Most people I speak to are aware of the 10 percent penalty for withdrawing from an IRA prior to age 59 1/2. But there also are penalties for contributing too much in a given year or for not withdrawing enough each year in retirement. Which is worse? By far it’s the latter.
The penalty for making excess contributions to your IRA – more than $5,500, or $6,500 if you’re over age 50 – is only 6 percent of the excess amount. That’s less than the penalty for withdrawing too soon. As long as you withdraw the excess amount prior to Oct. 15 of the year the tax is due (that’s Oct. 15, 2018, for the 2017 tax year), no penalty will be imposed.
But remember that the $5,500 limit applies across all of the IRAs and Roth IRAs you own. It’s easy to make a mistake if you keep your savings in a number of different IRA accounts. Remember also that the $5,500 can come only from earned income. If you’re unemployed, you can’t contribute anything.
The excess contribution penalty also accumulates every year you fail to remove the excess amount (plus earnings), so it’s a good idea to double check each year to make sure you haven’t made a mistake.
The 6 percent excess-contribution penalty and the 10 percent early-withdrawal penalties both pale, however, beside the 50 percent (that’s right: 50 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 70 1/2. This is the time when the IRS begins to collect on the embedded taxes you owe on all of that tax-deferred growth, and the government wants to ensure that it gets its money back.
Your broker and/or financial adviser 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. If you have an inherited IRA, for which RMDs are required every year regardless of your age, the rules are too complex to go into here.
Correcting a mistake
But don’t throw yourself out the window if you made a mistake. Believe it or not, the IRS can be quite generous when it comes to waiving the 50 percent penalty. Following 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 enables you to avoid prepaying the penalty and starts the statute of limitations clock.
3. Attach a letter of explanation to Form 5329. The letter should include why you missed the RMD and assurance that it has now been taken and that you commit to taking future RMDs as required.
The IRS will determine whether or not to grant the waiver. Although I would recommend avoiding the “my dog peed on it” excuse, the IRS has granted waivers in the past to people who lost documentation due to a natural disaster, to those who were in the hospital and even to someone who failed to withdraw the RMD because he was in jail. 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 that you follow the IRA rules very carefully. The cost of a mistake can be 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 should have been a completely tax-free withdrawal.