How To Avoid IRA Penalties

How To Avoid IRA Penalties

The Wall Street Journal recently reported that the IRS will be going after taxpayers that made contribution or withdrawal errors in their IRAs. There were over $280 million in uncollected tax penalties in 2007, according to the Treasury Inspector General for Tax Administration. That’s low-hanging fruit for a federal government strapped for revenues. With this in mind, here is a brief review of the restrictions and the penalties.

Contribution Penalties

The 2012 contribution limits for traditional and Roth IRAs are $5,000 per person, or $6,000 for people 50 or older. However, remember that you cannot contribute more than your earned income. That includes wages, commissions, and alimony, but not rental-property income, pension and annuity income, or deferred compensation. You can find the complete list at http://www.irs.gov/pub/irs-pdf/p590.pdf. The penalty for excess contributions is 6% each year the excess contributions and gains remain in the account. That can become pretty expensive if the mistake was made years ago.

Also keep in mind that you cannot contribute to a Roth if your AGI is above a certain threshold. There are also income limits that prevent you from deducting contributions to an IRA if you or your spouse additionally contributes to a company retirement plan. Any of these mistakes will cost you an additional 6%.

If you own an inherited IRA or Roth, any contributions made to it will incur the 6% penalty.

Withdrawal Penalties

If you withdraw funds before age 59 ½, the amount withdrawn from a traditional IRA (or the gains portion if withdrawing from a Roth) is subject to a 10% penalty. There are a number of exceptions to this rule, however. You can withdraw from an inherited IRA or Roth without penalty. You can withdraw from any IRA or Roth if you are disabled, for qualified education or medical expenses, or to purchase your first home. Here’s a chart from the IRS listing all the exceptions: http://www.irs.gov/pub/irs-tege/early_distributions.pdf.

Roth IRAs have an additional restriction: if you withdraw within 5 years of your first contribution or within 5 years of your latest conversion you will incur the 10% penalty on any gains withdrawn.

Note that there is a way for anyone to withdraw from an IRA prior to age 59 ½ without penalty. You can set up what’s called a section 72(t) series of distributions that allows you to prematurely deplete the IRA over time. This is generally not recommended since the whole point of an IRA is to save for retirement. Nonetheless this escape clause might be needed in cases of extreme hardship. You can find additional Q&A on this topic from the IRS at http://www.irs.gov/retirement/article/0,,id=103045,00.html.

The biggest IRS penalty applies to the failure to withdraw from your IRA when required. And it’s a whopper: 50%! This is one mistake you do not want to make. For traditional IRAs, the rule requires you to begin distributions in the year following the year you turn 70 ½. These required minimum distributions (RMD) start at about 3% of the value of your IRA and increase each year. The good news for Roth account holders: there is no RMD.

RMDs also apply to inherited IRAs and Roths. Distributions must begin the year following the year you inherited the account. While the IRS allows several methods of withdrawal, the one that is most advantageous to the beneficiary is to “stretch” the withdrawals out over your statistical lifetime.

One last note: the IRS considers all your traditional IRA accounts as a single IRA. For that reason it generally makes sense to consolidate them so that you don’t accidentally forget one.

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