You must pay an overcontribution penalty equal to 6 percent of the amount you contributed to your Roth IRA when you contribute, even if you're not eligible. If you don't correct the error, you'll have to pay the penalty every year the excess remains in your account. If you don't meet the requirements to accept a qualified distribution of your IRA to correct the error, you'll pay an additional 10% early withdrawal penalty on earnings (interest). You can avoid excess contributions by paying attention to your earned income, modified adjusted gross income, and annual contribution limits.
Also, keep track of the contributions you've already made for the tax year and be sure to assign the contributions made between January. Finally, if you make a mistake, act quickly to fix it so you can limit the fines you'll owe. Your Adjusted Initial Balance (AOB) is the balance of your Roth IRA before your excess contribution, plus all contributions, including excess contribution, consolidations, and account transfers you have made since the excess contribution. The five-year Roth IRA rule states that you can't withdraw your earnings tax-free until at least five years after you've first contributed to a Roth IRA.
Every year you make a contribution to the Roth IRA, the custodian or trustee will send you Form 5498 with information about IRA contributions. Under certain conditions, Roth IRAs also allow tax-free earnings to be withdrawn, which are subject to taxation in a traditional IRA. While not tax-deductible, contributions to a Roth IRA provide you with an opportunity to create a tax-free savings account. You don't have to keep your IRAs in the same accounts from the date of contribution until the date of retirement.
You may have already heard the acronym IRA, but if not, we'll explain what an IRA means. In general, to avoid these errors, it's a matter of keeping track of how much you contribute to all your IRAs during the year and understanding any other rules, such as the income limits of Roth IRAs, that may restrict the amount you can contribute during the year. Previously, if you converted another tax-advantaged account (Simplified Employee Pension IRA (SEP), Supplemental Employee Savings Incentive Plan (SIMPLE), Traditional IRA, 401 (k) Plan or 403 (b) Plan)) into a Roth IRA and then changed your mind, you could cancel it in the form of a requalification. One method of conversion is to take a distribution from the traditional IRA and contribute it (reinvestment) to a Roth IRA within 60 days from the date of distribution.
In addition, transfers from one Roth IRA to another are not taken into account for the purpose of making annual contributions. Converting to a Roth IRA from a taxable retirement account, such as a 401 (k) plan or a traditional IRA, has no impact on the contribution limit; however, making a conversion increases the MAGI and may cause or increase the phasing out of the Roth IRA contribution amount. If you're married and one spouse doesn't receive compensation or receives less compensation, you can open an IRA account for the spouse who receives less taxable compensation than the other spouse. You may be able to get around income limits by converting a traditional IRA to a Roth IRA, which is called a clandestine Roth IRA.