There's an old adage in the construction world: measure twice, cut once. Otherwise, pipe connections leak, electrical connections fail and houses fall. Now, I don't consider myself a handy person by any stretch of the imagination but I do know my way around some common power tools. And although it's probably safest for me to "outsource" home projects, I have completed a few on my own. I can't even tell you how many times measuring twice has saved me from disaster.
You see, once you make a cut, there's no going back, and anyone who has finished a construction project can tell you that it's a heck of a lot easier to think it through and do it right the first time, than it is to try to correct it later.
Hmm. Of course, there is a life lesson there; do it right the first time.
In life, it is not often that we have an option to correct a mistake before we bear the brunt of its results. This is especially true in the financial world, where bearing the brunt of a mistake usually means paying for it, literally. So, it's important to apply that "measure twice, cut once" philosophy to our financial systems and make sure that we do it right the first time around.
That being said, people do make mistakes. And, just like in life, sometimes there are ways to correct those mistakes.
A great example of this involves a very nice young couple who just left my office, let's call them Ron and Debbie. Ron and Debbie told me they read this column "religiously" and felt embarrassed that they had "messed up" their financial plan. They had each made an excess contribution to their IRAs last year, and they were not sure how to fix it.
You may remember that recently I wrote an article about how to manage your finances so that you can successfully (and legally) contribute to an IRA. We all know the basic rule that people younger than 50 can only contribute up to $5,500 per year and those older than 50 can contribute up to $6,500 per year, to either a Roth IRA or a Traditional IRA. What many people don't know is that in order to make those contributions, they must have or their spouse must have earned income in that same year. If not, every dollar contributed is in excess and violates the rules.
Things get a bit stickier for high income earners who contribute to a Roth IRA. The issue here is that eligibility to make a Roth contribution gets phased out with Modified Adjusted Gross Income (MAGI) (for married couples filing jointly) beginning at $184,000. At the $194,000 mark, Uncle Sam says you cannot contribute to a Roth, at all. Ron and Debbie are ages 45 and 42 respectively, have two kids and live here in town. They file a joint tax return and in years past had combined compensation of about $150,000. Ron is in sales and had, as he described, a "banner" year last year and earned a bonus, pushing their combined income to just over $200,000. But they each contributed their normal $5,500 to their Roth IRAs. So, as a couple filing jointly with MAGI more than $200,000, well over the $194,000 cap, Ron and Debbie have an issue. All of their contributions are deemed by Uncle Sam to be "Excess Contributions." Excess contributions are subject to a very costly 6 percent penalty on the amount deemed to be in excess, not just the year they are made, but every following year that the excess amount remains in the account.
Luckily for Ron and Debbie, this is one of the few opportunities where Uncle Sam gives us a "get out of jail free card" and allows us to correct the mistake—but the correction must be done quickly.
As I said, any excess contributions made in 2016 will be charged that 6 percent penalty, unless they are removed by October 16, 2017. This is what I explained to Ron and Debbie?
The most simple, and most widely used method, is to withdraw the contribution and any corresponding earnings or losses attributed to that money. Any earnings are taxable. And if you are under age 59 1⁄2, this withdrawal would be considered an early distribution and would be subject to the 10 percent penalty that applies.
Another option could be to recharacterize the contribution. This would involve transferring the excess amount (and, again, any earnings or losses) from a Roth to a Traditional, or a Traditional to a Roth, depending on the original contribution. Doing so could save in terms of the immediate tax hit and any penalties. But, it is important to note that this recharacterization can only be done under certain circumstances. If an excess contribution to a Roth IRA would also be considered an excess contribution in a traditional IRA (due to being over the $5,500 limit, or not having earned income), recharacterizing would not be helpful. On the other hand, if a contribution is made to a Roth IRA when MAGI is too high, that contribution could be recharacterized to a traditional IRA, which has no income limits.
Of course, Gary's Weekly Finance readers, make sure you check with your retirement specialist because it can get a bit tricky.
There are not many second chances in the financial world, so we need to always ensure that we measure twice and cut once. However, if a mistake is made, there may be options to fix it. Everyone makes mistakes. What is important is that we do our best to correct the mistakes we make, before they become too costly.