Individual Retirement Arrangements (IRAs) can be a great way to save for retirement because of the tax benefits they may provide. If you're eligible, you can choose a traditional IRA for an up-front tax deduction and defer paying taxes until you take withdrawals in the future. Or if eligible, you might opt for a Roth IRA and contribute after-tax money in exchange for tax-free distributions down the road.
If you run afoul of some of the IRS rules surrounding these accounts, the penalties can be quite stiff—all the way up to a disqualification and taxation of your entire account if you're not careful. Ignorance of the law is no excuse, and with very few exceptions the IRS isn't forgiving of mistakes. These mistakes fall into the categories of contributions, withdrawals and estate planning, which we will discuss in separate articles.
These are the common IRA mistakes that occur related to withdrawals:
If you withdraw money from your IRA before age 59½, you will incur a 10% penalty plus ordinary income tax on the amount attributable to previously deductible contributions and earnings. There are some exceptions to this rule under Internal Revenue Code (IRC) section 72 (see IRS Publication 590), including:
• Disability or death of the IRA owner
• Withdrawals that constitute a series of "substantially equal periodic payments" made over the life expectancy of the IRA owner
• Withdrawals used to pay for unreimbursed medical expenses that exceed 7½% of AGI
• Withdrawals used for a first-time home purchase (subject to a lifetime limit of $10,000)
• Withdrawals used to pay for the qualified higher-education expenses of the IRA owner and eligible family members
Even if you can avoid the 10% penalty, you will still pay tax. More importantly, you will be leaving less money to work for your retirement account because you will lose out on any future potential deferred compounding. Remember, you can only contribute so much to these accounts annually, so you may never be able to make up for the lost ground.