IRAs appear to be relatively simple retirement planning tools. However they are chock full of complexities that can cause the account owner to lose benefits and pay a needless IRA penalties and . There are yet other instances when you pay a penalty in the form of an additional IRA tax.
The first problem has to do with limits on contributions. If you contribute more than allowed or deduct more than permitted given your level of income, you have an excess contribution problem that needs to be corrected or face penalties. Ask an accountant, financial planner or look on the web for the limits each year.
Once the money is in the account, you have restrictions on what items are allowable for investment. For example you can’t purchase art or collectibles or pursue items of self-dealing with your IRA. Even certain securities such as master limited partnerships which have unrelated business taxable income can create problems for your IRA. Assuming you only make allowable investments, typically stocks, bonds, mutual funds, ETF’s, and annuities – you want to make the most of the tax shelter aspect of your IRA. It is therefore foolish to put in your IRA items which would normally have a low tax rate outside of your IRA such as stocks held for more than a year, the gains on which are taxed only at 15%. The best investments for IRAs are those that are normally taxed at full ordinary income rates.
Of course, when you do make withdrawals of gains or principal from your IRA, you have ira tax. While there are numerous exceptions, for withdrawals prior to age 59 1/2, you are subject to a 10% IRA penalty. Knowing the exceptions can often help you avoid the penalty.
Next, it’s possible to run afoul of the IRA distribution rules which require that you start withdrawing money from your IRA after you reach age 70 1/2. Failure to make these withdrawals has a very heavy extra 50% IRA tax. You must then stick to a mandated IRA distribution schedule every year thereafter.
Further, you have restrictions on moving your IRA from one institution to another or from one account type to another. For example, should you withdraw your IRA money from one bank to move to another bank, you must do that within 60 days (60 day rule) or pay tax on the amount moved. Similarly, should you leave the employment of a company and receive your 401(k) account, the company must withhold 20% of the balance from your check. Therefore, when doing a rollover or setting up a rollover IRA from another account, it’s best to do so as a direct trustee to trustee transfer which avoids all withholding or time limitations.
All of these issues are covered in one document – IRS publication 590. It’s well worth a one-time read.