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.
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 Contribution limits and rules for IRA and CESA.
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.
In order to avoid the 6% tax on the excess contribution, you must withdraw:
Traditional IRA distributions
If you take a distribution from your traditional IRA before you turn 59½, 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:
If your Roth IRA Distribution is not a qualified distribution, any earnings that are withdrawn are taxable and may be subject to the 10% early distribution penalty, unless one of the exceptions in the chart below applies:
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) at some point. Effective 2023, the Required Beginning Date (RBD) changed from age 72 to age 73 and is planned to increase to age 75 by 2033. If you reach age 73 this year, you will be required to start taking the annual RMD. If you are still working and do not own 5% or more of the business, your employer plan may allow you to defer until after you retire.
Roth IRAs don’t have RMD requirements during the account owner’s lifetime. IRA beneficiaries were generally required to take distributions starting the year after the account owner’s death. However, starting in 2023, most beneficiaries will now be subject to annual distributions based on their life expectancy with a lump sum in year 10. This applies when the original IRA owner died on or after the required beginning date (RBD).
More information on RMDs can be found in Taking required minimum distributions.
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.