How to calculate earnings on excess Roth IRA contributions?

If you have a Roth IRA, you may unknowingly contribute more than is allowed to your retirement account. Typically, there is a limit on the amount you can contribute to a Roth IRA in a year. If you have exceeded the annual contribution limit, you must remove the excess contribution to avoid owing penalties on the excess contribution.

The IRS provides the Net Income Attributable (NIA) formula to calculate the earnings on excess contributions to a Roth IRA. You will need to determine the excess contribution, adjusted opening balance, and adjusted closing balance. Once you know these figures, use this formula to calculate the earnings or losses on the excess contributions:

Net income= Excess contribution x (Adjusted Closing Balance – Adjusted Opening Balance)/ Adjusted Opening Balance)

What are Roth IRA Contribution limits?

In 2022, you can contribute up to $6,000 to a Roth IRA. If you are 50 or older, you can contribute an additional $1,000 in catch-up contribution, for a total of $7,000. However, your Roth IRA limits may be lower depending on your modified adjusted gross income (MAGI) and your filing status. The limits vary for single filers, married couples filing jointly, or married couples filing separately.

As of 2022, you can contribute up to the full limit if your MAGI is less than $204,000 if you are married and file a joint return, or less than $129,000 if you are single or married filing separately.

The contribution limits start decreasing when the income increases to more than $204,000 but less than $214,000 for married filing jointly, or more than $129,000 but less than $144,000 for single, head of household, or married filing separately. The contribution limits reach zero at incomes of $214,000 or more for married couples filing jointly, or $144,000 or more for single, head of household, and married couples filing separately.

The contribution limits apply cumulatively to both traditional and Roth IRAs. If you have both types of IRAs, the total contributions should not exceed $6,000 or $7,000 if you are above 50, in 2022.

What are excess contributions?

An excess contribution occurs when you exceed the annual contribution limit, contribute more than your earned income, or contribute more than is allowed due to high income. Also, if you made an ineligible rollover contribution, it can be considered an excess contribution if it exceeds the annual contribution limit.

There will be a 6% penalty on excess Roth IRA contributions for every year the amount remains in the account. This means that, if you exceeded the annual contribution limit by $1,000, you will owe a $60 penalty each year until when you fix the issue. However, unlike a traditional IRA that imposes a 10% penalty for early distribution of the excess contribution, you won’t pay this penalty when you withdraw the excess contribution from a Roth IRA before 59 ½.

How to calculate earnings on excess Roth IRA contributions

The IRS provides the Net Income Attributable (NIA) formula to calculate the earnings or losses attributable to the excess Roth IRA contributions. The NIA formula is as follows:

Net income= Excess contribution x (ACB – AOB)/ AOB)

Where:

ACB is the adjusted opening balance, which equals the prior month's Roth IRA balance plus all contributions made to the account, including any excess contributions, transfers, and consolidations made to the account since the contribution occurred. 

AOB is the adjusted closing balance, which equals the current Roth IRA balance minus any transfers, consolidations, and distributions made since the contribution occurred.

Excess contribution example

Ann, now 49, contributed $7,000 to her Roth IRA in the past year. However, when filing taxes, she realizes she was only eligible to contribute $6,000, meaning there is a $1,000 excess contribution. She now requests to withdraw the excess contribution. Her Roth IRA balance before the contribution was $30,000, and it is now worth $39, 850. There were no transfers, distributions, or contributions.

The earnings attributable to the excess contribution are calculated as follows:

=$1,000 x [($39,850-$30,000)/$30,000]

=$1,000 x [$9,850)/$30,000)

=$1,000 x 0.32833

=$328.33

Therefore, to avoid paying the 6% penalty on the excess contribution, you must remove the $1,000 excess contribution and the $328.33 earnings from that contribution. If the calculation shows you incurred a loss instead of earning a profit on the excess contribution, you should deduct the loss from the excess contribution. In this case, if you incurred a loss of $328.33, you would have to withdraw $671.67.

How to fix excess IRA contributions

Once you detect the excess contributions, you have several options to correct the issue. Here are the main methods of fixing excess contributions:

Withdraw excess contributions and earnings before the tax deadline

You can withdraw the excess contribution plus any earnings before the tax filing deadline, usually April 15. If you withdraw the excess contribution after you file your taxes on April 15, you have six months to file an amended Form 5329 to show you have withdrawn the excess contribution and reported any earnings made from the excess contribution.

Carry forward the excess contributions

If you qualify to contribute to the Roth IRA in the next year, you can use the excess contribution in the current year to offset the contributions for the next year. You must determine how much to reduce the following year’s contribution by taking the contribution limit less the excess contribution.

For example, if your contribution limit is $6,000, and you have an excess contribution of $1,000, you can limit the following year’s contributions to $5,000. You will still owe a 6% penalty tax in the current year since you did not withdraw the excess contribution by the tax deadline.

Recharacterize the excess contribution

When you recharacterize your Roth IRA excess contributions, it means you are transferring the excess contributions to a traditional IRA. However, you can only recharacterize up to the allowable maximum contribution.

When you recharacterize an annual Roth IRA contribution, it will be deemed to have been a contribution for the same tax year when the original contribution was made. You must calculate the earnings attributable to the excess contribution and recharacterize that amount as well. There are no tax implications when you recharacterize the excess contributions.