IRA Taxes: Rules to Know and Understand (2024)

Individual Retirement Accounts (IRAs) can be a great way to save for retirement because of the tax benefits they can provide. Traditional IRAs offer an up-front tax deduction and defer taxes until you withdraw funds. Roth IRAs allow you to contribute after-tax money in exchange for tax-free distributions down the road.

So, what's the catch? There are a few. If you run afoul of some of the IRS rules surrounding these accounts, the penalties can be quite stiff—all the way up to a disqualification and taxation of your entire account.

Ignorance of the law is no excuse, and with few exceptions, the IRS isn't very forgiving of mistakes. Knowing the rules can help you navigate potential IRA tax traps you might encounter on your way to retirement.

Here we'll cover some of the more common pitfalls, divided into three major categories:

1. Contributions and investments
2. Withdrawals
3. Estate planning

Keep in mind that when we discuss taxes and penalties, we're referring to those at the federal level. In most states, you will also face ordinary state taxes and may incur additional state penalties.

While you'll want to save as much as you can for your retirement, you don't want to contribute more than you're allowed. If you exceed the contribution or income limits for your filing status, the penalty is 6% of the excess amount for each year until you take corrective action. For example, if you funded $1,000 more than you were allowed, you would owe $60 each year until you fix this mistake. To do that, you have two options:

• Withdraw the excess amount, plus any earnings specifically tied to the contribution, by the due date (plus extension) of your tax return for the year you contributed.
• Leave the excess contribution alone. You might choose to do this if the amount of the 6% penalty isn't worth the hassle of fixing it or if your contribution has increased in value so much that the tax on the earnings (plus the 10% penalty for early withdrawal) would be worse than paying the penalty. In that case, you would pay the 6% penalty for one year, and then count the excess as a deemed contribution in the next year (assuming you're eligible to make a contribution at that point).

If you personally manage and invest your own retirement money through a self-directed IRA, be aware that IRA rules prohibit investing in collectibles, which include artwork, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, and certain other tangible personal property. Any amount you invest in collectibles will be considered a distribution in the year invested, subjecting you to taxes and a 10% penalty if the premature distribution rules apply.

However, you can invest IRA contributions in coins minted by the U.S. Treasury Department that contain one ounce of silver or gold or one-half, one-quarter, or one-tenth of an ounce of gold. You can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion. Likewise, owning real estate directly in an IRA isn't prohibited, but you could find yourself engaged in a prohibited transaction if you're not extremely careful.

If you want to invest in precious metals or real estate in your IRA, then a mutual fund or exchange-traded fund (ETF) may be a better choice (although you might be subject to unrelated business taxable income, or UBTI). But if the ETF or mutual fund ever makes an in-kind distribution of a prohibited investment—for example, gold bullion that doesn't meet the Treasury's definition of allowable investments—you'll be subject to the prohibited investment rules. Be sure to check with your fund provider for details on any past distributions.

Interest income, dividends, capital gains, and profits from options transactions are exempt from UBTI, but an IRA could earn UBTI if it has any of the following characteristics:

• Operates a trade or business
• Has certain types of rental income
• Receives certain types of passive income from a business it controls or from a pass-through entity such as a partnership that conducts a business (for example, master limited partnerships and real estate partnerships)
• Uses debt to finance investments

If your IRA earns UBTI exceeding $1,000, you must pay taxes on that income. Your IRA might be required to file IRS Forms 990-T or 990-W and pay estimated income taxes during the year. And in the case of a traditional IRA, UBTI results in double taxation because you have to pay tax on the UBTI in the year it occurs and the year you take a distribution.

Regardless of what you invest in, you should avoid prohibited transactions since they could cause your entire IRA to lose its tax-deferred status. Prohibited transactions include these:

• Borrowing money from your IRA (for example, treating it as a margin account)
• Selling property to it
• Using it as security for a loan
• Using IRA funds to buy property for personal use (not including the first-time home buyer exemption)

If you engage in a prohibited transaction, your entire account stops being an IRA as of January 1 of that year, and the IRS treats the transaction as a taxable distribution of all assets based on fair market value on the first of the year.

If you need to move funds from one IRA into another, you can perform a rollover. However, when you take receipt of the money yourself, you face a number of restrictions.

First, you have 60 days to redeposit the funds into the same or another IRA or else it counts as a taxable distribution. In addition, you're allowed only one such "rollover" each year. If you deposit the funds into another IRA and then attempt another rollover within 12 months, you'll owe taxes on the withdrawal. Also, be aware that any transaction resulting in a taxable IRA distribution could be subject to a 10% penalty if you're under the age of 59½.

One other thing to keep in mind is that rollover funds could be subject to withholding. You'll get the withholding back when you file your tax return (assuming you don't violate rollover rules), but in the meantime, you have to come up with 100% of the distribution amount in 60 days.

If you need to switch custodians, play it safe and stick to a direct (trustee-to-trustee) transfer. With this method, the current custodian issues a check made payable to the new trustee and sends it directly to you to forward to the new financial institution. Unlike rollovers, you can make unlimited direct transfers of your IRA funds.

Converting from a traditional IRA to a Roth IRA might make sense if you think you'll be in a higher tax bracket when you begin taking withdrawals, you can pay the conversion tax from outside sources, and you have a reasonably long time horizon for the assets to potentially grow. However, even if you meet these basic criteria, you should consider the following potential conversion traps:

• Hidden taxes: Funds from a Roth conversion could not only impact your marginal ordinary income tax, but also, depending on your modified adjusted gross income (MAGI) before converting, the additional income could have other implications:
  • Increase taxes on Social Security benefits
  • Trigger the alternative minimum tax (AMT)
  • Phase out exemptions, deductions, or other tax breaks
  • Affect financial aid eligibility because of a higher AGI
• Aggregation rule for partial conversions involving after-tax money: If you've ever made nondeductible contributions to your traditional IRA (tracked via IRS Form 8606), you can't pick and choose which portion of the traditional IRA money you want to convert to a Roth. When it comes to distributions, the IRS looks at traditional IRA balances in aggregate, so the amount converted consists of a prorated portion of taxable and nontaxable money.
• Failure to first take required minimum distributions (RMDs), if applicable: You can't avoid taking RMDs by converting funds from a traditional IRA to a Roth IRA.
• Premature withdrawal penalty: If you're under 59½, you'll pay a 10% penalty if you withdraw funds to pay the conversion tax. Also, even though withdrawals of regular contributions made to a Roth IRA are normally penalty free, you can't convert from a traditional IRA to a Roth in order to avoid the premature withdrawal penalty (unless you wait at least five years or reach age 59½, whichever happens sooner).

If you're considering a Roth IRA conversion, you can potentially reduce your tax burden with careful planning.

Generally, if you withdraw money from your IRA before age 59½, you will incur a 10% penalty plus ordinary income tax on the amount attributable to previously deductible contributions and earnings. There are some exceptions to this rule, such as using the funds to pay for unreimbursed medical expenses that exceed 7.5% of your AGI, a first-time home purchase (subject to a lifetime limit of $10,000), or qualified higher-education expenses for yourself or eligible family members.

Even if you can avoid the 10% penalty, you will still pay ordinary taxes, and more importantly, you'll have less money in your retirement account and lose out on any potential tax-deferred growth. Remember, there are limits to how much you can contribute to these accounts annually, and you may never be able to make up for the money you withdraw.

If you're age 73 or older, you generally must take RMDs from your traditional IRA before December 31 each year. The one exception is the year you turn 73, when you have the option of waiting until April 1 of the following year to take your initial distribution. Delaying, however, means you'll have to take two RMDs that year, which could bump you into a higher tax bracket.

For Roth IRAs, original owners are exempt from RMD rules, but beneficiaries who inherit a Roth are generally required to take distributions. (See "Designating a beneficiary for your IRA.")

The IRS requires that you calculate the RMD for each IRA separately, based on the value of the account at the end of the prior year divided by your life expectancy factor (taken from the appropriate table in IRS Publication 590-B). However, once you've calculated your RMD for each traditional IRA account, you can aggregate the total and take it from one or multiple IRAs in any combination, as long as you withdraw the total amount required. If you fail to take your total RMD, you'll owe a penalty of up to 25% of the amount not taken (plus ordinary income tax, of course).

Make sure you have up-to-date beneficiaries on your IRA accounts, since these assignments supersede a will. For example, if your will states that your IRA is to go to your daughter but you have your sister listed on your IRA account as the beneficiary, your daughter may not get the funds.

Beyond that, beneficiaries need to be careful about how and when they access inherited IRA funds. As a general rule, beneficiaries should defer withdrawals for as long as the law allows to avoid taxes or giving up potential tax-deferred growth. Eligible beneficiaries may also be able to "stretch out" the IRA distributions for several years.

Tax rules surrounding inherited IRAs can be complicated and are in flux, so talk to a tax professional for taking any action.

Most of the time, naming your spouse as your IRA's primary beneficiary provides the greatest flexibility. The next best route is to name a non-spouse beneficiary, such as a child or even your favorite charity.

In a few cases, it does make sense to name a trust as the beneficiary of your IRA—for instance, if the intended beneficiary is a young child or someone who is not savvy with money. But naming a trust as beneficiary can lead to all kinds of unintended consequences if you're not careful. For example, naming a trust instead of a spouse as beneficiary removes the surviving spouse's ability to roll over the IRA into his or her name to take advantage of the IRA ownership rules.

Be sure you have a legitimate reason to name a trust as beneficiary, and then only do so after you consult with an independent and objective tax and estate expert working in conjunction with your financial advisors and account providers.