An inevitable part of mutual fund investing for retirement is the need to make decisions that will impact your taxes, both now and in the future. You also need to be aware of potential tax penalties so you can plan accordingly and avoid them, if possible. Here are some ways you may be able to avoid tax penalties on IRAs.
Tax Resource Center
Avoiding Tax Penalties on IRAs
Tax penalties are additional fees you’re required to pay the IRS—separate from taxes—if you break the account’s rules. For example, you may incur penalties for contributing more than the allowed limit or taking money out too early. The more you know about the rules that trigger tax penalties, the better you’ll be prepared to avoid them, or find ways to use the rules to your advantage.
Excess Contributions
Mutual fund accounts with a tax benefit—like retirement accounts—place limits on the amount of money you can contribute per year. These contribution limits differ by account type, your modified adjusted gross income (MAGI), your age, and your tax filing status. More information on these limits can be found in IRS Contributions and Deduction Limits.
The Penalty
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The Triggers |
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Way to Avoid |
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Other Options |
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10% Early Distribution Penalties
The Penalty |
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Penalty Exceptions |
See IRS Pub 590-B for more information about these exceptions. |
Roth IRA Distributions
You do not have to include Roth IRA distributions in your gross income if they are a return of your regular contributions or if they are qualified distributions. A qualified distribution is any payment or distribution from your Roth IRA that meets both of the following requirements:
- You have had a Roth IRA for at least 5 years (based on your first Roth IRA contribution date)
- The distribution is made for one of the following reasons:
- After you reach age 59 ½
- You’re disabled (see IRS Pub 590-B for definition)
- You’re the beneficiary of the someone else’s Roth IRA
- You’re using to purchase your first home ($10,000 lifetime limit, see IRS Pub 590B for details)
If your Roth IRA distribution is not qualified, part of it may be taxable. Distributions are considered to be taken from your contributions and earnings in a set order:
- Regular contributions (not taxable)
- Conversions (the amounts you included in your gross income when you converted first, then the non-taxable portion)
- Earnings
On a non-qualified Roth IRA distribution, the amount considered to be the non-taxable portion of any conversion and earnings may be subject to income tax. If you are under age 59 ½, it may also be subject to the 10% early distribution tax discussed above.
Penalty Exceptions |
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Required Minimum Distributions (RMDs)
Tax-deferred accounts don’t keep building assets indefinitely. For a traditional IRA, and most employer retirement plans, you’ll need to start taking an annual required minimum distributions (RMD) when you reach age 70 ½ (some employer plans allow you defer until after you retire if you are still working). Roth IRAs don’t have RMD requirements during the account owner’s lifetime. IRA Beneficiaries are generally required to take distributions starting the year after the account owner’s death. More information on RMDs can be found in All About Required Minimum Distributions.
The Penalty |
50% additional tax on the amount not distributed |
The Trigger |
Failure to take the RMD by the due date |
Consult Your Tax Advisor
Depending on your individual tax situation, you may wish to consult with your tax advisor before making any IRA account decisions. For more information about the different types of tax penalties, please visit IRS.gov
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