Retirement accounts can be subject to tax penalties if rules aren’t followed carefully
Learn some of the retirement account mistakes to avoid
Look to limit penalties by understanding contributions, withdrawals, and distributions
Tax penalties usually occur when taxpayers don’t file returns or extensions or make other errors that raise red flags with the Internal Revenue Service (IRS).
But retirement accounts can also be subject to tax penalties if investors make mistakes. Christine Russell, senior manager of retirement and annuities at TD Ameritrade, likens this to Goldilocks and the three bears.
“You have withdrawal penalties for trying to take out your money too quickly when you’re too young. Then you have a penalty if you leave your money in too long when you’re old. So you have to hit that sweet spot to avoid penalties,” she said.
Early Withdrawal Penalties
The premature distribution penalty is 10%, Russell said. That penalty applies when people who are younger than age 59 1/2 take money out of their retirement accounts and spend it. This applies to both traditional Individual Retirement Accounts (IRAs) and 401(k)s. Of course, making a valid rollover is an exception to the 10% penalty tax, so if you do get a payout of 401(k) or IRA benefits, consider the rollover approach.
One way to avoid a 401(k) or IRA withdrawal penalty is simply to leave the money untouched until you reach age 59 1/2. It can be helpful to build a cash emergency fund that you can draw on if required.
But if you still find that you need money from your retirement account before you reach age 59 1/2, there are some exceptions to the penalty rule. With workplace plans such as 401(k)s, people who are at least age 55 and quit their jobs—whether or not they’re starting new jobs—can spend 401(k) money and avoid the 10% withdrawal penalty. But to qualify, you have to be at least age 55 before ending your employment. Plus, you may still owe income taxes on your withdrawal, so plan accordingly.
Note: This exception does not apply to IRAs.
If you’re still working, some 401(k)s allow “in-service” withdrawals, but the 10% penalty applies up until age 59 1/2.
Another way to tap into your 401(k) is to take a plan loan. If you take a loan from your 401(k), you need to start repaying that loan at least quarterly (plus interest) to avoid the 401(k) withdrawal penalty, Russell said. You’ll pay your own account back with the interest. Many workplaces automatically deduct loan repayments from paychecks to help folks avoid that 10% premature penalty, Russell added. Employees who leave their companies while an outstanding 401(k) loan is due need to repay the loans in full if they are under age 59 1/2. Otherwise, they’re subject to the penalty plus any taxes owed on the money not repaid.
Note: IRAs do not allow investors to take loans.
Small business owners who have their own plans—such as a solo 401(k) or a profit-sharing plan—and take loans must also pay those back, Russell said. It’s particularly important that small business owners pay back loans, because not only are they subject to the 10% penalty, “but their whole plan could become disqualified, which means all their plan assets, not just the loan, are subject to taxation,” she said.
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For IRA plans, there are some additional exceptions to the 10% premature penalty, including certain higher education expenses and first-time home purchases. Both 401(k) and IRA distributions avoid the 10% penalty if the account owner meets the disability exception, but be careful. Proof of disability goes beyond obtaining Social Security disability payments. Other retirement account penalty exceptions also exist.
To report an early withdrawal, look for the tax forms from account custodians. The withdrawal will be reported on a 1099-R tax form, which goes out by the end of January for the previous tax year. The form will have codes that flag it as a premature distribution. Individuals should enter the information on their tax forms and file Form 5329 to report the penalty.
Correcting Excess Contributions
Did you accidentally put a little too much in your retirement account? That’s called an excess contribution, and the penalty is 6%. But the good news is you can correct an excess contribution without facing tax penalties, Russell said.
Contact your IRA custodian with the amount of the excess contribution you made. Filers have until the extension filing date to correct an IRA excess—usually October 15. However, Russell said, you also need to take out the earnings on that excess contribution. Custodians can usually calculate that for you. You’ll owe a 10% premature distribution penalty on the earnings if you are under age 59 1/2. If you don’t correct the excess, the 6% penalty applies each year you miss the deadline until it’s fixed.
April 15 is the deadline to correct a 401(k) excess. The 401(k) limit for 2019 is $19,000 for those under age 50. It’s possible to contribute to multiple 401(k)s if you switch jobs or work two jobs; if you contribute more than $19,000 in a year, it’s called an excess deferral. Contact your 401(k) service provider or your HR department to let them know and get assistance correcting the excess deferral. Any earnings will be taxed but not subject to the 10% premature penalty. Note that all deferral plans are included in the $19,000 limit, including the SIMPLE IRA, individual or solo 401(k), and SARSEP (a specific SEP IRA).
If you don’t correct your 401(k) excess deferral by April 15, the excess deferral will be subject to double taxation, both in the year contributed and the year it’s finally withdrawn. It will also be subject to the 10% premature penalty if you’re under age 59 1/2. The earnings on the excess deferral are taxable in the year withdrawn.
Required Minimum Distributions
Given the tax advantages of IRAs and 401(k)s, it’s no surprise that some people delay making withdrawals from their accounts for as long as possible. Retirees can wait until they’re 70 1/2 to start taking their required minimum distributions (RMDs), and they can even wait until April 1 of the following year. People who are still working at age 70 1/2 and have an employer-sponsored work plan like a 401(k) can delay RMDs until they actually stop working. (That exception doesn’t apply to business owners.)
Penalties for not taking RMDs are stiff, at 50% of the missed withdrawal amount, Russell said.
Traditional IRA owners need to take their RMDs at age 70 1/2 regardless of work status to avoid an IRA withdrawal penalty, Russell said. They can put off taking their initial RMD until the following April, but they still need to take funds for the current year. For example, people who turn 70 1/2 in 2018 can delay the first RMD until April 1, 2019, but they need to take a second RMD by December 31, 2019 to avoid paying a penalty.
“By waiting, people end up doubling up. So that could double up your tax bite as well and put you into a higher tax bracket. The year you turn 70 1/2, you might want to seriously consider not waiting until April,” Russell said.