I am currently looking into 2021 Tax and arranging all the documents. I contributed $6000 (myself) and $6000 (spouse) for Roth IRA contributions. Now I am calculating my income for 2021 Tax and it seems like I will be pushing over 198K. I think my income may come out to be around 204K. I have a side job which also earns income and that has pushed me over the limit. What should I do in this case? I know that I will have to pay a 6% penalty but how do I know about this penalty? I mean how will I know and whom should I pay?
If you already know that you'll end up above the limits, I suggest you call your custodian ASAP and ask them to re-characterize the contribution to Traditional. Then (assuming you have no other Traditional IRA amounts), immediately convert back to Roth (ideally before 2022 starts, in case BBB passes).
This way you don't end up paying any penalty, and end up with the same Roth IRA you intended.
If you already have Traditional IRA amounts, conversion becomes complicated because of proration rules, but you can just leave it in Traditional then.
Remember that the 6% excess contribution penalty is charged every year until you withdraw it, so you better do recharacterization.
When you file your federal income tax return for the year, if you have an IRA penalty for that year, you must fill out Form 5329, and the penalty is added to the total taxes for the year on your federal income tax return (Form 1040). As with income taxes, you are supposed to have withheld or have paid estimated taxes through the year to reach approximately the level you needed to have paid, and when you file your tax return, any excess you have paid will be refunded, and any deficit you will owe (and if you owe too much there can be an underpayment penalty). A penalty will increase the tax you will owe, and therefore decrease your refund or increase the amount you will owe.
Now, assuming you made the contributions in 2021, and it is before the 2021 tax return filing deadline (April 15, 2022) right now, there are still two ways to avoid an excess contribution penalty:
- You can withdraw the excess contribution (plus earnings attributed to that contribution) before the tax filing deadline, and it won't count as an excess contribution. You will have to pay tax on the earnings. I am not sure if there will be an early withdrawal penalty on the earnings.
- You can recharacterize the Roth IRA contribution into a Traditional IRA contribution before the tax filing deadline. The IRA custodian will transfer the contribution, plus earnings attributed to the contribution, into Traditional IRA. It will be treated as if you guys contributed to Traditional IRA to start with. Since Traditional IRA does not have a contribution income limit, there will not be an excess contribution penalty. (There is an income limit for deducting the contribution if either of you contributed to a 401k, however. But if that's the case, it just means you have a non-deductible Traditional IRA contribution.) You may then, if you choose, convert that money into Roth IRA, paying tax on the earnings, effectively executing a belated "backdoor Roth IRA contribution". Roth IRA conversion also has no income limit, though pending legislation may affect wealthy people's ability to do this in future years. But only do the conversion if you have no pre-tax money in Traditional/SIMPLE/SEP IRAs, or the pro-rata rule will get you.