|How to avoid IRA penalties|
|Written by Artie Green|
|Wednesday, 25 July 2012|
The Wall Street Journal recently reported that the IRS would penalize taxpayers who made contribution or withdrawal errors in their IRAs.
Uncollected tax penalties totaled more than $280 million in 2007, according to the Treasury Inspector General for Tax Administration. That’s low-hanging fruit for a federal government strapped for revenue. With this in mind, following is a brief review of the restrictions and the penalties.
The 2012 contribution limits for traditional and Roth IRAs are $5,000 per person, or $6,000 for those 50 and 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. The complete list is available at www.irs.gov.
The penalty for excess contributions is 6 percent 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 adjusted gross income 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 an additional 6 percent.
If you own an inherited IRA or Roth, any contributions to it incur this penalty.
If you withdraw funds before age 59, the amount withdrawn from a traditional IRA (or the gains portion if withdrawing from a Roth) is subject to a 10 percent penalty.
There are some exceptions to this rule. 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. A chart on the IRS website lists the exceptions.
Roth IRAs have an additional restriction: If you withdraw within five years of your first contribution or within five years of your latest conversion, you will incur a 10 percent penalty on any gains withdrawn.
Note that there is a way to withdraw from an IRA prior to age 59 without penalty. You can set up a Section 72(t) series of distributions that allows you to prematurely deplete the IRA over time. This is generally not recommended, as the whole point of an IRA is to save for retirement.
This escape clause might be needed in cases of extreme hardship. You can find additional information on the topic on the IRS website.
The heaviest IRS penalty applies to failing to withdraw from your IRA when required. And it’s a whopper: 50 percent!
This is one mistake you do not want to make. For traditional IRAs, the rule requires you to begin distributions during the year following the year you turn 70. These required minimum distributions (RMD) start at approximately 3 percent 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 after 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 of 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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