Everyone who has a retirement account or 401(k) has one goal on his or her mind, and it is SAVING. However, it is not easy to handle IRAs and 401(k)s, especially if you are poorly informed when it comes to the ins and outs of investing in them. With these retirement plans, certain circumstances and conditions are taxable, and they can change the course of your savings. Not knowing about these tax mistakes can be disastrous, but these mistakes are not unavoidable, and you can even fix some of them after the fact.
Take that minimum distribution
You are not allowed to keep your funds in your Traditional IRA forever. You are only allowed to keep your money in your Traditional IRA until you reach the age of 70½. By the year you turn 70½, you are REQUIRED to start taking minimum distributions on a regular basis. This requirement starts on the year you turn 70½ or on April 1st the following year. Failure to withdraw the required amount of funds will result to 50% excise tax. If you do not withdraw or if you withdraw less than the required minimum amount, you will have a 50% tax on the undistributed balance.
Be sure to make correct contributions
Contributing too much or too little can result in more taxes on your part.
Excess Contributions: Any amount in excess of the allowable contribution, which is $5000 if you are less than 50 yrs. old and $6000 if you are older than 50, or your taxable compensation for the given year, whichever is the lesser of the two will be subjected to 6% tax. This includes your contribution, your spouse’s contribution, or your employer’s contribution. This excess amount (including interests earned) can be withdrawn before the due date of the year’s return to avoid the taxes being imposed on it. However, as long as the excess amount remains in your account after the due date of the year’s return, it is subject to 6% yearly tax.
If you wish to transfer funds from a 401(k) to an IRA, do it through direct transfer from trustee to trustee. Otherwise, rollovers by withdrawing the money and reinvesting it will result to 20% withholding tax since the withdrawn money will be treated as income ,and you will be given only 60 days to reinvest the withdrawn amount.
In a trustee to trustee transfer, you will get no distribution; therefore, it is not taxable.
If you inherit an IRA or if you are the beneficiary of a deceased person’s IRA, it is advisable to stretch the distributions over your life expectancy to defer the tax over time. If you get the distributions in lump sum, then it will be subject to income tax, and a large chunk of the inherited IRA will be lost to tax.
The wrong kind of retirement
A huge investment mistake is investing in the wrong kind of retirement plan. IRAs are taxable, but it will depend on the type of IRA. The traditional IRA is tax-deductible during contributions (sometimes), but the taxes will be imposed once you start getting distributions. The Roth IRA is not tax-deductible, but its distributions are tax-free. To avoid making an investment mistake, it is imperative to study which kind of IRA will suit you better.
The first thing to consider when investing in an IRA is the time when you want to pay your taxes. All IRAs are taxable at one point. You just need to take into consideration your current situation and which one will be best for you.
You can avoid retirement tax mistakes, and there are ways to amend them once committed. If you have made one or some of these mistakes, do not worry, you are not the only one.
Have you made any tax mistakes on your IRA or 401(k) in the past? What steps did you take to amend them?
YFS is owner and author of Your Finances Simplified. He was born and raised in West Philadelphia and is now a financial adviser, IT contractor, landlord, and treasurer of a non-profit. He created his blog partly due to his desire to help people with their finances.