roth IRA.
  
• Keeping track of contributions. Avoiding overcontributing is typically a matter of keeping track of all IRA contributions made throughout the year and grasping rules about limits.
  
• Consultation with a financial advisor. It is wise to run any questions one might have about annual contribution limits by a knowledgeable professional.

What to Do After Maxing Out Roth IRA

Once a Roth IRA has been maxed out, investors have other places to put their capital, including in alternatives, which are basically assets other than stocks and bonds.

While all investments carry risk, and there is no way to completely skirt economic and market turmoil, alternatives such as art and real estate can diversify portfolios while generating steady secondary income. Because of their correlation to public markets, alternative investments are not subject to volatility.

The alternative investment platform Yieldstreet, which has a private market IRA with which alternatives can be added to one’s retirement portfolio, offers a number of curated alternative opportunities.

Alternative Investments and Portfolio Diversification

Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

To democratize these opportunities, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

To avoid unnecessary penalties and tax consequences, it is vital for investors to follow IRA contribution rules and limits. However, if an overcontribution occurs, there are ways to remedy the situation. Investors should consult with a professional to make sure optimal actions are taken on a timely basis.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.