IRA Taxes: Rules to Know and Understand

Individual Retirement Accounts (IRAs) can be a great way to save for retirement because of the tax benefits they can provide. There are numerous types of IRAs you can contribute to, each with their own pros and cons. The most common are the traditional IRA, which can offer an up-front tax deduction and defer taxes until you withdraw funds, and the Roth IRA, which allows you to contribute after-tax money in exchange for tax-free distributions down the road.

So, what's the catch with these retirement plans? There are a few IRA tax rules to consider so that you don't run afoul of the IRS and end up paying penalties—or even worse—having your IRA disqualified and the entire account being taxed.

Ignorance 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 are some of the more common pitfalls, divided into five categories:

1. Contribution and income limits
2. Investment and transaction rules
3. Withdrawal rules 
4. Rollover and conversion rules
5. Estate and inheritance rules

Keep in mind, this discussion covers taxes and penalties at the federal level only—states differ on how they handle retirement income taxes.

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. Contribution limits vary according to the type of IRA you have, and some accounts have income restrictions. For example, high-income earners generally can't directly make Roth IRA contributions, but with careful planning, there are ways you can fund a Roth account if you exceed income limits.

And with SEP IRAs, your compensation—which may include wages, tips, overtime, bonuses, commission, and other forms of payment as determined by your plan—is used to calculate how much you can contribute. If you're self-employed, the contribution limit will be based on your earned income, or net earnings.

Taxpayers who exceed the contribution or income limits for their filing status or account type may be hit with a tax bill. The tax penalty for contributing more than you're allowed is 6% of the excess amount, which you'll owe every year until you take corrective action. For example, if you funded $1,000 more than you were allowed, you would pay $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 additional 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 higher 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).

Though your IRA account may be tax-exempt, unrelated business taxable income (UBTI) generated by assets held in the plan could be taxed on its own. Typically, interest, dividends, capital gains, royalties, and some income are exempt from UBTI. But an IRA could earn UBTI if it has any of the following characteristics:

• Operates a trade or business
• Holds 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

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

Improper use of your traditional IRA account may not only result in taxes, but also your entire IRA could lose its tax-deferred status. Prohibited transactions include:

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

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

You can withdraw funds from your IRA account at any time, but there are restrictions if you want to avoid paying taxes or penalties. Here are some guidelines to follow.

Depending on your needs and goals, rollovers and conversions allow you to transfer money from one IRA account to another. Each method has its own set of rules to follow, so you'll want to move funds correctly to avoid any tax implications.

Generally, if you withdraw money from your IRA before age 59½, you will incur a 10% penalty plus ordinary income tax on the amount attributed to tax-deductible contributions as well as earnings on those contributions. There are some exceptions to the 10% penalty, such as using the funds to pay for unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI), a first-time home purchase (subject to a lifetime limit of $10,000 per individual), and up to $5,000 in birth or adoption expenses.

With a tax-deferred IRA, even if you can avoid the 10% penalty, you'll still pay ordinary income taxes. With a Roth account, you typically can withdraw your contributions at any time, tax-free without penalty, but you could owe both tax and penalties on early withdrawals of any earnings. 

Withdrawing funds from your IRA before retirement means less money in your account and losing out on any potential growth. And remember, because you're limited to how much you can contribute to these accounts annually, you may never be able to make up for the money you take out.

If you're age 73 or older, you generally must take RMDs from your tax-deferred IRAs before December 31 each year. The one exception is the year you turn 73, when you may wait 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 tax-deferred IRA separately, based on the value of the account at the end of the prior year divided by your life expectancy factor, which you can find in IRS Publication 590-B. You can then aggregate the RMDs for each IRA account and take your distribution 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 by the due date, you'll owe a penalty of up to 25% of the amount not taken (plus ordinary income tax, of course).

Take note that RMDs count toward your income, so your distributions could increase your taxes. If you expect to be in a higher tax bracket in retirement, it's worth looking at ways to help reduce your RMD taxes, such as a Roth conversion (see "Converting a traditional IRA to a Roth") or a qualified charitable distribution (QCD).

Make sure your beneficiaries are up to date 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 your sister is listed as the account beneficiary, your daughter may not receive 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" distributions for several years. 

The tax rules surrounding inherited IRAs can be complicated and are in flux, so it's best to talk to a tax professional before making any decisions.

Most of the time, naming your spouse as your IRA's primary beneficiary provides the greatest flexibility. The next best route is to designate a non-spousal beneficiary, such as a child or even your favorite charity. But you also may also choose to make a trust the beneficiary of your IRA. 

Naming a trust as beneficiary can often make sense when your intended heir is a young child or someone who isn't savvy with money, but it could lead to unintended consequences if you're not careful—for example, it could remove your spouse's ability to roll over the IRA into their name to take advantage of IRA ownership rules.

Be sure you have a legitimate reason to designate 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.