A reader named Jim recently wrote in asking how to handle an excess contribution to a traditional IRA. Upon receiving his e-mail I ran a quick search of the archives and was surprised to discover that I hadn't covered this topic in the past. With the filing deadline almost upon us, I decided it was high time to rectify the situation.

For starters, let's define our terms. According to the IRS (see Pub. 590):

Generally, an excess contribution is the amount contributed to your traditional IRAs for the year that is more than the smaller of:

• $5,000 ($6,000 if you are age 50 or older), or

• Your taxable compensation for the year.

The taxable compensation limit applies whether your contributions are deductible or nondeductible.

Contributions for the year you reach age 70.5 and any later year are also excess contributions.

An excess contribution could be the result of your contribution, your spouse's contribution, your employer's contribution, or an improper rollover contribution. If your employer makes contributions on your behalf to a SEP IRA, see Publication 560.

There are a couple of points here…

For starters, you may have noticed that they referred to “IRAs” plural. This is because you can have (and contribute to) more than one IRA at a time. And this isn't just talking about traditional vs. Roth. You could have multiple traditional IRAs, multiple Roth IRAs, or a combination thereof.

It's important to note that all of your IRAs (traditional and Roth) share a common contribution limit which currently stands at $5k/year ($6k/year if you're 50 or older), so don't contribute more than $5k total.

It's also important to distinguish between how much you can contribute and how much you can deduct. While the deductibility of traditional IRA contributions is phased out above certain income limits, you can make non-deductible contributions no matter how much you earn. In fact, this is the basis of the contribute-and-convert strategy for funding a Roth IRA (a.k.a., a “backdoor” Roth) if your income is too high to contribute directly.

So… What happens if you make an excess contribution?

The short answer is that you'll face a 6% annual tax for excess contributions that aren't removed by the filing deadline - and this penalty will continue year in and year out until you rectify the situation. The good news is that you can buy yourself some time by requesting an extension.

This tax, which is figured using Form 5329, cannot exceed 6% of the total value of your IRAs.

To rectify the over-contribution, you'll need to withdraw it plus any related earnings before the filing deadline (or extended deadline if you request an extension). You should contact your IRA custodian for instructions on withdrawing the excess contribution and any associated income.

As for the tax treatment of the withdrawn contributions, you'll need to report it as taxable income if you previously deducted it. Depending on how much time has passed, this can get messy so be sure to read through Chapter 1 of Publication 590 before acting. You will also have to report as taxable income any money earned on the excess contribution, and this amount might be subject to a 10% early withdrawal penalty.

Oh, and if you've already filed your 2011 return, don't fret… You still have six months to withdraw the contribution and file an amended return - this is essentially an after-the-fact extension. Here again, be sure to read through Publication 590 (or seek professional help) to be sure you get the details right.

The original article can be found at FiveCentNickel.com:
What Happens if you Contributed Too Much to an IRA?