Roth contribution limits and exceeding the allowable earnings

[user17581364142]

My wife contributes to a Roth IRA monthly.  $125 each month ($1500 annually).  My work is shutting down and I expect to get a significant severance payment when it closes ($220K before withholding).  That will move us from $235K gross earnings to $456K.  That exceeds the allowable for Roth IRA contribution.  What do we do once we know when the severance will occur.  Not sure if late this tax year or next year.

[K M W]

For the 2025 tax year,  on a married filing joint tax return, your ability to contribute to a Roth IRA is based on your Modified Adjusted Gross Income (MAGI).

• Full Contribution: You can contribute the maximum amount ($7,000, or $8,000 if age 50 or older) if your MAGI is less than $236,000.

• Partial Contribution (Phase-Out): Your contribution limit is gradually reduced if your MAGI is between $236,000 and $246,000.

• No Contribution: You cannot contribute to a Roth IRA if your MAGI is $246,000 or more.

A 6% excise tax applies to any excess contribution to a Roth IRA. For your situation, if you receive the severance pay in 2025, the contributions to the Roth IRA will be considered excess contributions.  It seems you are unsure on if the severance income will be in 2025 or 2026, so at the present you do not know if you will be above the threshold or not.

As such, you may want to consider waiting until later to determine which situation applies to you.  If down the road you realize you overcontributed, there are options to correct the excess contributions, as follows:

1. Withdraw the excess contributions by the due date of your tax return. For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. 

2. Applying excess contributions. If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in 1 year to a later year if the contributions for that later year are less than the maximum allowed for that year. IMPORTANT: if you choose to go this route, you will pay the 6% excise tax on the excess contribution on your 2025 return, so this option is typically only used in the situation when you are past the filing deadline for the year of the excess contribution.

3. Recharacterize the contribution: This is the most common and effective way to fix the problem. A "recharacterization" allows you to treat a contribution made to one type of IRA (in this case, a Roth IRA) as if it had been made to another type of IRA (a traditional IRA) from the start. To recharacterize, contact your IRA custodian (e.g., Vanguard, Fidelity, Schwab) and request to "recharacterize" your Roth IRA contribution to a traditional IRA. Note that there are NO income limitations to contributing to a traditional IRA, although there are income limits on whether you can deduct a contribution to a traditional IRA.

So, the silver lining is that you have time to figure out the timing on the severance payment and the impact on the Roth IRA contributions, and then take steps to correct, if needed, as indicated above.  I hope that answers your questions today, user17581364142!

[Jennifer_A]

If you find out that your 2025 AGI is over the Roth IRA contribution limits, you will need to contact the IRA provider and withdraw the excess amount plus any earnings.  This will need to be done before April 15, 2026.  If it is not withdrawn by that date, there is a 6% penalty on the excess that remains in the account.

You could also apply the excess contribution to 2026, however, you will still incur the 6% penalty on your 2025 tax return.

You may also be able to recharacterize the contribution into a Traditional IRA.