Building and living off a nest egg is tough — but you can make the situation even more difficult if you run afoul of some key laws governing retirement accounts.
Make one wrong move, and the long arm of Uncle Sam may soon tap you on the shoulder, demanding a few explanations.
Following are penalties to avoid at all costs when contributing to or withdrawing from retirement accounts.
Excess IRA contribution penalty
Building a large amount of retirement savings is an admirable goal. But contributing too much to an individual retirement account (IRA) can cost you, according to the IRS.
It’s possible to commit this offense by:
- Contributing an amount of money that exceeds the applicable annual contribution limit for your IRA
- Improperly rolling over money into an IRA
What happens if you get a little too eager to build a nest egg and make one of these mistakes? The IRS explains:
“Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA. The tax can’t be more than 6% of the combined value of all your IRAs as of the end of the tax year.”
The IRS offers a remedy to fix your mistake before any penalties will be applied. The agency says you must withdraw the excess contributions — and any income earned on those contributions — by the due date of your federal income tax return for that year.
For example, if you contributed too much to an IRA for 2020, you have until April 15, 2021, to withdraw the excess and thus avoid a penalty.
Early withdrawal penalty
Taking money out too soon from a retirement account is another potentially costly mistake.
If you pull money from your IRA before the age of 59½, you might be subject to paying income taxes on the money, plus an additional 10% penalty, the IRS says.
The agency notes, though, that there are several circumstances in which you are allowed to take early IRA withdrawals without penalties. For example, if you lose a job, you are allowed to tap your IRA early to pay for health insurance premiums.
The same penalties apply to early withdrawals from retirement plans like 401(k)s, although again, there are exceptions to the rule that allow you to make early withdrawals without penalty.
It’s crucial to note that the exceptions that allow you to make early retirement plan withdrawals without penalty sometimes differ from the exceptions that allow you to make early IRA withdrawals without penalty.
Note: The Coronavirus Aid, Relief, and Economic Security Act (CARES) Act of 2020 created a one-time exception to the early-withdrawal penalty for both retirement plans and IRAs due to the coronavirus pandemic: Generally, coronavirus-related distributions of up to a total of $100,000 that were made in 2020 are exempt.
Missed RMD penalty
Retirement plans are great because they generally allow you to defer paying taxes on your contributions and income gains for decades. Alas, eventually, Uncle Sam is going to demand his share of that cash.
Previously, taxpayers were obligated to take required minimum distributions — also known as RMDs — from most types of retirement accounts beginning the year they turn 70½. But the Secure Act of 2019 bumped up that age to 72.
The consequences of failing to make these mandatory withdrawals still apply, though. Fail to take your RMDs starting the year you turn 72, and you face harsh penalties, says the IRS:
“If you do not take any distributions, or if the distributions are not large enough, you may have to pay a 50% excise tax on the amount not distributed as required.”
It’s important to note that the RMD rules do not apply to Roth IRAs. You can leave money in your Roth IRA indefinitely — although another provision of the Secure Act means your heirs have to be careful if they inherit your Roth IRA. For more, check out “Why Roth Retirement Accounts Are Now Even Better.”
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