Additional Tax on IRAs and Similar Accounts: What You Need to Know

Individual Retirement Accounts (IRAs) and other tax-advantaged retirement accounts offer valuable benefits, but they come with strict rules. Violating these rules can lead to taxes and penalties that reduce the value of savings. Many investors make mistakes—such as contributing too much, withdrawing funds early, or mishandling rollovers—that trigger costly consequences. Understanding these pitfalls helps protect retirement funds.

Excess Contribution Penalties

Contributing more than the allowed limit to an IRA results in a 6% excise tax on the excess amount for each year it remains in the account. For 2024, the annual contribution limit is $7,000, or $8,000 for individuals aged 50 and older.

For example, exceeding the limit by $2,000 results in a $120 penalty annually until corrected. This penalty applies even if the mistake was unintentional, such as miscalculating income eligibility for a Roth IRA.

Removing the excess contribution before the tax filing deadline, including extensions, prevents the penalty. Any earnings on the excess amount must also be withdrawn and reported as taxable income. If not corrected, the penalty continues each year.

Missed Required Minimum Distribution Charges

Failing to take the required minimum distribution (RMD) from an IRA or other tax-deferred retirement account leads to penalties. As of 2024, withdrawals must begin at age 73, based on the account balance at the end of the previous year and a life expectancy factor from IRS tables.

If an RMD is not taken or is insufficient, the IRS imposes a penalty. Before 2023, this penalty was 50% of the shortfall, but under the SECURE 2.0 Act, it has been reduced to 25%. If corrected within two years, it drops to 10%.

For example, if someone was required to withdraw $10,000 but only took out $4,000, the penalty on the $6,000 shortfall is $1,500. If corrected within two years, it is reduced to $600.

To avoid penalties, account holders should calculate RMDs accurately. While financial institutions offer guidance, the responsibility ultimately falls on the individual. IRA RMDs can be taken from a single account, but 401(k) RMDs must be withdrawn separately from each plan.

Early Distribution Taxes

Withdrawing retirement funds before reaching the appropriate age results in tax liabilities. The IRS imposes a 10% penalty on early distributions from traditional IRAs, 401(k)s, and similar accounts if taken before age 59½, in addition to regular income taxes.

For example, a taxpayer in the 22% federal tax bracket who withdraws $10,000 early owes $2,200 in income taxes and an additional $1,000 penalty, leaving them with $6,800.

Certain exceptions allow penalty-free early withdrawals, including:

– Up to $10,000 for a first-time home purchase from an IRA
– Higher education expenses
– Unreimbursed medical costs exceeding 7.5% of adjusted gross income
– Permanent disability
– Up to $22,000 for victims of federally declared disasters under the SECURE 2.0 Act

Another exception is Substantially Equal Periodic Payments (SEPP), which avoids penalties if withdrawals follow an IRS-approved schedule for at least five years or until age 59½, whichever is longer.

Prohibited Transaction Consequences

Engaging in a prohibited transaction within an IRA or other tax-advantaged account can trigger severe tax consequences, often resulting in the loss of the account’s tax-deferred status. The IRS defines prohibited transactions under Internal Revenue Code 4975, primarily targeting dealings between the account and a “disqualified person,” including the account holder, certain family members, and controlled entities.

Common violations include:

– Using IRA funds to purchase assets for personal use
– Lending money to a business owned by the account holder
– Receiving unreasonable compensation for managing the account’s investments

If a prohibited transaction occurs, the IRA is considered fully distributed as of the first day of the year in which the violation happened. The entire account balance becomes subject to ordinary income tax, and if the account holder is under 59½, the 10% early distribution penalty may apply.

For example, if an individual with a $500,000 IRA improperly uses $50,000 to finance a personal real estate purchase, the entire $500,000 could be treated as taxable income for that year, potentially pushing them into a higher tax bracket.

Invalid Rollover Consequences

Rolling over funds from one retirement account to another can be tax-free if done correctly, but mistakes can lead to unexpected tax liabilities. Rollovers typically occur when transferring funds between IRAs or from an employer-sponsored plan, such as a 401(k), to an IRA. The IRS allows two primary types of rollovers: direct and indirect.

Direct rollovers, where funds move between financial institutions, avoid tax complications. Indirect rollovers, where the account holder receives the funds before redepositing them, introduce risks if not handled properly.

One common mistake is failing to complete an indirect rollover within 60 days. If funds are not redeposited in time, the entire amount is treated as a taxable distribution.

For example, if an individual withdraws $50,000 from a 401(k) and fails to redeposit it within 60 days, that amount becomes taxable income. If they are under 59½, an additional 10% early withdrawal penalty may apply.

Another mistake is attempting multiple rollovers within a 12-month period. The IRS allows only one indirect IRA-to-IRA rollover per year. Violating this rule results in the second rollover being classified as a taxable distribution.

Employer-sponsored plans add complexity. If a participant receives a distribution from a 401(k), the plan administrator must withhold 20% for federal taxes. To complete a full rollover, the individual must deposit the entire distribution amount, including the withheld portion, using other funds.

For example, if someone receives a $100,000 distribution, they will only receive $80,000 after withholding. To avoid taxation, they must contribute the full $100,000 to a new retirement account within 60 days, covering the withheld $20,000 out of pocket. If they only deposit $80,000, the remaining $20,000 is taxed as income and may be subject to the early withdrawal penalty.