The IRA Tax Trap
Individual Retirement Accounts (IRAs) can offer great tax benefits, yet their rules can be complex and mistakes could have serious repercussions.
For instance, when rolling over a distribution from a traditional IRA into a Roth IRA, 20% must be withheld for income tax withholding purposes and subject to an early withdrawal penalty if you are under age 59 1/2.
Double taxation on non-deductible IRA contributions
Tax rules related to non-deductible IRA contributions can be complex and thus cause many individuals to avoid making these contributions. But by not contributing they could be missing out on significant tax savings opportunities; to avoid falling into this trap it would be wiser to work with an experienced financial advisor.
IRS Form 8606 must be used to track nondeductible IRA contributions so as to avoid double taxation when money is withdrawn later from an IRA account. Failure to file this form results in double taxation: first on original contribution plus earnings when distributed, plus again later when distributed later.
Assume Dan made $100,000 of nondeductible IRA contributions that totalled $1,000,000 at the end of last year and his MAGI included wages, investment income and above-the-line deductions; his taxable income totals $240,000 as well as taxes due on his distribution from his IRA – $64,800 in this example.
The 10% additional tax on Roth IRA conversions
One strategy used by many IRA owners is converting pretax retirement accounts to Roth IRAs in order to avoid income taxes on distributions at retirement and preserve tax-deferred growth. Unfortunately, however, the rules surrounding conversion can be complicated for new investors.
Tax laws regarding IRAs can be complex and changing frequently, making it challenging to keep up with all of their rules and stay informed. Unfortunately, investors often ignore them and end up paying too much in taxes than necessary.
An inexperienced investor might not realize that an indirect IRA rollover is subject to taxes if distributed within 60 days, and making an error when designating beneficiaries can lead to their estate having to pay taxes on all account balances within one year of death. To protect themselves from potential traps like these, consult an advisor or CPA regarding current rules and regulations.
Rollovers from a former employer’s qualified retirement plan
Rollovers can be an excellent way to help keep your retirement savings intact while postponing taxes on any gains. To maximize their effectiveness, however, it’s essential that you understand all applicable tax rules prior to moving any money.
As well as general rules pertaining to IRAs, there are special regulations regarding eligible rollover distributions. One such regulation is known as the 60-day rule – this requires you to rollover an eligible distribution within 60 days after receiving it. Furthermore, penalties can be levied by the IRS on distributions which fail to satisfy these rollover requirements.
Before initiating a rollover, it is wise to check with the new plan administrator and ensure it will accept your funds. Also take time to research investment options available within the plan as they could differ significantly from those offered at your former employer’s retirement account. It is also wise to be mindful of vesting schedules; for instance if your employer contributed matching funds directly into your retirement account and vesting occurs gradually over time before rolling those assets over.
IRA withdrawals before age 59 12
Savers under age 59 1/2 may incur a 10% early withdrawal penalty from their retirement accounts if they withdraw funds early, with some exceptions applying: for instance, medical insurance premiums or funeral expenses don’t count against this penalty, nor does being permanently disabled or receiving distribution due to government-declared disaster.
However, naming the wrong beneficiary on your IRA could result in unexpected taxes and penalties; beneficiary designation supersedes that of your will. Furthermore, failure to initiate required minimum distributions by their due dates can push into higher income brackets and trigger stealth taxes; new rules delay starting RMDs until age 73 so a qualified charitable distribution (QCD) may help meet RMDs while simultaneously lowering taxable income.
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