How to Avoid an IRA Penalty

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Individual Retirement Arrangements (IRAs) are a great way to save for your retirement. The tax benefits allow the account owner to accumulate far more than would be possible without the tax deferral.  This is true whether you have a traditional IRA, which allows a tax deduction at the time of contribution, or a Roth IRA which allows tax exempt distributions.

However, making mistakes with these accounts can lead to a costly IRA penalty. If you manage your account properly and avoid the below mentioned pitfalls, you will succeed in keeping your retirement savings intact and will continue to benefit all through your working days. Let's look at two of the most common situations that trigger an IRA penalty.

The foremost among these mistakes is taking premature IRA withdrawal. Since IRS intends for all IRA to be used for securing your retirement, they provide a disincentive to take any distributions prior to age 59 1/2 by assessing a 10% IRA penalty. In addition to the penalty, you would also pay income tax (in the case of a traditional IRA) on the early IRA withdrawal.

But there are exceptions to this penalty where the premature withdrawal is permitted and no IRA penalty is assessed. For instance, if you are purchasing your a home and have not owned a home for the past two years, or going for higher education, or have an accident that handicaps you, you will be excused from paying the IRA penalty. You will need to ask a professional tax accountant if you qualify for a penalty-free withdrawal prior to acting.

Another common penalty action is taking a withdrawal from your IRA with the intent on returning those funds in 60 days (i.e. taking advantage of the IRA 60-day rule).  If you fail to do so, it gets expensive as you will have not only the tax to pay but also the 10% penalty prior to age 59 1/2.  The same costs get incurred when you leave employment from a company with a qualified plan and you have the check sent to you for your plan balance and you fail to deposit the funds into a rollover IRA within 60 days.

The last and most expensive IRA penalty is the failure to take a required minimum IRA distribution on time (does not apply to a Roth IRA).  Every year after turning age 70 1/2, you must take a distribution from your traditional IRA by April 1 based on the balance in your IRAs as of the prior December 31.  The penalty is very onerous - 50% of the amount you failed to withdraw.  Say your required distribution was $4000.  You will have a late withdrawal IRA penalty of $2,000 plus you will need to take the withdrawal and pay the income tax. For a taxpayer in the 30% tax bracket, the tax is $4,000 x 30% = $1200.  Some people think that their IRA custodian should notify them or be responsible for this but IRA says the responsibility rests with you, the IRA owner.

Now that you know the three most common types of IRA penalties, put some notes in your daily planner to make sure you don't miss any important dates.

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