IRAs offer tax benefits for retirement savings, but there are penalties for early withdrawals and excess contributions. Following the rules and keeping careful records can help avoid penalties. Review potential penalties before opening an IRA to ensure contributions can be made without risking early withdrawals.
An individual retirement account (IRA) is a common means of saving for retirement. The benefits of an IRA include tax-deferred or tax-free contributions, which can help an investor save more money in the long run. There are some drawbacks to using an IRA to save for retirement, including several different types of IRA penalties. Understanding the different types of IRA penalties can help you avoid losing valuable savings through accidents or accounting errors.
Since IRAs are intended to fund retirement, there are usually early withdrawal penalties if the money is withdrawn before the account holder has reached a certain age, typically 59.5. Almost all IRA systems have an early withdrawal penalty, usually about 10% of the amount withdrawn. There are several exceptions to these IRA penalties, including the use of withdrawn funds for unreimbursed medical expenses, higher education, first-time home purchase, or in the event of the account holder’s death or permanent disability.
Some IRA accounts, such as the popular Roth IRA, are subject to IRA penalties known as five-year rules. This means that an account must be funded for five years before the withdrawal can be made without penalty, even if the account holder is over the minimum age for a penalty-free withdrawal. Essentially, this prevents a person from opening an IRA at age 58 and withdrawing the money without penalty at the minimum age of 59.5.
Some IRAs are income-linked, which means there is a maximum contribution per year based on the account holder’s income level and age. IRA penalties may be incurred if contributions exceed the maximum limit in any given year. It’s easy to accidentally incur this penalty if income levels rise mid-year. Since maximum contribution levels drop to zero for high earners, an accidental overcontribution can occur before the change in income occurs. The usual penalty for an excess contribution is a 6% annual tax on the excess amount.
Avoiding IRA penalties is usually a matter of following the rules and keeping careful account records. As long as a withdrawal meets the age requirement and the five-year requirement, it is extremely unlikely that you will incur penalties. Before choosing to open an IRA, it’s important to review all potential penalties and make sure a budget can handle contributions without being in danger of having to access the account early and losing earnings. While an IRA can be a great way to maximize retirement funds, falling victim to penalties can wipe out your rainy day funds very quickly.
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