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Many of the best retirement saving strategies use employer-sponsored retirement plans like a 401(k), or individual plans like an IRA or Roth IRA. These retirement savings vehicles provide credit protections, preferential tax treatment to the investments, and in some cases, sizable tax deductions for contributions.
For instance, when you save in a 401(k), you can do so pre-tax, and allow for up to $19,000 of salary deferral into the plan in 2019 and $19,500 in 2020. This amount is fully deductible and not included in your taxable income. Additionally, employer contributions to your 401(k) aren’t included in your taxable income.
You make pre-tax contributions to traditional IRAs and pay taxes on withdrawals. The tax treatment is a bit different, but still powerful, for a Roth IRA. They’re funded with after-tax money, so investments can grow tax-deferred and if certain requirements are met, contributions and gains are distributed income tax free.
The government wants you to use the money in these accounts for retirement, and therefore imposes a number of account contribution limits and restrictions so people can’t shelter hundreds of millions of dollars from taxes with no real plan to save for retirement. Eventually, the government also wants to earn taxes on these tax-deferred investments and savings. They can apply penalty taxes to your retirement funds, if you’re not careful about how you contribute or withdraw.
Let’s take a closer look at the three main retirement-related penalty taxes and how to avoid them.
1. Excess Contribution Penalty of 6%
If you have an excess contribution to an IRA, you’ll owe a 6% penalty tax on the excess each year it remains in the account. Traditional and Roth IRAs have restrictions to prevent over-contributing.
For Roth IRAs, your income dictates your ability to make direct contributions.
With traditional IRAs, the contribution rules are a bit more complex. Before the passage of the SECURE Act, you had to be under age 70.5 and have earned income of at least the amount you want to contribute, up to $6,000 if under age 50, and up to $7,000 over age 50. After the passage of the SECURE Act, you can now contribute to an IRA at any age as long as you meet the other requirements. However, the first year in which someone over age 70.5 can contribute directly to an IRA is for income earned in 2020, not 2019. To better understand some additional impacts of the SECURE Act check out this calculator.
So while you can contribute directly to an IRA after age 70.5, you can still phase-out of a deductible IRA contribution based on your filing status, participation in an employer-sponsored retirement plan and your income levels. Additionally, you can have excess contributions from rolling over an ineligible rollover amount, rolling over a required minimum distribution (RMD), or contributing more than the annual allotted amount.
The first thing to do before putting money into a retirement account is to make sure you meet the contribution requirements. But sometimes you make mistakes or forget you already contributed for the current year. What happens when you overcontribute?
Let’s say you contribute $6,000 to a Roth IRA in 2019, but earn too much money to be legally allowed to contribute. At this point you have a few options. The simplest option is to withdraw the money. What you need to withdraw depends on when you catch your mistake. If you withdraw money before your taxes are due, you won’t owe the 6% excise penalty, but you could owe a 10% penalty on taxable gains.
If you withdraw the money after your tax filing deadline – which is April 15, or Oct. 15 including extensions – you have to pull out the principal contribution but not any earnings attributed to the excess contribution. At this point, you owe the 6% excise tax for at least the first year and then each year it stays.
It’s possible in some cases you might owe a 10% penalty tax on the excise if your aggregate contributions for the excess year exceeded the annual contribution limit set for IRAs. However, you won’t have to withdraw any investment gain or pay penalty taxes on the excess.
Another option is to leave the contribution and carry forward the excess into a year when you can make the contribution. However, you will owe the 6% each year until you fix it, or you can use it up as a contribution in another year. This isn’t the best strategy since you’re being penalized for saving.
As a final option, you can recharacterize a contribution to a Roth up until Oct. 15 of the year after the year you put the money in the account. If you funded a Roth in 2019 with $6,000, but were ineligible because you earned too much money, you could recharacterize your contribution to a traditional IRA as a deductible or non-deductible contribution up until Oct. 15, 2020. This helps you avoid the penalty tax and still save for retirement. You’d need to make sure you’re eligible to save in an IRA, either as a non-deductible or deductible contribution.
2. 10% Penalty For Early Withdrawals
Perhaps the most well-known penalty tax that applies to retirement accounts is the 72(t) 10% penalty tax for early withdrawals. This penalty tax applies to taxable distributions from most tax-advantaged retirement accounts if the distribution is taken before the account owner reaches age 59.5. The idea behind this penalty is to help keep money in the retirement plan.
As an example, if you withdraw money from your 401(k) as a taxable distribution to pay for college education expenses when you’re 45, you will likely owe ordinary income taxes on the distribution plus an additional 10% on the withdrawal. This can be a huge tax hit and deplete your savings if you aren’t careful.
That being said, a number of exceptions allow you to take early distributions prior to age 59.5 and not owe the additional 10% penalty. For instance, death of the account owner and disability both get you out of the penalty tax. For IRAs, that includes traditional, Roth, SEPs and SIMPLEs. You can withdraw up to $10,000 of taxable distributions for first-time homebuying expenses without being subject to the 10% penalty tax.
The 10% exceptions are not the same for 401(k)s and IRAs. You can withdraw money from an IRA to pay for college education expenses, but you can’t use a 401(k) for the same use and avoid the 10% penalty. You can withdraw money from a 401(k) or other employer-sponsored qualified retirement plan if you separate from service with your employer in the year you reach age 55 or later. This means if you retired at age 56, you could take money directly from your 401(k) and avoid the 10% penalty tax, instead of having to wait until age 59.5. However, if you rolled over the 401(k) to an IRA when you retired at 56, you would then be required to wait until 59.5 before you could withdraw from the IRA and avoid the 10% penalty.
Finally, there’s a strategy and exception to the 10% penalty tax called substantially equal periodic payments. This allows someone of any age to withdraw money penalty-tax-free from a 401(k) or IRA as long as they do so with substantially equal periodic payments that last 5 years or until you’re age 59.5. This is like creating an annuity or close to equal cash flow distribution annually from your account.
If you started at age 40, you’d have to keep taking annual payments through age 59.5, nearly 20 years. However, if you started at age 57, you’d have to take annual payments for five years, or until age 62. The calculation and rules around SEPP are complex, so make sure you consult a qualified financial advisor and tax professional before engaging in such a strategy.
3. 50% Penalty Tax For Missed RMDs
IRAs, 401(k)s and other tax-deferred retirement accounts are subject to something called required minimum distributions (RMDs) after the owner reaches age 72, for those that have not already reached age 70.5 by the end of 2019. Again, the SECURE Act dramatically impacted when RMDs must begin. To better understand the impact, read this Forbes article. Roth IRAs aren’t subject to the same RMD rules while the owner is alive, but heirs of the Roth IRA are subject to the same RMD rules as IRA and 401(k) heirs.
After you reach age 72, you owe an RMD for that year. Let’s say you reach age 72 in 2021. That means you owe an RMD from your IRA for 2021. You take the account balance of the IRA at Dec. 31 of the previous year and divide it by the appropriate IRS factor to determine the amount you need to take out. Typically, this distribution, if from an IRA or 401(k), is taxable as ordinary income.
For the first year of RMDs, the first distribution must be out by April 1 the following year. In our example, that date is April 1, 2022. However, there will be a second RMD due for 2022 by Dec. 31, 2022. If you push the first year RMD to the following year, don’t forget you’ll likely have two taxable distributions due that year.
However, if you fail to take your timely RMD, you’re liable for a 50% penalty tax on the amount of the RMD not received. The IRS has rolled out self-correction and reporting systems to help fix missed RMDs. Typically, it’s advisable to fix the missed RMDs by pulling them out and self-reporting into the IRS system. Since the RMD penalty is so large, you want to be sure you understand all of the RMD rules and take the correct RMD each year.
Remember, the penalty tax is on top of ordinary income taxes, which are also likely to be owed on any taxable portion of the RMD. If you miss an RMD with a defined contribution plan like a 401(k), you will also need to distribute any interest or earnings on the RMD that you missed to correct the issue. You can also ask the IRS to waive the RMD on Form 5329 if there was reasonable cause for missing the RMD. For a deeper dive into RMDs, read this article.
Your retirement funds are yours, so don’t let these penalty taxes reduce the amount of money you have to support your lifestyle and spending needs. Missed RMDs, excess contributions and the early withdrawal penalty tax can be extremely painful and cost you a lot of money in taxes if you are not careful. When planning for retirement and around penalty taxes make sure you do so in coordination with your long-term financial planning goals. In many cases, it’s advisable to speak with a qualified financial planning professional and tax professional about your specific situation.