Tax Considerations for IRAs

IRAs are an effective way to save for retirement. Along with offering tax breaks, one of the biggest perks of an IRA (both traditional and Roth) is that they offer tax-free growth on your investments. You won’t be taxed on dividends or capital gains while the investments are in your account. IRA accounts are easy to set up and easy to fund. Automatic contributions from your checking or savings account make investing for your retirement one less thing to worry about. If you already have a 401(k) plan through your employer, an IRA is an excellent way to supplement your retirement savings while also providing you with a tax break now and in the future.

Roth IRAs differ from Traditional IRAs as they allow the money to be taken from the account income tax-free. They also allow for the account to pass to beneficiaries tax free, as well. However, unlike the Traditional IRA, the account holder does not receive a reduction in earned income for making the contribution.

While IRA’s are known for their tax benefits, they come with a lot of tax rules, with forms to file, contributions to make, distributions to take and penalties to avoid. Failure to follow the rules can result in penalties, excise taxes, double taxation, and even the loss of your tax-deferred status. Here are a few tips to help you avoid potentially costly mistakes.

IRA Contributions: Eligibility and Operational Requirements

Your ability to contribute to IRAs require certain requirements, and failure to meet them can result in excess IRA contributions, potentially leading to double taxation and excise tax being owed to the IRS. Following are some general eligibility requirements that must be met for IRA contributions:

Eligible Compensation: Regular IRA contributions must be made from W-2 wages, commissions, self-employed income, nontaxable combat pay and other income earned while working. This is the money earned from the “sweat of your brow” not from the seat of your couch.

Spousal Contributions: A spouse who is not employed but is married to someone who is employed may make contributions based on his/her spouse’s income, but a joint federal tax return must be filed. Often, this is an overlooked way to further save for retirement.

Contribution Limit: The dollar limit for annual IRA contributions is the lesser of a) $6,000 plus $1,000 if you are age 50 or older by the end of the year, or b) 100% of the eligible compensation you receive for the year under $6,000.

Modified Adjusted Gross Income (MAGI): Contributions can not be made to an IRA if your MAGI exceeds a certain amount. These amounts vary based on your income and how you file.

Deposit Deadline: IRA contributions must be made by your tax filing date, and tax filing extensions do not apply. If you made any contributions between Jan. 1 and April 15 for the previous year, you must clearly designate which year the contributions apply.

Basis-Related Activity

IRS form 8606, “Non-deductible IRAs” must be filed to report basis-related activity, including non-deductible contributions made to traditional IRAs and distributions/Roth conversions from traditional IRAs if you have any basis in any traditional IRA.

Reporting Non-Deductible Contributions

Non-deductible traditional IRA contributions, as well as roll-over of after-tax amounts from an employer-sponsored retirement plan (such as a 401(k)), creates basis in the IRA and form 8606 just be filed for every non-deductible contribution made. Failure to file the form may result in a $50 penalty unless you can show “reasonable cause” for the failure.

Avoiding Double Taxation

Generally, distributions from IRAs are treated as taxable income, unless they are distributions of basis amounts. Many pay income tax on basis amounts because Form 8606 was not filed when it should have been. To prevent this from occurring, Form 8606 MUST be filed for any year you make a withdrawal or convert amounts from a traditional IRA if that IRA has a basis. Form 8606 helps you and the IRS determine the non-taxable portion of IRA distributions and conversions.

The 50% Accumulation Tax

You MUST begin taking RMDs from your traditional, SEP and SIMPLE IRAs for the year you reach age 72 and continue every year thereafter for as long as you live. Generally, RMD amounts must be withdrawn by Dec. 31st of the year for which they are due. If you miss your RMD deadline, you will owe the IRS a 50% excess accumulation penalty on the RMD shortfall. The IRS will waive the fee if the deadline is missed for a “reasonable cause,” and the individual must file an IRS Form 5329 to either report and pay the penalty or request the waiver if eligible.

While operational mistakes and ineligible contributions can be corrected, it’s better to avoid making costly mistakes in the first place in order to optimize the amount of the RMDs you have to maximize your estate plan through purchasing an annuity that has enhanced death benefits or paying life insurance premiums.

IRAs are a tool that should not be forgotten about. Both Roth IRAs and Traditional IRAs allow the pre-retiree to create an additional savings vehicle for future retirement income.