Is your IRA costing you too much money?

June 1, 2021
woman considering an IRA with a laptop in the kitchen

Is your IRA costing you too much money? Here are essential tax tips you should know what it comes to your IRA.

When it comes to IRAs there are numerous and confusing rules. There are forms to file, contributions to make, distributions to take. Failure to follow the rules can result in penalties, excise taxes, double taxation, and in a worst-case scenario, the loss of your tax-deferred status. Here are a few tips that can help you avoid unnecessary and costly errors.

Tip #1

IRA contribution eligibility and operational requirements.

You need to meet certain requirements in order to be eligible to make contributions to IRAs. Failure to meet these requirements can result in excess IRA contributions. And if these excess contributions aren’t properly corrected you may end up paying double in taxes and owe excise taxes to the IRS. There are several requirements to look out for. For example:

  • Regular IRA contributions must be made from eligible compensation, such as W-2 wages, salary, commissions, self-employment income, nontaxable combat pay, and other amounts earned from working.
  • There are also special rules for spouses. If a wife, for example, does not earn income from working outside the home but is married to someone who does, her IRA contribution can be based on her working spouse’s income.
  • And there’s also a contribution limit with IRAs. The total contribution you can make each year to your IRA can’t be more than $6,000 if you’re under the age of 50, or $7,000 if you’re age 50 or better and it can’t be more than your taxable compensation for the year. So you made $3,000 for the year, than your total eligible contribution is $3,000.
  • There’s also the modified adjusted gross income limit. Contributions cannot be made to Roth IRAs if your modified adjusted gross income exceeds a certain amount. Roth IRA contribution limits are phased out if the MAGI falls within a certain range. MAGI limits can be found here.
  • Remember, there a deposit deadline with IRAs. IRA contributions must be made by your tax filing due date, which generally is April 15 for calendar-year tax filers. Tax filing extensions do not apply. If you make any contributions between Jan. 1 and April 15 for the previous year, you need to clearly designate which year contributions apply. If you don’t, then that information may result in the IRA custodian applying the contribution to the current year.


Tip #2

Reporting nondeductible contributions.

If you make nondeductible contributions to your IRA, for example a rollover of any after-tax amounts from an employer-sponsored retirement plan creates something called basis in the IRA. Basis represents the funds in an IRA that have already been taxed, either because they were nondeductible IRA contributions, or they were after-tax funds rolled over from company retirement plans. If that happens, you’ll want to file an IRS Form called the 8606 for every nondeductible contribution made to your traditional IRA. If you don’t report a nondeductible IRA contribution that it may result in a penalty being owed to the IRS, unless you can show “reasonable cause” for the failure.


Tip #3

Avoiding double taxation for distributions of basis

retired couple in a boat

Generally, distributions from IRAs are treated as taxable income. However, distributions of basis amounts are not taxable – because they’ve already been taxed. Unfortunately, many individuals pay income tax on those basis amounts because IRS Form 8606 was not filed when it should have been. To prevent this from occurring, IRS Form 8606 must be filed for any year you make a withdrawal or convert amounts from a traditional IRA, if the IRA has basis. For this purpose, all your traditional IRAs, SEP IRAs, and SIMPLE IRAs are treated as one traditional IRA.

Form 8606 and its instructions helps you, the IRS, and other interested parties determine the non-taxable portion of IRA distributions and conversions. If you know you have non-deductible money in your IRA, don’t forget Form 8606.



Tip #4

Understand The 10% penalty

Distributions that are made from retirement accounts before you reach age 59½ are subject to a 10% early distribution penalty unless an exception applies. In some cases, IRA custodians will indicate that exception the form IRS 1099-R, the same form used to report distributions from retirement accounts. If you qualify for an exception, but the custodian does not indicate the exception, Form 5329 can be filed to claim the exception.


Happy senior couple taking financial advice at home

Tip #5

The 6% excise tax

Generally, extra contributions and ineligible rollover amounts that are not corrected by the tax due date—including extensions—are subject to a 6% excise tax for every year the amount remains in the IRA. In those cases, the penalty must be calculated and reported on IRS Form 5329. So, make sure you review your eligible IRA contributions.

Tip #6

The 50% accumulation penalty.

This is a big one. You must begin taking required minimum distributions, or RMDs, from your traditional, SEP, and SIMPLE IRAs for the year you reach age 72 and for every year thereafter for as long as you live. Generally, RMD amounts must be withdrawn by Dec. 31 of the year for which they are due. If you miss an RMD deadline, you may owe the IRS a 50% accumulation penalty on the RMD shortfall. If you miss a deadline, look into filing IRS Form 5329 to either report and pay the penalty, or request a waiver if eligible.

With all that being said, here’s the biggest takeaway – an ounce of prevention is better than a pound of cure. While some mistakes can be corrected, it’s usually better and less costly to prevent them from happening in the first place. Talk to your financial advisor or a tax professional for help on how to prevent these types of mistakes, or even to figure out ways to review your retirement tax efficiency strategies. If you don’t have a financial advisor, you can contact us. We’re available for complimentary meetings or 15-minute phone consultations to answer any questions.

We are an independent firm helping individuals create retirement strategies using a variety of insurance and investment products to custom suit their needs and objectives. This material is intended to provide general information to help you understand basic financial planning strategies and should not be construed as financial advice. All investments are subject to risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. A Roth Conversion is a taxable event and may have several tax related consequences. Be sure to consult with a qualified tax advisor before making any decisions regarding your IRA. Our firm does not provide and no statement contained herein shall constitute tax or legal advice. All individuals are encouraged to seek the guidance of a qualified tax professional regarding their personal situation. Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified tax professional for guidance before making any purchasing decisions. Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified tax professional for guidance before making any purchasing decisions. 1250525 3/22.

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