By Jim Saulnier, CFP | May 24, 2019

Excess IRA Contributions: Basic Qualifications

We hear a lot about how important it is to contribute to an IRA. So, ‘how to contribute correctly’ becomes an important topic. Not that it is difficult, but there are some important rules regarding IRA contribution qualifications that you have to follow.

And since you put money into an IRA to allow it to grow in a tax-advantaged environment, you don’t want to break one of the rules and have it cost you money. One of the main ways that could happen is if you make excess contributions.

In this three-part guide on excess IRA contributions, we are going to review (1) the basic qualifications for making valid contributions, (2) some of the more complex situations you will have to navigate and (3) how you can fix accidental excess contributions and avoid costly penalties.

Why would you want to contribute to an IRA?

In a traditional IRA, your contribution may be fully or partially deductible from the amount of income on which you will be taxed this year. Your contribution will be made with ‘pre-tax dollars.’ Because you won’t pay taxes on those funds now, the portion you would have paid in taxes is also allowed to grow until it is withdrawn, or ‘distributed.’ You will pay the tax upon withdrawal, both on original funds and any gains.

When can you take money back out of an IRA?

You can withdraw money from an IRA whenever you want. However, if you are below age 59½ when you do so, you will pay 10% additional tax on the funds, above your applicable tax rate for that year. From age 59½ forward, you will pay just that year’s applicable tax rate. Then, at age 70½, you will start having to take out Required Minimum Distributions, or RMDs, based on an IRS formula. Not doing so may lead to hefty penalties.

How much can you contribute to an IRA?

For 2019, each person can contribute a total of $6,000 (or $7,000 if you are age 50 or older), as long as you have at least that much in ‘qualified income.’ Anything you contribute above your qualified income will be considered an excess contribution. You have to be particularly careful if you contribute to IRAs being held by multiple custodians (such as authorized banks and brokers), as it is your responsibility to monitor the total, and not the custodians’.

How do you define ‘qualified income’ for contributions?

In general, the IRS defines qualified income as wages, salaries, tips, professional fees, and bonuses. It also includes commissions, self-employment income, alimony, and separate maintenance, as well as nontaxable combat pay. However, you cannot consider Social Security, rental income, investment income, dividends, interest or royalties (among others) in your calculations. Using the wrong kind of income to justify contributing to a traditional IRA puts you at risk of making an excess contribution.

How does spousal income figure into IRA contributions?

You may not have any (or enough) qualified income to justify contributing fully to an IRA. However, if your spouse does and if you file a joint tax return, you can use your spouse’s income to qualify. Each spouse will hold a separate IRA, but the total of your combined contributions cannot be larger than the taxable income reported on the return. If it is, you will be facing penalties for excess contributions.

How long can you contribute to an IRA?  

You can only contribute to a traditional IRA until the year in which you turn 70½. Say you turn 70½ in December of 2019. You cannot contribute at all to a traditional IRA in 2019, even if you were still 69 in early 2019. When in the year you contribute is irrelevant. Any contribution you do make will be considered an excess IRA contribution.

What about Roth IRAs, how do they differ from traditional IRAs?

To start, contributions to a Roth IRA are not tax-deductible, so they are made with ‘after-tax dollars.’ As long as you meet the distribution qualifications, funds will not be taxed when withdrawn. (Remember, you already paid tax on the funds). However, because of the tax advantages Roth IRAs offer on gains, the IRS places caps on the income of those allowed to contribute. If your income is higher, you will have made an excess contribution.

Other differences? You can contribute to a Roth IRA regardless of age, that is, even after you reach 70½. You also do not have to start taking distributions at 70½ but can leave funds there for life.

What next?

Now you have the basic guidelines for contributing to an IRA without being penalized for excess contributions. More complex issues will be reviewed next. However, if you would like to make IRA contributions part of a strategic retirement plan, please reach out to our office so we can help.