TODAY ON REASONED REFLECTIONS:

• Personal finance articles 💰;

• The best way to spread Reasoned Reflections is loudly for all to hear;

• Exceeded the Roth IRA income limit? Here’s what to know!;

• Quote of the Reflection.

Personal Finance Articles 💰

Time for a bit of R&R

• Roth conversions = immediate taxes

  My Take - Converting pretax retirement money to a Roth IRA can be a prudent decision. However, it’s important to run your personal numbers through a Roth conversion calculator. The difficult part of the calculation is determining what tax bracket you’ll be in when you are retired. Who knows what the tax rate will be 20-40 years from now?!

• Time to start making money moves

  My Take - The end of the year is always a good time to recalibrate yourself with your financial situation. If any big life events have happened this year—like the birth of a child, for example—it makes sense to update your beneficiary designations on retirement accounts, life insurance policies, etc.

• The worst long-term asset is now Warren Buffett’s fave? 

  My Take - It is absolutely crazy to think about $325 billion. That is just such a large stack of cash. I just hope Warren Buffett lives long enough so we can see what he does with all of that cash!

• Bye-bye pensions

  My Take - Ever since ERISA was enacted, employers have slowly transitioned away from pensions (aka defined benefit plans) and more towards 401(k)s (aka defined contribution plans). A pension sure does sound nice, but I don’t know that I could work for the same employer for 30+ years. I guess it’s not all bad.

• Taxes on dividends

  My Take - As if taxes weren’t confusing enough. It’s important to understand how dividends are taxed (typically as ordinary income) and the differences between qualified and nonqualified dividends. This is especially true if you have investments in a taxable brokerage account.

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Reflection No. 13: Roth IRA Mistake: What Happens If You Contribute Too Much?

I - Issue: What options do I have if I contribute to a Roth IRA but my income exceeds the eligibility limit?

R - Rule: The IRS sets income limits for Roth IRA eligibility based on modified adjusted gross income (MAGI). If you exceed these limits, you’ll need to take corrective action to avoid penalties, such as recharacterizing or withdrawing the contributions before the tax filing deadline.

A - Analysis: Accidentally contributing to a Roth IRA despite exceeding the income limit is more common than you’d think, especially when income varies or goes up unexpectedly. For 2024, Roth IRA eligibility phases out at a MAGI of $146,000 to $161,000 for single filers and $230,000 to $240,000 for married couples filing jointly. If you’ve contributed and discover you’re ineligible, don’t panic—there are solutions.

First, let’s talk about why this matters. The IRS charges a 6% penalty for each year an ineligible contribution remains in your Roth IRA. So, if left unaddressed, even a tiny over-contribution can create a compounding penalty issue over time.

One option to correct this is recharacterizing your contributions. Recharacterization allows you to transfer the excess contributions from your Roth IRA to a Traditional IRA. Recharacterization essentially “converts” those contributions as though they had been made to the Traditional IRA in the first place. This strategy avoids those pesky penalties. You can recharacterize your contributions plus any returns those contributions generated. Recharacterizations must be completed by the tax filing deadline (April 15)—including extensions (October 15)—to count for the previous year. Depending on your tax situation, you may be eligible for a tax deduction after recharacterization from the money you contributed but not any investment returns. For example, if you contributed $6,000 and that amount grew to $6,500, you would only get a deduction from the $6,000.

If you don’t want to recharacterize, another approach is to withdraw the excess contributions and any returns generated before filing taxes. This solution has a couple of catches, though. You’ll owe income tax on the investment returns (but not on the contribution itself since you’ve already paid tax on those dollar bills). In the olden days (okay, before 2022), you would have also owed an additional 10% penalty on any earnings if you’re under 59½. However, the Secure Act 2.0 removed that additional 10% early withdrawal penalty when correcting an excess Roth contribution.

Alternatively, if you caught this after the tax deadline or prefer not to withdraw the funds, you could leave the excess in the Roth IRA and apply any excess contributions to a Roth IRA in the future. The 6% excise tax applies to the excess contribution until that money is applied to a future year, though. If the excess is minimal, the excise tax might not be that big of a deal for a short amount of time. You’ll need to remember that the 6% penalty can quickly add up if you somehow forget to apply the excess to a future year. Applying the excess funds forward also assumes that you’ll qualify for a Roth IRA next year, which might not happen if your income stays where it is or goes up! If that’s the case, then using one of the other two corrective measures makes the most sense.

Suppose your income does stay the same or goes up but you want to continue taking advantage of the Roth IRA. In that case, you might consider using the “backdoor” Roth IRA strategy if you anticipate exceeding income limits. This method allows high earners to fund a Roth IRA indirectly by making a nondeductible contribution to a Traditional IRA and then converting those funds to a Roth IRA—taking advantage of tax free growth and tax free withdrawals in retirement. This strategy has gained popularity among high-income earners looking to benefit from Roth accounts (we see you, Peter Thiel).

C - Conclusion: If you’ve contributed to a Roth IRA and later realize you’re over the income limit, you should consider recharacterizing your contributions or withdrawing the excess amount. Remember: if you’d still like to take advantage of a Roth IRA (aka all of that tax free growth), you can look into taking advantage of the backdoor Roth as this strategy can help maximize retirement savings while avoiding income-limit complications.

Time to Reflect…

Realizing you’ve overshot the Roth IRA income limit isn’t the end of the road. You’ve got options. You can steer clear of extra penalties by recharacterizing or withdrawing the excess. And if you still want those sweet, sweet Roth perks, exploring the backdoor route can keep your retirement savings thriving. Even as your income climbs.

Quote of the Reflection

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