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.
To avoid the 6% tax on the excess contribution, you must withdraw:
Please consult a qualified tax advisor to explore alternative options and assess the tax implications based on your personal situation.
For more information, please visit IRS Pub 590-A.
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If your Roth IRA Distribution is not a qualified distribution, any earnings that are withdrawn are taxable and may be subject to the 10% early distribution penalty.
See IRS Pub 590-B for more information about these exceptions.
Tax-deferred accounts don’t keep building assets indefinitely. For a Traditional IRA, and most employer retirement plans, you will need to start taking an annual required minimum distribution (RMD) at some point. For those born in 1960 or later, 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 you retire. If you retire during the year, you will need to take an RMD for the year you retire in.
Roth IRAs don’t have RMD requirements during the account owner’s lifetime. Roth IRA beneficiaries are generally required to take distributions starting the year after the account owner’s death. However, Roth IRA owners are assumed to die prior to the RBD since no RMDs are required of the owner. Non- EDBs are subject to the 10-year rule which requires the account to be emptied by the 10th year following the IRA owners death. No requirement to take money out during those 10 years.
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.