How to Avoid These Common IRA Withdrawal and Contribution Errors

If funding retirement were easy, everyone would be doing it, right? Actually, funding retirement can seem easier than withdrawing your money. There are rules for both, and if you happen to make a mistake, you will have to pay penalties and fees to the government–after you determine how to resolve the issue at hand.

Let’s discuss some of the most common IRA contribution errors and how to avoid them. Then, we’ll discuss some of the most common IRA withdrawal errors, and how you can prevent them.

Excess Contributions

Unlike the stock market, there are caps on the amount of money you can contribute to your IRA each year.

For 2019, the total amount you can contribute to all your IRA accounts (doesn’t matter if it’s a traditional or Roth) is $6,000. This amount is an increase from the $5,500 level over the past few years. If you are 50 or older, you can contribute an additional $1,000 to catch up. Are you 70 ½ or older? You can no longer contribute to a traditional IRA but can contribute to a Roth IRA.

If you make less than the contribution amount this year, you can only contribute up to the amount you make.

What can you do if you realize that you have contributed excess funds?

• Prior to the due date of your tax return (typically April 15 of the following year, plus any extensions), withdraw all of the excess from the IRA.
• If there was any income earned on that amount, you will also have to withdraw this amount.

If you don’t do either of these, you’ll be taxed at 6 percent on the excess amount each year that you do not withdraw from your IRA account.

Roth vs. IRA Contributions

For many reasons, Roth and traditional IRAs are not created equal. One common error that people make is contributing to their Roth without realizing there is an income cap on contributions.

Here is the breakdown for the 2019 tax year based on modified adjusted gross income (MAGI):

• Single filer—$122,000
• Married filing jointly—$203,000 (with a reduced amount from $193,000 to the cap)
• Married filing separately—dependent on whether you lived with your spouse during the tax year or not
  • If you did not live with your spouse—$137,000 with a reduced amount from $122,000
  • If you did live with your spouse—a reduced amount from $10,000 to the cap

So, what can you do if you exceeded the contribution cap? Here are some options:

• Withdraw prior to filing your 2019 tax return
• Withdraw prior to October 15, 2020—you will likely have to file an amended return if you already filed, and you may have to amend your state return as well
• Withdraw and re-contribute the amount to the following tax year—if you do this, you’ll have to remember that your contribution limit is further capped by that amount next year
• Recharacterize the contribution from your Roth to your traditional IRA
• Do nothing and pay the 6% excise tax mentioned above

Required Minimum Distributions

Once you reach age 70 ½, you must start withdrawing a minimum portion of your traditional, simplified employee pension (SEP), or savings incentive match plan for employees (SIMPLE) IRAs. This amount is called a required minimum distribution, or RMD.

Worksheets are provided by the IRS and must be calculated each year for each account that you have. This does not include Roth IRAs.

For information on RMDs and how to avoid errors, you can read more here.

Pledged IRAs

You don’t hear about this type of distribution often, but some banks will allow you to pledge (or collateralize) some of your IRA for a loan.

Be very wary of this approach for a few reasons:

• It’s treated as a withdrawal, which means
  • You’ll owe federal income taxes on the withdrawal amount if it’s not a Roth
  • If you are under 59 ½, you’ll owe a 10 percent early withdrawal penalty

Plus, you’ll have to pay interest on the loan on top of the penalty and taxes.

What’s the best way to avoid this error? Don’t make it in the first place.

Beneficiaries

You can name almost anyone a beneficiary of your IRA account(s). Choose wisely, because the beneficiary will have to navigate the IRS and ensure they don’t make one of these mistakes.

If you inherit an IRA, you cannot contribute to it. If you mistakenly contribute to the inherited account instead of your own, you then make the entire amount taxable. That means you’ll likely have a huge tax bill due for that tax year.

If you fail to title the inherited IRA appropriately, you can fall victim to the same scenario above and have the full amount become taxable.

If you are a non-spouse beneficiary, you cannot do an indirect rollover of the account from which the money is withdrawn and then deposit into another IRA within 60 days to avoid taxes and penalties. Instead, you have to do a direct rollover. If you access the money via withdrawal, be prepared to pay taxes on the entire IRA value.

You also need to be sure you take RMDs at the appropriate time, which is not always when the original owner would have been 70 ½. When you inherit an IRA, RMDs are usually required the year following the original owner’s death.

Prohibited Transactions

There are certain transactions that may be prohibited in an IRA account. This extends not only to the owner, but the family, beneficiary, and fiduciary.

Prohibited transactions can include the following:

• Selling property to the IRA
• Borrowing money from the account
• Using it as collateral for a loan (see above)
• Using funds to purchase personal property

If a prohibited transaction is found, the account will cease to be an IRA as of January 1 of that year, and the money will be considered taxable income.

Avoid the Early Withdrawal Penalty

If you plan to withdraw funds prior to turning 59 ½, there are a few ways to avoid the 10 percent withdrawal penalty. You can use the funds for any of the following reasons:

• Health insurance premiums
• Medical expenses
• First home purchase
• Funding college
• Military service
• Disability
• Rollover to qualified account

The RMD Waiver

If you are requesting a waiver and/or paying a penalty for a forgotten RMD, you will have to complete IRS Form 5329 to attach to your tax return. Each person’s circumstances may be different, and the instructions for filling out the form according to each situation can be found here.

If you are requesting a waiver, then you must send a letter of explanation along with your tax return and the completed form. It’s important to know the most common IRA contribution errors and how to resolve them.