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IRAs: Too Much Or Too Little, Which Is Worse?

Most people I speak to are aware of the 10% penalty for withdrawing from an IRA prior to age 59½.  And as with most government rules there are always exceptions that have been added on afterwards to support specific situations not considered when the original legislation was promoted.  But there are also penalties for contributing too much to your IRA in a given year or for not withdrawing enough in retirement.  Which is worse?  By far it’s the latter.

The penalty for excess contributions is only 6% of the amount over $5,500 (or $6,500 if you’re over age 50).  That’s less than the penalty for withdrawing too soon as stated above.  And as long as you withdraw the excess contribution prior to October 15 of the year the tax is due (that’s October 15, 2017 for the 2016 tax year), no penalty will be imposed.  But remember that the $5,500 limit applies across all IRAs and Roth IRAs that you may have.  If you contributed $2,500 to your Roth, for example, that leaves only $3,000 available for a contribution to your IRA. It’s easy to make a mistake if you have a number of different IRA accounts. In addition, the $5,500 can only come from earned income.  If you’re unemployed, for example, you cannot sell your house and contribute $5,500 to your IRA from the proceeds, or this penalty may apply.

The excess contribution penalty also continues to apply every year you fail to remove the excess contributions and their earnings.  So it’s a good idea to double check each year to make sure you haven’t made a mistake.

The 6% excess contribution penalty and the 10% early withdrawal penalty both pale beside the 50% (that’s right: fifty percent!) penalty for failing to withdraw what the IRS calls required minimum distributions (RMDs).  These are the withdrawals that you are required to make starting in the year you turn age 70½. This is the time when the IRS begins to collect on the embedded taxes you owe on all that tax-deferred growth, and the government wants to ensure it gets its money back!

Your broker and/or financial advisor should be reminding you of RMDs when they become due.  But you are the one who is ultimately responsible for withdrawing the correct amount from your IRA.  RMDs are due by December 31st of the tax year (although they are based on the IRA balance as of the end of the previous year).  The exception is the year in which you turn 70½, in which case they are due April 1st of the following year.  And the rules for inherited IRAs (for which RMDs are required every year) are too complex to go into here.

But don’t throw yourself out the window if you made a mistake.  Believe it or not, the IRS can be quite generous when t comes to waiving the 50% penalty.  Here are the three steps you will need to take:

  1. Immediately (or as soon as possible) correct the error by withdrawing the appropriate RMD amount.
  2. File Form 5329, Additional Taxes on Qualified Plans (Including IRAs). Filing this form allows you to avoid prepaying the penalty and also starts the statute of limitations clock.
  3. Attach a letter of explanation to Form 5329. The letter should include why the 2015 RMD was missed, the fact that it has now been taken, and that you have taken steps to be sure that future RMDs will be taken as required.

The IRS will determine whether or not to grant the waiver.  They have granted waivers in the past to people who lost documentation due to a natural disaster, to those who were in hospital, and even to one who failed to withdraw the RMD because he was in jail!  (I would avoid the “my dog peed on it” excuse however).  If the IRS denies the waiver, you’ll not only be on the hook for the penalty but also for interest owed on the penalty.

The lesson here is to make sure you track your RMDs very carefully.  The cost of a mistake can be very steep.  And the worst mistake of all: failing to take a timely RMD from an inherited Roth IRA.  That could cost you thousands on what would have been a completely tax-free withdrawal!



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