When researching the Self-Directed IRA and how it works, you have probably gotten comfortable with this idea of a “contribution limit.” In some cases, it can be relatively modest—about $6,000 per year—or it can be a major portion of a self-employed individual’s income. For people who are interested in setting aside as much money as possible for retirement, it makes sense to get acquainted with the contribution limit rules. After all, if someone is going to “max out” their retirement contributions, they have to know what the maximum is.
However, there may be cases where it is possible that investors go over the contribution limits on an account, which can create the potential for penalties. In this case, it is important for investors to get a sense of what happens if they hit the contribution limit.
What Happens When a Self-Directed IRA Investor Contributes Too Much to a Retirement Account
First things first: why does the IRS set contribution limits for certain accounts? That answer should be obvious: it has to prevent people from abusing retirement accounts for their personal benefit. Because retirement accounts are set up for retirement savings, often for the average American, these accounts come with certain tax benefits. And it is important that individuals never abuse these tax benefits. For example, an account may have tax-deductible contributions; for investors who go over the contribution limit, they may be claiming tax deductions for which they are not eligible, which can create problems down the road.
To get more specific, let us deal with what happens if an investor were to contribute too much to a Traditional or Roth IRA. According to Debra Greenberg writing for Merrill, who was talking about 2020 cases, “If you contribute more than the IRA or Roth IRA contribution limit, the tax laws impose a 6% excise tax per year on the excess amount for each year it remains in the IRA.” In other words, it becomes prohibitive for an investor to make these excess contributions, as it ends up costing them money. Keep in mind, however, that rules may change from year to year, so this is not prescriptive for what might happen in your situation.
What about other account types? The IRS has a “fix it” guide for people who make excess contributions to their SEP IRA. It can be common for SEP IRA investors to run into this problem because there is not a “fixed” contribution limit on a SEP IRA; it may depend on the income/compensation received during a calendar year. For this reason, an investor looking to “max out” their retirement accounts may quickly run afoul of the SEP IRA contribution limits. The good news is that in this case, it is easy to fix, as the investor can take corrective actions.
Why Should Investors Avoid Going Over Contribution Limits?
Contribution limits are more than just a “nice guideline.” They are hard-set rules. That is why it is so important that investors plan accurately, to ensure that their monthly contributions or yearly contributions to a Self-Directed IRA are in line with what the IRS outlines for their specific case. Investors should avoid going over these limits to avoid the penalties and taxes that can come with running afoul of the rules. It is far better—and simpler—to do your homework upfront and understand what your specific contribution limits are going to be. It can be different for specific individuals, so keep that in mind as you research.