Retirement Funds and Early Withdrawal Penalties

We would like to caution you to fully understand
your year's tax situation to determine whether
or not you are allowed to make a contribution
to a retirement fund.
 


Making the decision to put money into a retirement fund is a personal choice.  In our office we are frequently asked our opinion and we usually opt out of helping our clients except when we are asked to assist in providing straight forward tax advice.  We don’t consider ourselves financial advisors and don’t want to be placed into the position of providing that type of advice.  Nor do we pretend to be life coaches entitled to tell you how to handle your available income. 

But as we get older, or simply more mature, the idea of investing for our future becomes more and more appropriate.  As a result, the tax implications of placing your money into an IRA, either a Roth or a Standard IRA is a question we are asked about quite frequently. 

Just as frequently we get asked about taking the money out of these accounts by people who find themselves in a bind financially and need to know what the cost will be if they make early withdrawals from their retirement accounts.

WARNING:

Before we get into these answers, and the possible costs of the early withdrawal of these funds, we would like to caution you to fully understand your year's tax situation to determine whether or not you are allowed to make a contribution to a retirement fund. 

As you read below you will learn that there are income restrictions (when you make too much money) and sometimes marriage considerations, placed upon whether or not you can contribute to an IRA of any kind.  All too often a bank or other financial institution will be all too happy to take your money without learning all of your personal information they should before they open an account.  When this happens it can put you in the position of having to pay an "Excess Contribution Tax."  

Tax on excess IRA contributions

An excess IRA contribution occurs if you:

  • Contribute more than the contribution limit.
  • Make a regular IRA contribution to a traditional IRA at age 70 or older.
  • Make an improper rollover contribution to an IRA.

Excess contributions are taxed at 6% per year as long as the excess amounts remain in the IRA. The tax can’t be more than 6% of the combined value of all your IRAs as of the end of the tax year.

We urge you to delay placing money into a retirement fund until you are sure of the possible tax implications.  We suggest meeting with us and having the bulk of your tax return prepared so you can be sure if such a contribution is allowed, especially if this is your first time making a contribution.  We have no problem in setting up a second meeting with you to accommodate the financial arrangements you may subsequently make with your financial institution.  you always have until April 15th to make your contribution, even if it is for the prior year.

First, what’s the difference between a Roth IRA and a Standard IRA? 

The key difference between a Roth IRA and a standard IRA is that the money contributed to a Roth IRA is NOT tax deductible (subtracted from your overall income before you pay taxes) on your return while the money contributed to a standard IRA IS deductible on your tax return (in general—that may be subject to limitations.) 

In other words you are paying taxes on the money you are contributing into a Roth account, but you are not paying taxes on the money you place into a standard IRA account.  The subsequent benefit for you is when you start taking withdrawals out of the Roth account you do NOT have to pay taxes on either the original money placed into the account OR the additional interest the money may have accrued.

This is NOT the case with a standard IRA.  Because you haven’t yet paid the taxes on the money placed into the account, both the original funds AND any interest it has built up is considered taxable by the IRS when the money is taken out and is therefore subject to tax at the rate you are paying at that time.

So how do you choose which type of IRA you should put you money in?  The first step is to speak with an investment expert to make sure you understand everything you should.  But a general rule of thumb has been if you can leave the money in the account for a sufficient time to build up significant interest, you may want to place the money into a Roth account so the interest, along with the principle, is then tax free when you decide to withdraw it when you reach normal retirement age.

If you are older and hopefully you are currently in a higher tax bracket, it may be beneficial to put money into a standard IRA. Yes, there will be less time for interest to build up but you can probably use the tax deduction now.  And when you decide to make use of the money, you will probably be in a lower tax bracket and the money will be taxed at a lower rate than it would be currently.   

Finally you cannot contribute to a standard IRA past the age of 70 and ½ . However, contributions can be made to your Roth IRA after you reach age 70½ and you can leave amounts in your Roth IRA as long as you live.

Individual Retirement Account or “Standard IRA”

An individual retirement account is a trust or custodial account set up in the United States for the exclusive benefit of you or your beneficiaries. The account is created by a written document. The document must show that the account meets all of the following requirements.

  • The trustee or custodian must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee or custodian.

  • The trustee or custodian generally cannot accept contributions of more than the deductible amount for the year. However, rollover contributions and employer contributions to a simplified employee pension (SEP) can be more than this amount.

  • Contributions, except for rollover contributions, must be in cash.

  • You must have a nonforfeitable right to the amount at all times.

  • Money in your account cannot be used to buy a life insurance policy.

  • Assets in your account cannot be combined with other property, except in a common trust fund or common investment fund.

  • You must start receiving distributions by April 1 of the year following the year in which you reach age 70½.

Individual Retirement Annuity

You can open an individual retirement annuity by purchasing an annuity contract or an endowment contract from a life insurance company.
An individual retirement annuity must be issued in your name as the owner, and either you or your beneficiaries who survive you are the only ones who can receive the benefits or payments.

An individual retirement annuity must meet all the following requirements.

  • Your entire interest in the contract must be nonforfeitable.

  • The contract must provide that you cannot transfer any portion of it to any person other than the issuer.

  • There must be flexible premiums so that if your compensation changes, your payment can also change. This provision applies to contracts issued after November 6, 1978.

  • The contract must provide that contributions cannot be more than the deductible amount for an IRA for the year, and that you must use any refunded premiums to pay for future premiums or to buy more benefits before the end of the calendar year after the year in which you receive the refund.

  • Distributions must begin by April 1 of the year following the year in which you reach age 70½.

Deemed IRAs. 

For plan years beginning after 2002, a qualified employer plan (retirement plan) can maintain a separate account or annuity under the plan (a deemed IRA) to receive voluntary employee contributions. If the separate account or annuity otherwise meets the requirements of an IRA, it will be subject only to IRA rules. An employee's account can be treated as a traditional IRA or a Roth IRA. For this purpose, a “qualified employer plan” includes:

  • A qualified pension, profit-sharing, or stock bonus plan (section 401(a) plan),

  • A qualified employee annuity plan (section 403(a) plan),

  • A tax-sheltered annuity plan (section 403(b) plan), and

  • A deferred compensation plan (section 457 plan) maintained by a state, a political subdivision of a state, or an agency or instrumentality of a state or political subdivision of a state.

Designated Roth accounts. 

Designated Roth accounts are separate accounts under 401(k), 403(b), or 457(b) plans that accept elective deferrals that are referred to as Roth contributions. These elective deferrals are included in your income, but qualified distributions from these accounts are not included in your income. Designated Roth accounts are not IRAs and should not be confused with Roth IRAs. Contributions, up to their respective limits, can be made to Roth IRAs and designated Roth accounts according to your eligibility to participate. A contribution to one does not impact your eligibility to contribute to the other. See Publication 575, for more information on designated Roth accounts.

2010 conversions and rollovers to Roth IRAs. 

If you converted or rolled over amounts to your Roth IRAs in 2010 and did not elect to include the entire amount in income in 2010, you must include part of the amount in income for 2011. For information on reporting a 2010 rollover from a qualified employer plan to a Roth IRA, see Publication 575.

What Is a Roth IRA?

A Roth IRA is an individual retirement plan that, except as explained in this chapter, is subject to the rules that apply to a traditional IRA (defined later). It can be either an account or an annuity.

To be a Roth IRA, the account or annuity must be designated as a Roth IRA when it is opened. A deemed IRA can be a Roth IRA, but neither a SEP IRA nor a SIMPLE IRA can be designated as a Roth IRA.

Contributions not reported.   

You do not report Roth IRA contributions on your return.

When Can a Roth IRA Be Opened?

You can open a Roth IRA at any time. However, the time for making contributions for any year is limited.

Can You Contribute to a Roth IRA?

Generally, you can contribute to a Roth IRA if you have taxable compensation (defined later) and your modified AGI (defined later) is less than:

  • $184,000 (up to the limit) and a reduced amount up to $194,000 for married filing jointly or qualifying widow(er),

  • $117,000 (up to the limit) and a reduced amount up to $132,000 for single, head of household, or married filing separately and you did not live with your spouse at any time during the year, and

  • $10,000 for married filing separately and you lived with your spouse at any time during the year.

Can you contribute to a Roth IRA for your spouse?  

You can contribute to a Roth IRA for your spouse provided the contributions satisfy the spousal IRA limit, you file jointly, and your modified AGI is less than $184,000.

Roth IRAs only.   

If contributions are made only to Roth IRAs, your contribution limit generally is the lesser of:

  • $5,500 ($6,500 if you are age 50 or older), or

  • Your taxable compensation.

  However, if your modified AGI is above a certain amount, your contribution limit may be reduced.
 

Roth IRAs and traditional IRAs.  

If contributions are made to both Roth IRAs and traditional IRAs established for your benefit, your contribution limit for Roth IRAs generally is the same as your limit would be if contributions were made only to Roth IRAs, but then reduced by all contributions for the year to all IRAs other than Roth IRAs. Employer contributions under a SEP or SIMPLE IRA plan do not affect this limit.

  This means that your contribution limit is the lesser of:

  • $5,500 ($6,500 if you are age 50 or older) minus all contributions (other than employer contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs, or

  • Your taxable compensation minus all contributions (other than employer contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs.

However, if your modified AGI is above a certain amount, your contribution limit may be reduced.

For actors the biggest issue with contributing to an IRA of any kind is the fluctuation of their income and the need to make use of whatever savings they may have at various times to just pay their bills, let alone for emergencies.  When that time comes the money that sits in IRA accounts look very tempting but withdrawing that money may come at a very high price.  For that reason we urge you to read through the balance of this page and consider these points before you make the choice to invest in IRAs or retirement accounts of any kind without fully thinking it all through.


EARLY WITHDRAWALS

Taking the money out of your 401K or a standard IRA makes that money taxable at the current rate your normal income is taxed at in the given year. 

In addition the retirement account income would be charged with another 10% early withdrawal penalty by the IRS so if you were in the 25% tax bracket you would be losing 35% of the money when you took it out.  That’s just what the IRS would require.

You also have to consider the state will have their share.  If you live in California arguably you could add at least another 7% in normal taxes plus an additional 2 ½% early withdrawal penalty so that would mean approximately another 10%.

The end result is you lose about 45% of the money you withdraw to taxes alone to pay off the credit cards. 

So you should think things through before you pursue the idea of using these funds early.  It is usually a very expensive proposition when you are still out making money. 

The government does allow you to make use of this money without having to pay the early withdrawal penalty for several specific uses such as medical needs, first time home buying or educational tuition.  But you should investigate fully the rules for these allowances before you take out these funds.

One couple who came into the office wanted to use their retirement funds to help pay for their child’s tuition costs in college.  Unfortunately they made so much money they were taxed at the highest rate possible on the income from the withdrawals and then, because of their income level, weren’t allowed to escape the tax penalty (yes, the “wealthy” are often denied the same deductions most other taxpayers are allowed.  You just don’t hear about that quite so often).  In this case the husband just happened to have a great year in his career and they didn’t take that good fortune into their planning when they used the money for the tuition at the start of the year.

They would have been better off borrowing the money at a lower interest rate or even getting a second mortgage against their house which would have then been deductible. 

Many people think this is a good way to pay off high interest credit cards.  It can be but you have to be wise about the process for several years.  For example, if the cards were paid off and you were able to save monthly payments of $1,000 a month as a result, of which well more than 50% would be in wasted interest payments on the cards anyway, AND you put that money back into a savings plan each month for many years to come, then arguably you could come out way ahead in the end.


Before all of this discourages you from investing in retirement funds completely, you need to understand that these funds are established for the income to be withdrawn when you are no longer making significant income and you are therefore in a lower tax bracket.  Once you retire, because of the reduced income most people are taxed at just the 15% bracket and if you are over 59 and ½ you can take out these funds without paying the early withdrawal penalty. 


2017