Over-contributing to various tax-advantaged accounts isn’t allowed, but can be easy to do by mistake. Laura reviews the contribution limits for various accounts and how to correct an excess so you avoid costly penalties.
Amanda M. says:
I contributed to my Roth IRA for 2020, but now I realize that my income will exceed the allowable annual limit. Can I fix this error and use the money to contribute to a traditional IRA instead, or do I have to pay a penalty?
Thanks for your question, Amanda. And congrats on earning too much to qualify for a Roth IRA! That’s a significant milestone that I’ll explain here.
While overcontributing to various tax-advantaged accounts—such as a retirement account, health savings account (HSA), and 529 college savings account—isn’t allowed, it can be easy to do by mistake.
I'll answer Amanda’s question and explain the contribution limits for various accounts and what happens when you over-contribute to them. You’ll learn how to easily correct an excess and avoid costly penalties.
What is an IRA?
IRA is short for Individual Retirement Account or Individual Retirement Arrangement, a tax-advantaged savings vehicle designed for individuals. It’s one of my favorite retirement accounts because anyone with earned income qualifies to contribute, even minors. It also offers more flexibility for taking withdrawals compared to other retirement accounts.
No matter how much you earn, you can max out a traditional IRA. However, as Amanda mentioned, there are annual income limits to qualify for a Roth IRA.
Note that the Roth IRA is the only type of retirement account that comes with an income threshold. Other types of Roth accounts, such as a Roth 401(k) or a Roth 403(b), don’t have an annual income limit.
You can only contribute to a Roth IRA when your modified adjusted gross income (MAGI) is below the following annual limits for 2020:
- Single tax filers can’t make contributions when you earn $139,000 or more and increases to $140,000 for 2021.
- Married couples filing taxes jointly can’t make contributions when your household income is $206,000 or more and increases to $208,000 for 2021.
- Married couples filing separate taxes can only make reduced contributions with MAGI less than $10,000 and are ineligible when you earn more.
What happens if you over-contribute to an IRA?
Now that you know who qualifies for a traditional and a Roth IRA let's discuss how much you can contribute and ways to correct an excess.
For 2020 and 2021, you can contribute up to $6,000 to a traditional IRA, a Roth IRA, or a combination of both. If you're age 50 or older, you can contribute an additional $1,000, for a total of $7,000.
Excess contributions get taxed at 6% per year for each year they remain in your IRA. So, it's essential to quickly act when you realize that you've over-contributed so you pay as little as possible.
You can make contributions at any time, even up to the tax filing deadline for the previous tax year, and you’re never required to contribute. For instance, you can make 2020 IRA contributions until April 15, 2021.
Excess contributions get taxed at 6% per year for each year they remain in your IRA. So, it's essential to quickly act when you realize that you've over-contributed so you pay as little as possible. Here are three ways to correct your error:
1. Withdraw the excess before taxes are due
I recommend that you contact your IRA custodian to ask for help withdrawing excess contributions as soon as you realize the error. Besides your original contributions, you must also remove any investment income earned, which could get tricky.
When you make an IRA correction, you may still owe tax if your excess contribution generated earnings.
If you complete the withdrawal before your tax filing due date, it's like you never put the funds in the account. Also note that you can extend your due date to October 15 in any year by filing Form 4868.
When you make an IRA correction, you may still owe tax if your excess contribution generated earnings. Plus, you must pay a 10% early withdrawal penalty on the earnings portion if you're younger than age 59½.
For example, let's say you're 40 years old and make an excess IRA contribution of $500. If it earned $50 in investment income, you would need to withdraw $550 before your tax filing deadline to avoid an excess penalty of 6%.
You must include the $50 of earnings in your gross income for the tax year. And because you're younger than 59½, you must pay an additional 10% early withdrawal penalty on your earnings, or $5.
Your IRA custodian will send you Form 1099-R showing what amount of earnings are taxable when you make a correction so you can submit it with your taxes.
2. Withdraw the excess six months after filing taxes
If you file taxes but later realize that you contributed too much to an IRA, you have six months to correct it by withdrawing the contribution and earnings. You must file an amended tax return by October 15 using Form 1040X.
3. Apply the excess to the following year
You can ask your IRA custodian to apply over-contributions to the following year if they don’t exceed the maximum allowable limit for that year. However, the 6% penalty still applies to excess amounts that remain in your account at the end of the year.
For Amanda’s situation, I recommend that she make her Roth IRA correction right away. Once her excess contribution and earnings are returned to her, using them to make a contribution to a traditional IRA would be a smart move.
However, if Amanda also has a workplace retirement account, some or all of her traditional IRA contributions may not be tax-deductible. This is also the case if she files taxes jointly with a spouse who has a retirement plan at work. Read or listen to 401(k) vs. IRA—Should You Pick One or Have Both Retirement Accounts? to learn more.
What happens if you over-contribute to a workplace retirement plan?
Speaking of workplace retirement plans, if you’re fortunate enough to have one, such as a 401(k) or a 403(b), it’s an incredibly valuable benefit that you shouldn’t pass up. If you receive employer matching, be sure to contribute at least enough to get the maximum free funds.
For 2020 and 2021, you can contribute up to $19,500, or $26,000 if you're over age 50, to most workplace retirement plans. In general, the plan custodian has procedures in place to prevent you from contributing too much automatically.
But there are a couple of situations that make it possible to over-contribute, such as having two jobs with a retirement plan or switching jobs during the year. Again, it's your responsibility to make sure that you don't contribute too much.
Note that employer matching contributions don't count toward the annual limits. So, you can max out a retirement plan at work regardless of how much your company kicks in.
Just like with an IRA, if you discover an excess contribution in a workplace retirement plan, you should contact your plan administrator or custodian right away and ask for the excess, plus any earnings, to be withdrawn. If you correct it by your tax filing deadline (including extensions), you can avoid the 6% excess penalty.
You're required to add any earnings to your taxable income for the year and pay the 10% early withdrawal penalty if you're younger than age 59½. So, depending on the timing, your employer may need to amend your W-2 to show the returned amount as taxable wages.
What is an HSA?
Another tax-advantaged account that you could over-contribute to is an HSA or health savings account. You can open an HSA and make contributions to pay for qualifying medical expenses. However, you must be enrolled in a qualified high-deductible health plan (HDHP) to contribute to an HSA.
No matter if you purchase an HDHP on your own or through an employer, you own and manage an HSA as an individual. That means you don't need permission from an employer or the IRS to set one up, and it stays with you even if you change jobs, become unemployed, or lose your health plan.
Tax-deductible contributions to an HSA can come from you, someone else, or an employer. When you spend the funds on qualified medical expenses (such as doctor co-pays and prescription medications), the contributions and earnings are entirely tax-free. But if you use the funds for non-qualified expenses (such as rent or food), you must pay tax on withdrawn amounts, plus an additional 20% penalty.
More employers are offering HDHPs to help workers keep premiums as low as possible. They work in your favor when you're in relatively good health and aren't likely to spend the full deductible each year.
What happens if you over-contribute to an HSA?
Like with retirement accounts, there are limits on how much you can contribute to an HSA each year. For 2020, if you have a qualifying HDHP for yourself, the HSA contribution limit is $3,550. If you have a family plan with dependents the limit is $7,100.
Next year the HSA limits go up slightly to $3,600 for individuals and $7,200 for families. If you're over age 55, you can contribute an additional $1,000 when you have either type of plan.
The onus is on you, not your employer, to catch and correct excess contributions.
You can make HSA contributions at any time, even up to the tax filing deadline for the previous tax year--but you never have to make contributions. If you become uninsured or no longer have an HDHP, you can spend your HSA, but you can't make any new contributions.
The HSA contribution limits apply to the total contributed by you, someone else, or your employer. Unlike employer matching on a workplace retirement account, employer contributions to your HSA are included in your annual limit. That can make it easy to lose track and over-contribute if your employer makes contributions that are not clearly defined or are variable. The onus is on you, not your employer, to catch and correct excess contributions.
Another situation when you could over-contribute is when you make a large contribution early in the year but lose your HSA-eligible health plan later on. As I mentioned, once you don't have an HDHP, you're not allowed to make additional HSA contributions. That means you must remove a proportional amount of excess if you lose eligibility during the year.
Put a note on your calendar to review your retirement accounts and HSA at the beginning of December, so you have enough time to make changes before the end of the year.
If you over-contribute to an HSA and don't correct it, you must pay a 6% penalty each year on the excess that remains in your account. But if you catch the mistake before you file taxes (including extensions), you can avoid the penalty by withdrawing the excess, plus any investment or interest earnings.
Just like with retirement accounts, your excess HSA earnings are subject to tax. But if you catch an overage right away, the investment gain and tax due will likely be minimal.
I also recommend contacting the administrator of your HSA to discuss correcting an annual overage. The custodian must file Form 1099-SA showing a distribution of excess contributions and correct your Form 5498-SA, which shows annual HSA contributions.
Another option to correct excess HSA contributions is to apply them to a future year. While rolling over funds to the next year is easy, the downside is that you still must pay the 6% penalty on excess amounts that remain in your account.
As you can see, even making an honest mistake with a tax-advantaged account can get tricky, so be sure to get custodial advice and correct it quickly. Put a note on your calendar to review your retirement accounts and HSA at the beginning of December, so you have enough time to make changes before the end of the year.
If you find a problem that you can't get fixed before the New Year, getting excess contributions corrected in the first quarter of the following year is the next best option. You might have some tax to pay, but the faster your account gets cleaned up, the less you’ll have to pay.