While only the most diligent savers are likely to max out 401(k) contributions, IRAs are another matter. The maximum allowable contribution for IRAs in 2017 is $5,500 (and you can contribute an extra $1,000 if you're 50 or older), which is manageable for many everyday savers. And exceeding this contribution limit has serious consequences.
If you contribute more than the allowable annual limit to your IRAs, or if you contribute anything to a traditional IRA after age 70-1/2, you'll owe the IRS a tax of 6% of the excess contribution as long as that money stays in the IRA. For example, if you're under 50 and you contribute $7,500 to your IRA this year, you'll have made an excess contribution of $2,000. You'll owe the IRS an extra $120 in income taxes for this year and every year in the future until you take that $2,000 back out.
How excess contributions can happen
It may seem easy to avoid exceeding the contribution limits, but the rules are somewhat more complex than they appear at first glance. For example, if you have several IRAs and contribute to all of them, you could easily lose track of how much you've contributed total -- especially if you're using automatic savings plans. And many taxpayers don't realize that the $5,500 limit applies to contributions to both traditional and Roth IRAs combined. So if you contributed $4,000 to a traditional IRA and $3,000 to a Roth IRA, you'd be over the limit. Further, an incorrectly managed rollover to an IRA can qualify as a contribution and trigger the excess contribution rule.
Fixing the excess contribution
The earlier you catch your mistake, the less you'll end up paying for it. If you can pull the extra money back out of your IRA before you file your tax return for the year, you won't owe the 6% extra tax for that year. If you don't catch the excess contribution until after you file your tax return for the year, you can remove the money and file an amended return by Oct. 15. However, you'll have to pay income taxes plus a 10% early withdrawal penalty (if you're under age 59-1/2) for taking money back out of a traditional IRA. Paying 10% to save yourself 6% sounds like a pretty lousy deal until you remember that the 6% penalty will happen every year, whereas the 10% penalty is a one time event. You pay any penalties due for the year by filling out Form 5329 and turning it in with the rest of your federal tax return.
An ounce of prevention
The best way to fix an excess contribution is to not let it happen in the first place. Set your automatic contributions so that you'll finish the year slightly below the contribution; you can always toss in enough extra savings to max out your IRA at the end of the year. And if you're rolling over a 401(k), be sure to get instructions from your IRA trustee and follow them to the letter. The penalties you'd face for dumping tens or even hundreds of thousands of dollars into an IRA if it didn't qualify as a rollover are too terrible to contemplate.