Beware of IRA pitfalls

Aug 21, 2012

Individual Retirement Accounts (IRAs) are great for planning your financial future. But if you don't pay attention to the rules, you could find yourself in trouble.

Financial Commentator Greg Heberlein and KPLU's Dave Meyer look at IRA pitfalls to avoid on this week's Money Matters.

The law setting up IRAs for all Americans was passed in 1981. This discussion will focus on traditional IRAs, where the dollars you invest are tax-exempt until you start making withdrawals.  

Roth IRAs are the opposite: the money invested was taxed the year it was earned, but withdrawals from Roth IRAs are tax-exempt.

Both IRAs follow most of the same rules; we'll note exceptions below.

In the next few years, the first Baby Boomers will begin to face the mandatory withdrawal requirement for traditional IRAs that begins at age 70½. If you fail to begin withdrawing when you should, not only will you owe tax on the amount you were supposed to withdraw, but you’ll be required to pay a whopping 50 percent penalty.

Roth IRAs, however, have no mandatory withdrawal requirement.

Often overlooked by IRA holders of any age are a number of twists and turns that can generate additional tax and steep penalties.

If you put something into your IRA that you’re not supposed to, the entire IRA could lose its tax-exempt status. Prohibited transactions include borrowing IRA funds, such as for investing in stocks on margin; selling property to it, and using it as a security for a loan.

If you withdraw cash before age 59½, you will incur a 10 percent penalty and have to pay income tax on the profits earned when the money was in the IRA. 

But there are exceptions. Among them, early withdrawals for a first-time home purchase and college expenses. However, you still have to pay income tax on the amount removed from a traditional IRA.

Also, if you retire before reaching 59½, you can take money out of your IRA, but it must be distributed in substantially equal periodic payments over your life expectancy. You're locked into that payout schedule until the age of 59½ or for 5 years, whichever is longer.

If you put too much into an IRA, or contribute after age 70½, not only will you have to withdraw any excess and the profits made on that IRA investment, but you will have to pay a 6 percent penalty for each year on the overpayment.

There's an exception for Roth IRAs; you're free to keep putting money into them after 70½ because you've already paid tax on the investment.

You may not invest in collectibles, but you may buy US gold coins. If you do put in collectibles, the value will be considered a distribution to you and likely incur a 10 percent penalty.

You are allowed transfers directly from one IRA to another. You may transfer all or part of an IRA account.

You may prefer to have the IRA trustee send the money directly to you. But to avoid penalties, you must deposit the money in another IRA within 60 days. If you don’t, the action is considered a distribution and subject to tax and a penalty. Further, and less advertised, when you receive the money, you must pay 20 percent for income-tax withholding.

You may use IRA funds as a short-term loan. 

As long as you put the money back within 60 days, no penalty will apply. Funds you keep beyond 60 days generally will be considered an early withdrawal subject to tax and 10 percent penalty. Under some complex circumstances, you may not execute a rollover more than once a year.

IRAs are great way to supplement your retirement. Just be sure to pay attention to the rules.

Get the full scoop on IRAs at the IRS website.