Please note: This article may contain outdated information about RMDs and retirement accounts due to the SECURE Act 2.0, a law governing retirement savings (e.g., the age at which individuals must begin taking required minimum distributions (RMDs) from their retirement account will change from 72 to 73 beginning January 1, 2023). For more information about the SECURE Act 2.0, please read this article or speak with your financial consultant. (1222-2NLK)
Individual Retirement Accounts (IRAs) can be a great way to save for retirement because of the tax benefits they can provide. Traditional IRAs offer an up-front tax deduction and defer taxes until you take withdrawals in the future. Roth IRAs allow you to contribute after-tax money in exchange for tax-free distributions down the road.1
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.
Here we'll cover some of the more common pitfalls, divided into three major categories:
- Contributions and investments
- Estate planning
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.
1. Contribution and investments
Exceeding IRA contribution limits
If you exceed the contribution or income limits for your filing status, 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 correct 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 of 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. 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—for example, 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 when you take a distribution.
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.
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 else 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 the age of 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 potentially 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:
- 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. When it comes to distributions, the IRS looks at traditional IRA balances in aggregate, so 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 RMDs 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).
If you're considering a Roth IRA conversion, you can potentially reduce your tax burden with careful planning.
2. IRA 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
- Withdrawals for birth or adoption expenses of up to $5,000
Even if you can avoid the 10% penalty, you will still pay ordinary taxes, and more importantly, you'll have less money in your retirement account and lose out on any potential tax-deferred growth. Remember, there are limits to how much you can contribute 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 72 (or age 70½ prior to January 1, 2020) or older, you generally must take RMDs from your traditional IRA before December 31 each year. The one exception is the year you turn 72, when you have the option of waiting until April 1 of the following year to take your RMDs. Waiting, however, means you'll have to take two RMDs that 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 beneficiaries who inherit a Roth IRA are generally required to take distributions and those rules depend on several factors.
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. 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).
3. Estate planning
Designating a beneficiary for your IRA
Make sure you have up-to-date beneficiaries on your IRA accounts, since these assignments supersede a 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 inherited IRA funds. As a general rule, beneficiaries should defer withdrawals for as long as the law allows. For example, a spouse who inherits an IRA and has many years before hitting the RMD age may consider rolling over those assets into their own IRA. However, under the SECURE Act's new 10-year distribution rules, some non-spousal beneficiaries of a tax-deferred IRA may be better off taking distributions each of the 10 years, in order to avoid a large tax bill on the 10th year when all inherited assets will need to be distributed.
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 a few cases, it does make sense to name a trust as the beneficiary of your IRA—for instance, if the intended beneficiary is a young child or someone who is not savvy with money. But 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.
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.
1 Roth IRAs require a 5-year holding period before earnings can be withdrawn tax free. In addition, earnings distributions prior to age 59½ are subject to an early withdrawal penalty.
2 Check with your fund provider for details on any past distributions.
3 A 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.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Roth IRA conversions require a 5-year holding period before earnings can be withdrawn tax free and subsequent conversions will require their own 5-year holding period. In addition, earnings distributions prior to age 59½ are subject to an early withdrawal penalty.
This information is not intended to be a substitute for specific individualized tax, legal or investment-planning advice. Where specific advice is necessary or appropriate, Schwab recommends that you consult with a qualified tax advisor, CPA, financial planner or investment manager.
A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options which may include but not be limited to keeping your assets in your former employer's plan; rolling over assets to a new employer's plan; or taking a cash distribution (taxes and possible withdrawal penalties may apply). Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.1222-2A37