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

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	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 traditional IRA at age 70 ½ or older 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 When you recharacterize a contribution, it is treated as if it was originally made to the type of IRA it was recharacterized to.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

The Penalty	10% additional tax for the taxable portion of distributions taken from an IRA if you are under age of 59 ½
Penalty Exceptions	You’re disabled (see IRS Pub 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 (see IRS Pub 590-B for requirements) 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 medical expenses totaling more than 10% of your yearly adjusted gross income (7.5% if you or your spouse was born before Jan. 2, 1950) You’re using to pay qualified higher education expenses You have qualified reservist distributions You take distributions under an IRS levy See IRS Pub 590-B for more information about these exceptions.

The Penalty

10% additional tax for the taxable portion of distributions taken from an IRA if you are under age of 59 ½

Penalty Exceptions

You’re disabled (see IRS Pub 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 (see IRS Pub 590-B for requirements) 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 medical expenses totaling more than 10% of your yearly adjusted gross income (7.5% if you or your spouse was born before Jan. 2, 1950)
You’re using to pay qualified higher education expenses
You have qualified reservist distributions
You take distributions under an IRS levy

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	Distribution of contributions Distribution of assets from a conversion after five-year period since conversion occurred Distribution of earnings after age 59 ½ You’re disabled (see IRS.gov for details) You’re the beneficiary of someone else’s IRA Buying, building, or rebuilding your first home ($10,000 life time limit)

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.

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

Looking for an IRS form or publication?

The IRS's online resources can help.

VISIT IRS.GOV

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