[Editor's Note: The following is a post written by a general dentist and a chiropractor that blog as a couple about their journey to get out from under a combined $450k in student loans at Doctors On Debt. Today they're talking about a common mistake I often see with Roth IRA contributions — over contributing. A pesky $458.33 miscalculation can cause a lot of work!  What I love is that it that they found their mistake because they became educated about finances. After the headache of correcting the mistake, I'm guessing they are even more confident and financially literate than ever before.]

The beginning of a new year is typically a busy time for us at Doctors On Debt.  Amongst many other tasks, one of the things we try to complete as soon after the new year as possible is making our Backdoor Roth contribution.  For the most part, making Roth IRA or Backdoor Roth IRA contributions is pretty straightforward if you follow the directions.  As you’ll see, however, it’s still possible to get yourself into trouble if you don’t pay attention to the details.  Hopefully, this post will help prevent someone else from making the same mistakes we did.

Backdoor Roth IRA Review

Very quickly, let’s do a simple review.

The White Coat Investor has a great step-by-step guide on how to do a Backdoor Roth (also, and more properly, known as a Roth conversion).  There is also a guide for how to do a late contribution to the Backdoor Roth, for when you make the contribution and the conversion the year after the tax year for which you want the contribution to be treated.

I would direct you to reference the aforementioned guides for the nitty gritty details on how to do a Backdoor Roth, but the general steps are as follows:

  1. Make a non-deductible Traditional IRA contribution
  2. Convert that Traditional IRA contribution to a Roth IRA.

It’s really that simple. If you’re doing it on Vanguard, it is literally clicking a couple of buttons and inputting an amount.  Your specific situation may require some other steps, so be sure to refer back to the Backdoor Roth guides mentioned above.

In my opinion, the complications with a Roth, and particularly a Roth conversion, come from the paperwork.  It’s not really that hard, but it can be overwhelming if you’re not used to looking at it.

Roth Contribution Phase-Out

My wife and I are both healthcare professionals, and like many readers of this blog, our income doesn’t allow us to make direct Roth IRA contributions, hence the necessity to employ the Backdoor Roth technique.  However, early in our careers, this wasn’t the case.  For a year or two after our schooling, we were able to make direct Roth contributions – up to a point.  After a certain income level, one’s ability to make a direct Roth contribution begins to “phase out” and they are limited in how much they can contribute directly to a Roth IRA.

Taxpayers who are married filing jointly may each contribute the full $5,500 to a Roth IRA as long as their income is less than $189,000.  If they make more than $199,000 they can’t contribute to a Roth IRA at all (which is where the Backdoor Roth comes into play).  And if they make between $189,000 and $199,000 they can contribute a certain calculated amount that is less than $5,500, depending on their income.  You can read the rules for yourself here.

It just so happens that (according to a quick google search) the average physician salary is $189,000.  It’s not hard to imagine, then, that many single doctor couples who are married filing jointly will fall into that “phase out” income limit that is between $189,000-$199,000.  It’s very important that if this applies to your situation, you pay close attention to your Roth contributions.

We didn’t, and it turned into quite the headache.

How We Screwed Up our Roth IRA

Our Roth IRA screw-up was because we over-contributed in a year when our income dictated that we were to limit our contribution due to the phase-out rule.  This all began in 2014.  How we over-contributed is still a point of contention and to this day the details are enough to drive us mad, but in the simplest terms it came down to a few mistakes that were made:

We Complicated Our Contributions By Spreading Them Out

We were using a financial advisor at the time who was working for, let’s call it, Big Firm 1.  We were each contributing $458.33 per month with the plan of each having a full Roth IRA contribution of $5,500 for the year at the end of 12 months.  We didn’t begin contributing until May 2014, so we were going to contribute up until Tax Day 2015.  In other words, our contributions were being spread out over 12 months, across both 2014 and 2015, but all were going to be treated as 2014 tax year contributions.  Clear as mud, right?

We Messed Up Our Auto Payment System

On top of our spread out contributions, another complicating factor was that the financial advisor we were using at the time (we are no longer with that advisor) took a new job and left Big Firm 1 for Big Firm 2 at the end of 2014.  We were convinced to follow him to the new firm, further muddying up our automatic withdrawal system that had been put into place at Big Firm 1.

We Miscalculated Our Contribution Limit

While our financial advisor was making the transition from one firm to the other, we put our automatic contributions on hold after one monthly deposit to the new firm (this is an important detail) because we began to suspect we were going to be limited due to the phase-out rule. Up to that point, we had contributed $458.33 each for 8 months (7 at Big Firm 1 and one at Big Firm 2), for a total of $3,666.64 apiece.  Our accountant crunched the numbers and calculated our contribution limit to be $4,550 each.  Someone (we honestly don’t remember if it was our financial advisor, our accountant, or us) took this information and figured up one final contribution of $1341.69 apiece that we should make to reach our limit, and in March 2015 we made those final contributions for our 2014 Roth’s.  Do you see a problem here?

The result of the above was that we each over-contributed to our Roth IRA in 2014 by $458.33, the exact amount that our original monthly automatic withdrawal had been.  Coincidence?  Of course not; the single monthly deposit we had made to our financial advisor’s new firm at the end of 2014 had failed to be accounted for when figuring up our Roth contribution limit.

So whose fault was this oversight?  Our financial advisor’s, for failing to keep accurate records of our contributions across his two jobs and allowing us to make the final over-contribution when he should have known it was too much?  Our accountant’s, for not catching the mistake while reviewing our Form 5498’s?  Or was it ours, for not taking more ownership of our finances at the time and making sure we knew exactly what was happening with our money?  There’s probably enough blame to go around for all three.

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How We Found Our Over-Contribution Mistake

Tax year 2014 came and went, my wife and I simultaneously pleased about making more money in 2014 than we had anticipated and gleefully unaware of the mistake made contributing to our Roth IRA’s.  Ignorance is bliss, and any thoughts of our 2014 IRA contributions quickly disappeared after Tax Day came and went, our money concerns returning to more pressing matters like paying off student loans.

Fast forward through 2015 and again our income had gone up.  Even though we still didn’t realize a mistake had been made in regards to our 2014 Roth contribution, we knew that we didn’t want to hassle with figuring up our IRA contribution limit again; we thought we would be over it anyways.  We decided early on that we would make a Backdoor Roth contribution for 2015 and so we focused our efforts on learning about that process.  It’s also of note that in the meantime we had left our financial advisor and moved our assets to Vanguard, taking full responsibility of our finances for the first time, which dictated that we become more educated on the subject.

Humorously (if you have a sick sense of humor) it was because of our newfound interest in our finances that we discovered our 2014 Roth IRA over-contribution mistake while performing an educational review of our already submitted 2015 tax forms (this was after Tax Day 2016).  So, to break that down:  In May of 2016, after submitting our tax forms for 2015, we discovered an excess Roth IRA contribution made in 2015 for tax year 2014.  Again, clear as mud.

How We FIXED Our Over Contribution Mistake

So, okay, we found a problem. How do we fix it? After the initial shock of the discovery and frustration that it was missed to begin with, we began to research what we should be doing next.  On the surface, it sounded pretty easy: Contact Vanguard (who our funds were with at the time the discovery was made) and let them know we made an excess Roth IRA contribution.  They send some paperwork, we fill it out and sign it, they send a check, and voila, problem solved, right?  Unfortunately, when the IRS is involved things are not that simple.

After extensive research, we were finally able to get enough information on how to correct the mistake.  Remember, every situation is different and the devil is always in the details.  In our particular situation, we had 3 years we needed to account for to make the Taxman happy: 2014, 2015, and 2016.  Here’s how we did it.

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File Forms 1040X for both spouses and for both years 2014 and 2015.  Because we owed more taxes than we had originally reported and paid in those years, we needed to file amended 1040’s to report the missed tax and make our payments.  Those 1040X’s needed to include several other tax forms for each year, and those were as follows.

2014:  Account for the excess contributions that were made in both of our IRA’s in that year. To do this we used Part IV of the 2014 IRS Form 5329 (one for each spouse) and reported our excess contributions in that year.  After following the instructions, Line 25 showed the additional 6% tax we owed on the excess contributions.

2015:  Account for the excess contributions from 2014 that stayed in our accounts for tax year 2015.  Again, we used Part IV of the 2015 Form 5329 (and again, one for each spouse) and this form was used to show the carried over excess contribution from 2014.  That amount was placed on Lines 18 and 24, and Line 25 was again used to show the additional 6% tax we owed for holding 2014’s excess contributions in the accounts throughout 2015.

2016:  Take a distribution from each of our Roth IRA’s for the same amount as the excess contribution was.  This step required two forms each:  We both needed to use the 2016 Form 5329 to show that we took a distribution from our Roth’s and that it matched up to a prior year’s excess contribution (hence showing that excess was removed from the account and we were no longer on the hook for the additional 6% tax we owed on it), and we also needed to use Part III on IRS Form 8606 to show that the distribution we took was part of the basis in the IRAs, eliminating any potential taxes we owed on the distribution.

Write a narrative to the IRS explaining what we were doing.  We wrote to the IRS to explain our situation and clear up any questions they might have about what our intentions were.

So what did all of that amount to?  A lot of hours, 10 extra IRS Forms, and a page explaining ourselves.  Not to mention the additional 6% tax we had to pay on the excess contribution from 2014 and 2015, plus several stamps to mail it all.  Luckily, the tax liability was very small.  The hassle of going about correcting all of this was the bigger issue.

What Would Have Limited the Headache?

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Honestly, there’s one simple thing we could have done to avoid this problem entirely: Double- and triple-check our Roth contribution amounts and limits! If any of the three entities that cared about our finances (us, our accountant, or our financial advisor) had bothered to stop for a minute and double-check the numbers, this problem would have been completely avoided.

Thanks for reading our post.  Again, this was a very specific scenario for our own financial situation, and the steps we took to rectify it were based on the details of our situation.  Yours will be different, but with this post I hope we’ve done two things:  1) Given some indication of the annoyance it can be to correct an excess contribution mistake, and 2) made it sound bad enough that you’ll do your due diligence when making your own contributions and keep yourselves from making the same mistake!

For further reading on the subject, Vanguard has a pretty good page that gives more details on deadlines and instructions for different situations.

[Editor's Note: Want to make your financial life easier? Do your contribution and conversion step during the calendar year, do it all in one lump sum, and do the conversion the day after your contribution. Trust me.]

What do you think? Have you made mistakes requiring you to file a 1040X? Was it your fault or that of an advisor? Comment below!