IRA Taxes: Rules to Know and Understand

While you'll want to save as much as you can for your retirement, you don't want to contribute more than you're allowed. Contribution limits vary according to the type of IRA you have, and some accounts have income restrictions. For example, high-income earners generally can't directly make Roth IRA contributions, but with careful planning, there are ways you can fund a Roth account if you exceed income limits.

And with SEP IRAs, your compensation—which may include wages, tips, overtime, bonuses, commission, and other forms of payment as determined by your plan—is used to calculate how much you can contribute. If you're self-employed, the contribution limit will be based on your earned income, or net earnings.

Taxpayers who exceed the contribution or income limits for their filing status or account type may be hit with a tax bill. The tax penalty for contributing more than you're allowed is 6% of the excess amount, which you'll owe every year until you take corrective action. For example, if you funded $1,000 more than you were allowed, you would pay $60 each year until you fix this mistake. To do that, you have two options:

• Withdraw the excess amount, plus any earnings specifically tied to the additional contribution, by the due date (plus extension) of your tax return for the year you contributed.
• 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 higher 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).

IRA rules prohibit you from investing your retirement savings in collectibles, which include artwork, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, and certain other tangible personal property. If you include such prohibited investments in your account, the invested amount will be considered a distribution in the year purchased, subjecting you to taxes and a 10% penalty if the premature distribution rules apply (see "Early IRA withdrawals").

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 some gold, silver, palladium, and platinum bullion. Likewise, owning real estate directly in an IRA is allowed, but you could find yourself engaged in a prohibited transaction if you're not extremely careful (see "Prohibited transactions").

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 (UBTI). But if the ETF or mutual fund ever makes an in-kind distribution of a prohibited investment—for example, gold bullion that doesn't meet the Treasury's definition of allowable investments—you'll be subject to the prohibited investment rules. Be sure to check with your fund provider for details on any past distributions.

Though your IRA account may be tax-exempt, unrelated business taxable income (UBTI) generated by assets held in the plan could be taxed on its own. Typically, interest, dividends, capital gains, royalties, and some income are exempt from UBTI. But an IRA could earn UBTI if it has any of the following characteristics:

• Operates a trade or business
• Holds 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

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

Improper use of your traditional IRA account may not only result in taxes, but also your entire IRA could lose its tax-deferred status. Prohibited transactions include:

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

If you perform a prohibited transaction, your entire account stops being an IRA as of January 1 of that year, and the IRS treats the transaction amount as a taxable distribution of all assets based on fair market value on the first of the year.

You can withdraw funds from your IRA account at any time, but there are restrictions if you want to avoid paying taxes or penalties. Here are some guidelines to follow.

Generally, if you withdraw money from your IRA before age 59½, you will incur a 10% penalty plus ordinary income tax on the amount attributed to tax-deductible contributions as well as earnings on those contributions. There are some exceptions to the 10% penalty, such as using the funds to pay for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI), a first-time home purchase (subject to a lifetime limit of $10,000 per individual), and up to $5,000 in birth or adoption expenses.

With a tax-deferred IRA, even if you can avoid the 10% penalty, you'll still pay ordinary income taxes. With a Roth account, you typically can withdraw your contributions at any time, tax-free without penalty, but you could owe both tax and penalties on early withdrawals of any earnings. 

Withdrawing funds from your IRA before retirement means less money in your account and losing out on any potential growth. And remember, because you're limited to how much you can contribute to these accounts annually, you may never be able to make up for the money you take out.

If you're age 73 or older, you generally must take RMDs from your tax-deferred IRAs before December 31 each year. The one exception is the year you turn 73, when you may wait until April 1 of the following year to take your initial distribution. Delaying, however, means you'll have to take two RMDs that year, which could bump you into a higher tax bracket.

For Roth IRAs, original owners are exempt from RMD rules, but beneficiaries who inherit a Roth are generally required to take distributions (see "Designating a beneficiary for your IRA").

The IRS requires that you calculate the RMD for each tax-deferred IRA separately, based on the value of the account at the end of the prior year divided by your life expectancy factor, which you can find in IRS Publication 590-B. You can then aggregate the RMDs for each IRA account and take your distribution from one or multiple IRAs in any combination, as long as you withdraw the total amount required. If you fail to take your total RMD by the due date, you'll owe a penalty of up to 25% of the amount not taken (plus ordinary income tax, of course).

Take note that RMDs count toward your income, so your distributions could increase your taxes. If you expect to be in a higher tax bracket in retirement, it's worth looking at ways to help reduce your RMD taxes, such as a Roth conversion (see "Converting a traditional IRA to a Roth") or a qualified charitable distribution (QCD).

Depending on your needs and goals, rollovers and conversions allow you to transfer money from one IRA account to another. Each method has its own set of rules to follow, so you'll want to move funds correctly to avoid any tax implications.

Let's say you own multiple traditional IRA accounts that you'd like to consolidate into one to simplify RMDs in retirement. Or perhaps you need to move your IRA to a different financial institution. Maybe you inherited an IRA from your spouse and want to transfer funds into your own retirement account. A rollover can help you accomplish all these.

You can roll over an IRA either indirectly or directly. With an indirect rollover, you take receipt of the funds in a personal taxable account and then transfer the money into the new IRA account. In order for the withdrawal not to be counted as a taxable distribution, you must redeposit the money into the same or another IRA within 60 days. 

Be aware, you're allowed only one indirect transfer each year. If you deposit the funds into a new IRA and then attempt to perform a rollover from that account within 12 months, you'll owe taxes on the withdrawal. Also, any transaction resulting in a taxable IRA distribution could be subject to a 10% penalty if you're under the age of 59½.

Another thing to keep in mind is that rollover funds could be subject to withholding. You'll get the withholding back when you file your tax return (assuming you don't violate rollover rules), but in the meantime, you must come up with 100% of the distribution amount in 60 days.

Should you need to rollover an IRA, consider a direct, or trustee-to-trustee, transfer of your IRA instead. With this method, the current IRA custodian sends the funds directly to the new financial institution. And unlike indirect rollovers, you can make unlimited direct transfers from one IRA account to another.

A Roth conversion can have some tax advantages, such as tax-free withdrawals. Converting to a Roth IRA might make sense if you think you'll be in a higher tax bracket in retirement, 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 could not only impact your marginal ordinary income tax, but depending on your MAGI before converting, the additional income could also have other implications:
  • Increase taxes on Social Security benefits
  • Trigger the alternative minimum tax (AMT)
  • Phase out exemptions, deductions, or other tax breaks
  • Affect financial aid eligibility because of a higher AGI
• Aggregation rule for partial conversions involving after-tax money: If you've ever made nondeductible contributions to your traditional IRA (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 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, unless you wait at least five years or reach age 59½, any withdrawal of the converted contributions—that is, the principle—will result in a 10% penalty. Generally with Roth contributions, there is a 10% penalty plus taxes on any withdrawal of earnings before age 59½, unless you qualify for a specific exception, such as using the money to pay for your first home.

Before converting to a Roth IRA, consider speaking to your tax advisor. With careful planning, you can potentially reduce your tax burden.

Don't forget to include your IRA accounts in your estate plan. IRA taxes not only affect you while you're alive, but they could also impact the beneficiaries of your IRA accounts once you die.

Make sure your beneficiaries are up to date 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 your sister is listed as the account beneficiary, your daughter may not receive 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 to avoid taxes or giving up potential tax-deferred growth. Eligible beneficiaries may also be able to "stretch out" distributions for several years. 

The tax rules surrounding inherited IRAs can be complicated and are in flux, so it's best to talk to a tax professional before making any decisions.

Most of the time, naming your spouse as your IRA's primary beneficiary provides the greatest flexibility. The next best route is to designate a non-spousal beneficiary, such as a child or even your favorite charity. But you also may also choose to make a trust the beneficiary of your IRA. 

Naming a trust as beneficiary can often make sense when your intended heir is a young child or someone who isn't savvy with money, but it could lead to unintended consequences if you're not careful—for example, it could remove your spouse's ability to roll over the IRA into their name to take advantage of IRA ownership rules.

Be sure you have a legitimate reason to designate 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.

IRA accounts are an important component of your retirement plan. Thinking carefully about your contribution and withdrawal strategies can help maximize your savings and potentially minimize your taxes.