IRA Taxes: Rules to Know and Understand

Article from schwab.com


Individual Retirement Accounts (IRAs) can be a great way to save for retirement because of the tax benefits they can provide. If you’re eligible, you can choose a traditional IRA for an up-front tax deduction and defer paying taxes until you take withdrawals in the future. Or, if eligible, you might opt for a Roth IRA and contribute after-tax money in exchange for tax-free distributions down the road.

So, what's the catch? There are a few. If you run afoul of some of the IRS rules surrounding these accounts, the penalties can be quite stiff—all the way up to a disqualification and taxation of your entire account.

Ignorance of the law is no excuse, and with few exceptions, the IRS isn’t very forgiving of mistakes. Knowing the rules can help you navigate the many potential IRA tax traps you might encounter on your way to retirement.

Keep in mind that when we discuss taxes and penalties, we’re referring to those at the federal level. In most states, you will also face ordinary state taxes and may incur additional state penalties as well.

Contributions and investments

Exceeding IRA contribution limits

If you contribute more than the contribution or income limits for your filing status, or if you contribute after you reach the age limit (70½ for a traditional IRA), the penalty is 6% of the excess contribution for each year until you take corrective action. For example, if you contributed $1,000 more than you were allowed, you would owe $60 each year until you corrected this mistake. To do that, you have two options:

• Withdraw the excess amount, plus any earnings specifically tied to the excess contribution, by the due date (plus extension) of your tax return for the year of contribution.
• Leave the excess contribution alone. You might choose to do this if the amount is so small that the 6% penalty isn’t worth the hassle of fixing it or if your contribution has increased in value so much that the tax on the earnings (plus the 10% penalty for early withdrawal) would be worse than paying the penalty.[1] In that case, you would pay the 6% penalty for one year, and then count the excess as a deemed contribution in the next year (assuming you’re eligible to make a contribution at that point).

Self-directed IRA prohibited investments

If you personally manage and invest your own retirement money through a self-directed IRA, be aware that IRA rules prohibit investing in collectibles, which include artwork, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages and certain other tangible personal property. If you do so, the amount you invest will be considered a distribution to you in the year invested and subject to taxes and the 10% penalty, if the premature distribution rules apply.

However, you can invest IRA contributions in coins minted by the U.S. Treasury Department that contain one ounce of silver or gold, or one-half, one-quarter or one-tenth of an ounce of gold. You can also invest in certain platinum coins and certain gold, silver, palladium and platinum bullion. Likewise, owning real estate directly in an IRA isn't prohibited, but you could find yourself engaged in a prohibited transaction if you are not extremely careful.

If you want to invest in precious metals or real estate in your IRA, then a mutual fund or exchange-traded fund (ETF) may be a better choice (although you might be subject to unrelated business taxable income, or UBTI). But if the ETF or mutual fund ever made an in-kind distribution of a prohibited investment such as gold bullion that doesn’t meet the Treasury’s definition of allowable investments, you would still be subject to prohibited investment rules.2

Unrelated business taxable income (UBTI)

Interest income, dividends, capital gains and profits from options transactions are exempt from UBTI, but an IRA could earn UBTI if it has any of the following characteristics:

• Operates a trade or business
• Has certain types of rental income
• Receives certain types of passive income from a business it controls or from a pass-through entity such as a partnership that conducts a business (for example, master limited partnerships and real estate partnerships)
• Uses debt to finance investments

If your IRA earns UBTI exceeding $1,000, you must pay taxes on that income. Your IRA might be required to file IRS Forms 990-T or 990-W and pay estimated income taxes during the year. And in the case of a traditional IRA, UBTI results in double taxation because you have to pay tax on the UBTI in the year it occurs and taxes when you take a distribution.

Prohibited transactions

Regardless of what you invest in, you should avoid prohibited transactions since they could cause your entire IRA to lose its tax-deferred status. Prohibited transactions include these:

• Borrowing money from your IRA (for example, treating it as a margin account)
• Selling property to it
• Receiving unreasonable compensation for managing it
• Using it as security for a loan
• Using IRA funds to buy property for personal use (not including the first-time home buyer exemption)

If you engage in a prohibited transaction, your entire account stops being an IRA as of the first day of that year and the account is treated as having made a taxable distribution of all its assets to you based on fair market value on the first day of the year.

This is as bad as it sounds— engaging in a prohibited transaction could result in the destruction of your IRA.

Rollovers

You can make unlimited direct (trustee-to-trustee) transfers of your IRA funds. However, when you take receipt of the money yourself, you face a number of restrictions.3

First, you have 60 days to redeposit it into the same or another IRA or it counts as a taxable distribution. In addition, you are only allowed one such “rollover” each year. If you deposit the funds into another IRA and then attempt another rollover within 12 months, the withdrawal will be immediately taxable. Also, be aware that any transaction resulting in a taxable IRA distribution could be subject to a 10% penalty if you’re under age 59½.

One other thing to keep in mind is that when you take receipt of the money, it could be subject to withholding. You’ll get the withholding back when you file your tax return (assuming you don’t violate the rollover rules), but in the meantime you have to come up with 100% of the distribution amount in 60 days.

Bottom line: If you need to switch custodians, play it safe and stick to the direct trustee-to-trustee transfer method.

Traditional to Roth IRA conversion

Converting from a traditional IRA to a Roth IRA might make sense if you think you’ll be in a higher tax bracket when you begin taking withdrawals, you can pay the conversion tax from outside sources, and you have a reasonably long time horizon for the assets to grow. However, even if you meet these basic criteria, you should consider the following potential conversion traps:
Hidden taxes: A Roth conversion analysis shouldn’t just look at your marginal ordinary income tax impact. Depending on your modified adjusted gross income (MAGI) before converting, the additional conversion income could trigger increased taxation because of the following factors:

• Taxability of Social Security benefits
• Triggering the alternative minimum tax (AMT)
• Phase-out of exemptions, deductions or eligibility for other tax breaks
• Potential financial aid loss because of a higher AGI
• Aggregation rule for partial conversions involving after-tax money: If you have made nondeductible contributions to your traditional IRA in the past (tracked via IRS Form 8606), you can’t pick and choose which portion of the traditional IRA money you want to convert to a Roth. The IRS looks at all traditional IRAs as one when it comes to distributions. Traditional IRA balances are aggregated so that the amount converted consists of a prorated portion of taxable and nontaxable money.
• Failure to first take required minimum distributions (RMDs), if applicable: You can't avoid taking required minimum distributions by converting funds from a traditional IRA to a Roth IRA.
• Premature withdrawal penalty: If you’re under 59½, you'll pay a 10% penalty if you withdraw funds to pay the conversion tax. Also, even though withdrawals of regular contributions made to a Roth IRA are normally penalty free, you can’t convert from a traditional IRA to a Roth in order to avoid the premature withdrawal penalty (unless you wait at least five years or to age 59½, whichever is less).

(For more, see 3 Reasons to Consider a Roth IRA Conversion.)

2. IRA withdrawals

Premature withdrawals

If you withdraw money from your IRA before age 59½, you will incur a 10% penalty plus ordinary income tax on the amount attributable to previously deductible contributions and earnings. There are some exceptions to this rule (see IRS Publication 590-B), including these:

• Disability or death of the IRA owner
• Withdrawals that constitute a series of “substantially equal periodic payments” made over the life expectancy of the IRA owner
• Withdrawals used to pay for unreimbursed medical expenses that exceed 7.5% of AGI
• Withdrawals used for a first-time home purchase (subject to a lifetime limit of $10,000)
• Withdrawals used to pay for the qualified higher-education expenses of the IRA owner and eligible family members

Even if you can avoid the 10% penalty, you will still pay ordinary taxes. More importantly, you will have less money in your retirement account and you’ll lose out on any potential tax-deferred growth. Remember, you can only contribute so much to these accounts annually and you may never be able to make up for the money you withdraw.

Required minimum distributions (RMDs)

If you’re age 70½ or older, you’re required to take RMDs from your traditional IRA. The penalty for failing to take your RMD is a 50% excise tax on the amount you were required to take but didn’t (plus ordinary income tax, of course). You need to take your RMD before December 31 each year.

The one exception is for the year you turn 70½, in which you have the option of waiting until April 1 of the following year. Waiting, however, means you will have to take two distributions in that next year, which may not be a good idea if it bumps you into a higher tax bracket. Luckily, original owners of Roth IRAs are exempt from RMD rules, but non-spousal beneficiaries who inherit a Roth IRA must take distributions over their life expectancies.

The IRS requires that you calculate the RMD for each IRA separately, based on the value of the account at the end of the prior year divided by your life expectancy factor (taken from the appropriate table in IRS Publication 590-B). However, once you've calculated your RMD for each traditional IRA account, you can aggregate the total and take it from one or multiple IRAs in any combination, as long as you withdraw the total amount required.

3. Estate planning

Designating a beneficiary for your IRA

Make sure you have up-to-date beneficiaries on your IRA accounts, since who receives those assets is not normally controlled by your will. For example, if your will states that your IRA is to go to your daughter but you have your sister listed on your IRA account as the beneficiary, your daughter may not get the funds.

Beyond that, beneficiaries need to be careful about how and when they access IRA funds. In general, the beneficiary would want to defer withdrawals for as long as the law allows, but the rules surrounding inherited retirement accounts can be complex, depending on whether the recipient is a spouse and whether the original account holder had begun taking RMDs.

Given the right set of circumstances, a beneficiary may be able to “stretch out” the IRA distributions over his or her lifetime. For more information on inherited IRAs, see IRS Publication 590-B or talk to a tax professional.

Naming a trust as your IRA beneficiary

Most of the time, naming your spouse as your IRA’s primary beneficiary provides the greatest flexibility. The next best route is to name a non-spouse beneficiary such as a child or even your favorite charity.

In only a few cases does it make sense to name a trust as the beneficiary of your IRA. For example, a trust could make sense if the intended beneficiary is a young child or someone who is not savvy with money.

Naming a trust as beneficiary can lead to all kinds of unintended consequences if you’re not careful. For example, naming a trust instead of a spouse as beneficiary removes the surviving spouse’s ability to roll over the IRA into his or her name to take advantage of the IRA ownership rules. In addition, a trust is not a natural person and must make RMDs over the life expectancy of the oldest trust beneficiary.

Another pitfall arises if a charity is named as a co-beneficiary of an IRA trust, in which case the entire IRA would need to be distributed within five years of the IRA owner’s date of death (if it occurs before age 70½), or over the remaining life expectancy of the IRA owner if the owner had reached the age of 70½.

Bottom line: Be sure you have a legitimate reason to name a trust as beneficiary, and then only do so after you consult with an independent and objective tax and estate expert working in conjunction with your financial advisors and account providers.

1Early withdrawals from an IRA prior to age 59½ and held for fewer than 5 years are generally subject to being included in gross income plus a 10% additional tax penalty.

2Check with your fund provider for details on any past distributions.

3A check made payable to a new financial firm for the benefit of an account holder that is sent directly to the payee and then forwarded to the new financial institution is considered a transfer and not a rollover.