Tax Resource Center

Avoiding Tax Penalties on IRAs

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 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

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	For traditional, Roth, and SEP IRAs the excess contribution amount is taxed at 6% per year for as long as it remains in the account.
The Triggers	Contributions beyond the allowed annual limit No earned income Contributions to a Roth IRA when MAGI exceeds allowed limits Improper IRA rollover contributions
Way to Avoid	Withdraw the excess contribution, and any income earned on the contribution, before the date your taxes are due (including extensions)
Other Options	In some cases, you may be able to change how a contribution made to one IRA is handled by treating it as if it was made to another type of IRA. This is called recharacterization. When you recharacterize a contribution, it is treated as if it was originally made to the type of IRA it was recharacterized to. For more information, please visit IRS.gov.

10% Early Distribution Penalties

Traditional IRA Distributions

If you take a distribution from your traditional IRA, the taxable portion of the distribution may be subject to a 10% early distribution penalty unless one of the exceptions noted in the chart below applies.

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 conversions from a traditional IRA or employer retirement plan. A qualified distribution of earnings from your Roth IRA is non-taxable. That would include 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:
1. After you reach age 59 ½
2. You’re disabled (see IRS Pub 590-B for definition)
3. You’re the beneficiary of someone else’s Roth IRA
4. You’re using to purchase your first home ($10,000 lifetime limit, see IRS Publication 590-B for details)

If your Roth IRA distribution is not a qualified distribution, any earnings that are withdrawn are taxable. Distributions are 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), if any.
Earnings

The Penalty	10% additional tax on non-qualified distributions of earnings taken from an IRA unless a penalty exception applies. 10% additional tax for withdrawal of any conversion dollars within 5 years of conversion, unless a penalty exception applies.
Penalty Exceptions	You’re disabled (see IRS Publication 590-B for definition) You’re the beneficiary of someone else’s IRA You’re receiving distributions that are part of a series of substantially equal payments or in the form of an annuity. You’re using to purchase your first home ($10,000 lifetime limit, see IRS Pub 590-B for details) You’re using to pay medical insurance premiums while you were unemployed You had unreimbursed medical expenses that exceeded 7.5% of your Adjusted Gross Income (AGI) You’re using it to pay qualified higher education expenses You have qualified reservist distributions You take distributions under an IRS levy You have a new child through birth or adoption.* (A parent may withdraw up to $5,000 within one year of the birth or adoption date. This applies to each parent if they have separate retirement accounts.) See IRS Pub 590-B for more information about these exceptions.

The Penalty

10% additional tax on non-qualified distributions of earnings taken from an IRA unless a penalty exception applies. 10% additional tax for withdrawal of any conversion dollars within 5 years of conversion, unless a penalty exception applies.

Penalty Exceptions

You’re disabled (see IRS Publication 590-B for definition)
You’re the beneficiary of someone else’s IRA
You’re receiving distributions that are part of a series of substantially equal payments or in the form of an annuity.
You’re using to purchase your first home ($10,000 lifetime limit, see IRS Pub 590-B for details)
You’re using to pay medical insurance premiums while you were unemployed
You had unreimbursed medical expenses that exceeded 7.5% of your Adjusted Gross Income (AGI)
You’re using it to pay qualified higher education expenses
You have qualified reservist distributions
You take distributions under an IRS levy
You have a new child through birth or adoption.* (A parent may withdraw up to $5,000 within one year of the birth or adoption date. This applies to each parent if they have separate retirement accounts.)

See IRS Pub 590-B for more information about these exceptions.

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 distribution (RMD) in the year you reach age 72 (some employer plans allow you to defer until after you retire if you are still working). However, individuals who turned 70½ in 2019 must take distributions for 2019 and 2020. (See: SECURE Act alters retirement investing options for individuals and businesses)

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.

RMD Penalties

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

*This exemption shall apply to distributions made after December 31, 2019.

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