The IRA Tax Trap
As an example, if you convert from traditional to Roth IRA and then withdraw funds from it, any withdrawals would be taxed twice. One way around this double taxation trap is through qualified charitable distributions.
Be wary of falling prey to prohibited transactions such as investing in precious metals or real estate; any violations can lead to severe penalties that threaten to wipe out the value of your IRA account.
Contributions
If your work retirement plan doesn’t offer coverage for traditional IRA contributions, they can reduce taxable income dollar for dollar, provided they remain within annual contribution limits. But withdrawing pretax contributions before age 59 1/2 will incur tax on them and potentially an early withdrawal penalty of 10%.
if the account owner or beneficiary engages in any prohibited transactions, their IRA becomes disqualified and all its tax benefits are lost. Although this situation doesn’t occur frequently, it can have serious repercussions that require immediate attention.
IRAs offer great tax benefits, yet can be difficult to navigate. Before contributing after-tax contributions or seeking professional advice when planning for retirement, make sure you fully comprehend all rules related to an IRA and seek professional guidance when needed. Reach out to Thrivent financial advisors now for a complimentary no-commitment consultation session and don’t risk falling into an IRA tax trap! Schedule one now.
Withdrawals
If you withdraw money from an IRA before retirement, taxes and penalties could apply depending on your age and purpose of withdrawal. The precise amount will depend on when and why the withdrawal was made.
If the withdrawal is from a non-Roth IRA, income taxes at your marginal rate regardless of age will apply; earnings-related withdrawals will incur an additional 10% tax payment unless an exception applies.
Avoid this trap by taking your required minimum distributions (RMDs) through qualified charitable distribution (QCD). This option lowers your taxable income by deducting donations from your total RMD, helping reduce taxable income and decrease taxes due to that donation. For assistance on how best to implement this strategy, work with a financial professional – the IRS provides detailed instructions regarding this process. If not properly executed, this trap could eat into your retirement savings!
Rollovers
Tax implications associated with an IRA rollover can be complex. When this occurs, funds move from one pre-tax retirement account to another (either another IRA or your new employer’s plan) before being distributed back. You will typically receive an FBO distribution check; this method often proves to be cost-effective while also avoiding taxes from being withheld from you directly.
Alternately, your distribution provider could issue you a check that gives you 60 days to deposit the funds into a new IRA or else the IRS considers it as a taxable withdrawal and applies an early withdrawal penalty – although you should eventually get it back if you file your taxes timely.
If you miss the 60-day deadline, income taxes will be levied on all of the distribution and, depending on your age, may also incur an additional 10% surcharge for being under age 59 1/2. To prevent this scenario from unfolding, direct rollover may be an ideal solution; with your current custodian issuing a check directly to the trustee of your new IRA account.
Self-directed IRAs
Self-directed IRAs may offer greater investment flexibility; however, they also carry risks that could have unintended tax repercussions. For example, investing in real estate or alternative assets may require paying unrelated business income tax (UBIT).
Before engaging in self-directed investments, it’s crucial that investors understand prohibited transaction rules. These regulations govern any dealings between an IRA and disqualified parties such as its account holder, family members, businesses or certain advisors or service providers who have dealings with it. Disqualified persons cannot sell to or purchase from the IRA directly, guarantee loans to it through security pledged against assets in their portfolio, guarantee loan guarantees to it or receive compensation from it.
An IRA owner cannot occupy or use property owned by their IRA for personal gain; such actions violate IRS regulations and could lead to disqualification. Furthermore, UBIT may apply if income generated through financing portions of investments exceeds threshold levels.
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