How To Avoid Penalties for a Return of IRA Contributions

Individual Retirement Accounts or Agreements (IRAs) are funds that you can create to earn income for retirement savings. Several types of IRAs exist such as Traditional, Roth, SEP and Simple IRAs. Only individual taxpaying citizens can set up Traditional and Roth IRAs. One can contribute 100% of their income as long as it fits within the contribution limit and these contributions are tax detectable depending some certain factors. SEP and Simple IRAs are established by employers. Individuals can use their accounts as useful tax management tools. There are certain rules and stipulations one must abide by when handling and managing your IRA. Here is how to avoid penalties for a return of IRA contributions:

  • Correcting IRA contributions. There is a certain “cap” number to your IRAs. You will have to correct this amount in a timely manner lest you face taxes for going over the specified amount and the interest generated by the surplus amount. Quickly correct this before you are faced with a penalty.
  • How to use the IRA contribution correctly. There a number of ways you can use the amount in your IRA without incurring any fines. If you are paying tuition for a college or higher-education course, you can use the IRA contribution. You are also allowed to use it when buying a home for the first time. Retiring employees who are under a working and functional retirement plan can transfer the amount in their current IRA to another without facing any penalties.
  • Early distribution penalty. If you are less than 59 and a half years old, you have to pay additional taxes for every withdrawal from your IRA, referred to as an early-distribution penalty. Only individuals who fall under certain exemptions are free of this tax but you must have it properly reported by an IRA custodian/trustee. If you fail to do so in the correct manner, you can also face penalties.
  • Penalties on excess contributions. Every year, there is a limit to the total amount of your IRA contributions. This is in place so that individuals do not circumvent the rules and abuse the tax-saving features of the IRA. The surplus amount that is over this limit is referred to as an “excess contribution.” This amount along with any interest it accumulates must be completely withdrawn from the account or else you have to pay a fine.
  • Excess accumulation tax. If you are at the age of 70 and a half years or older, and an owner of a Traditional, SEP or Simple IRA, you have to make Required Minimum Distributions (RMD) from your account. Failure to do so or incomplete RMDs will lead to more taxes.
  • Specific forms to avoid penalties. Form 5329 should be filed if your IRA custodian/trustee fails to correctly file a distribution that is exempt the early-distribution penalty and thus is mistakenly used against you. Form 8606 is used notify the IRS of your nondeductible contributions and distributions.

Avoiding penalties is not that difficult, all you need to do is to follow the rules. It is only in breaking them that you can be fined.


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